Brunner, E.J., and J. Sonstelie. 2006. California’s school efficiency of capital; Mercantilism; Mill, J. S.

;
finance reform: An experiment in fiscal federalism. In Multiplier; Natural price; Natural rate and mar-
The Tiebout model at fifty, ed. W.A. Fischel. Cambridge,
MA: Lincoln Institute of Land Policy. ket rate of interest; Propensity to consume;
Fischel, W.A. 2006a. Will I see you in September? An Quantity theory of money; Rate of interest;
economic explanation for the standard school calendar. Saving and investment; Say’s Law; Smith, A.;
Journal of Urban Economics 59: 236-251.
Subjective theory of value; Supply and demand;
Fischel, W.A. 2006b. Why voters veto vouchers: Public
schools and community- specific social capital. Eco- Velocity of circulation
nomics of Governance 7: 109-132.
Hoxby, C.M. 1999. The productivity of schools and other
local public goods producers. Journal of Public Eco-
JEL Classifications
nomics 74: 1-30.
E12
Hoxby, C.M. 2000. Does competition among public schools
benefit students and taxpayers? American Economic
Review 90: 1209-1238. ‘Effective demand’ is the term used by Keynes in
Oates, W.E. 1969. The effects of property taxes and local his G e n e r a l T h e o r y ( ) to represent
public spending on property values: An empirical study the forces
of tax capitalization and the Tiebout hypothesis. Journal
determining changes in the scale of output and
of Political Economy 77: 957-971.
Tiebout, C.M. 1956. A pure theory of local expenditures. employment as a whole. Keynes attributed the first
Journal of Political Economy 64: 416-424. discussions of the determinants of the supply and
demand for output as a whole to the classical
economists, in particular the debate between
Ricardo and Malthus concerning the possibility of
‘general gluts’ of commodities, or what has come to
Effective Demand be known as Say’s Law of Markets. Indeed,
Keynes’s theory was intended to replace Say’s
J. A. Kregel
Law, although the emergence of effective demand
from his T r e a t i s e o n M o n e y (
) cri
tique of the quantity theory of money, and his
Abstract insistence on its application in what he originally
By ‘effective demand’ Keynes meant the forces called a ‘monetary production economy’, suggests
determining changes in the scale of output and that it should also be seen in antithesis to classical
employment as a whole. It was intended to monetary theory. For Adam Smith ( , p. 285), ‘A
replace Say’s Law. For Keynes, since man must be perfectly crazy
entrepreneurs maximized monetary returns, not who ... does not employ all the stock which he
employment or physical output, there was no commands, whether it be his own or other peoples’
reason why their investment decisions should on consumption or investment. As long as there
lead to an equilibrium at hill employment. Since was what Smith called ‘tolerable security’,
this account permitted any level of employment economic rationality implied that it was impossible
to emerge as a stable equilibrium, including full for demand for output as a whole to diverge from
employment, it is more general than the aggregate supply. Although Smith ( p. 73) did call
classical Say’s Law position, in which the only the demand ‘sufficient to effectuate the bringing of
stable equilibrium was the limit set by full the commodity to the market’, the ‘effectual
employment as given in the labour market. demand’ ‘of those who are willing to pay the
natural price’ of the commodity, the idea referred to
divergence of market from natural price of
Keywords particular commodities and the process of
Effective demand; Excess supply; Full gravitation of prices to their natural values. J.B.
employment equilibrium; Gold; Hume, D.; Say’s discussion of the problem of the ‘disposal of
Liquidity preference; Malthus, T. R.; Marginal commodities’ adopted Smith’s position. Against
those who held that ‘products would
always be abundant, if there were but a ready commercial confidence’, which he denies may be
demand, or market for them,’ Say’s ‘law of mar- caused by an overproduction of commodities (p.
kets’ argued ‘that it is production which opens a 74).
demand for products’ ( , pp. 132-3 ); if pro Mill’s defence of Say’s Law highlights the
duction determined ability to buy, then demand importance of the classical quantity theory, which
could not be deficient. While excesses in particular was originally formulated to oppose the undue
markets were admitted, they would always be offset emphasis given to precious metals as components of
by deficiencies in others. Ricardo used similar national wealth by the mercantilists. Hume noted
arguments against Malthus, who responded by that labour, not gold, produced the commodities
suggesting that: which composed national wealth; that gold was
from the want of a proper distribution of the actual only as good as the labour it commanded to produce
produce, adequate motives are not furnished to con- output. Thus the classical position that the velocity
tinued production,... the grand question is whether it
of circulation of money was independent of its
[actual produce] is distributed in such a manner
between the different parties concerned as to occa- quantity was built on the view that money would
sion the most effective demand for future produce ... only be held to be spent. Money could at best cause
(Malthus ) temporary general gluts; in the long term, ‘rational’
Malthus argues that the composition of output men would not choose to hold money rather than
affects its quantity by producing doubts in the spend it.
minds of Smith’s rational entrepreneurs concerning On the eve of the marginal revolution, classical
the ‘security’ of their future profit. theory thus admitted the temporary occurrence of
The final word in the classical debate was J.S. general gluts explained by cyclical disproportions in
Mill’s ‘On the Influence of Consumption on demand for money and commodities due to crises of
Production’, which sought exceptions to the prop- confidence. It is paradoxical that, while the
osition that ‘All of which is produced is already marginal revolution was motivated by the failure of
consumed, either for the purpose of reproduction or classical theory to give sufficient attention to the
enjoyment’ so that ‘There will never, therefore, be a role of demand in value theory, it failed to extend
greater quantity produced, of commodities in its analysis of demand to output as a whole in either
general, than there are customers for’ (1874, pp. 48- the long or the short period. Indeed, the emphasis
9). Mill accused those who argued that demand on individual equilibrium produced by the
limits output of a fallacy of composition, for the subjective theory of value which replaced the
individual shopkeeper’s failure to sell is due to a classical theory, made separate discussion of
disproportion of demand which cancels out for the aggregate supply and demand redundant. Thus
nation as a whole. Mill also notes that the argument Keynes’s reference to ‘the disappearance of the
that every purchaser must be a seller presumes theory of demand and supply for output as a whole,
barter, for money enables exchange ‘ to be divided that is the theory of employment a f t e r it has
into two separate acts’ so one ‘need not buy at the been for a quarter of a century the most discussed
same moment when he sells’ (p. 70). To avoid this thing in economics’ (Keynes )•
problem ‘money must itself be considered as a But it was discussion, not Say’s Law, which
commodity’, for ‘there cannot be an excess of all disappeared from neoclassical economics. Thus
other commodities, and an excess of money at the Keynes classed economists from Smith and Ricardo
same time’ (p. 71). Mill admits that if money were to Marshall and Pigou as ‘Classical’, for, despite
‘collected in masses’, there might be an excess of antagonistic theories of value and distribution, they
all commodities, but this would mean only a all held a similar theory of supply and demand for
temporary fall in the value of all commodities output as a whole.
relative to money. Similarly to Smith’s ‘tolerable Keynes suggests that this was due more to the
security’, Mill explains an excess of commodities in failure of neoclassical economists to heed Mill’s
general by ‘a want of warning concerning the extension of the
conditions faced by the individual to the economy Keynes’s theory of effective demand thus had to
as a whole, than to positive analysis. If consumers replace Say’s Law. To do this Keynes departed
(producers) maximize utility (profit) subject to an from the Classical position on two points. The first
income (cost) constraint, reaching the maximum by was to assume that wages exceed subsistence so
substituting in consumption (production) goods that expenditure on consumption goods does not
(inputs) which were cheaper per unit of utility exhaust factor incomes. As expressed in Keynes’s
(output), then excess supply of any good (resource) psychological law of consumption, this implied that
is due to its price exceeding its marginal utility as output increased, the gap between aggregate
(productivity). Market competition would lead to expenditure and factor costs increased, so that
relative price adjustments which eliminate excess unless investment expenditure expanded to fill the
supply. Since it was impossible for any single good gap, entrepreneurs would experience losses.
(resource) to be unsold (unemployed), it was natural The second departure was from the assumption
to extend this analysis to the aggregate level to deny that rationality dictated that entrepreneurs’ savings
the possibility of general gluts without further represented productive investment expenditure. If
analysis. investment could produce losses, or changes in
Any divergence from this position was interest rates change capital values, then greater
explained, not by reference to hoarding money due future enjoyment might be assured by not investing;
to crises of confidence, but by temporary holding money might be ‘rational’ in such
impediments to the automatic adjustment of relative conditions. Further, in a monetary economy,
prices in competitive markets. Thus, despite their nothing guarantees that maximization of returns in
new marginal theory of value, Keynes’s con- money will maximize either productive capacity or
temporaries reached a similar result that divergence the demand for labour.
of employment from its full employment level In Keynes’s theory the propensity to consume
would be determined by temporary non- persistent and the multiplier produce the proposition that it is
causes eliminated in the long ran. the level of output which adjusts saving to invest-
From 1921 to 1939 the unemployment rate in ment, rather than the rate of interest, while the
the United Kingdom never fell below ten per cent, explanation of the decisions over the level of
peaking in 1932 at 22.5 per cent (over 2.7 million). investment in a monetary economy requires an
This exceeded the limits that most economists explanation of rates of interest in money terms. The
attributed to short-period frictions. The self- two factors are closely related.
adjusting nature of the neoclassical version of Say’s In a 1934 letter to Kahn, Keynes gives a ‘precise
Law that Keynes chose to criticize was thus definition of what is meant by effective demand’ (
contradicted by reference to economic events as , p. 422). If O is the level of
well as by Keynes’s conception of effective output, W the marginal prime cost of production for
demand. that output, and P the expected selling price, ‘Then
Keynes was not concerned with impediments to OP is effective demand’. The classical theory that
the equality of the supply and demand, but with the ‘supply creates its own demand’ assumes that OP
problem of the equilibrium of supply and demand for equals OW, irrespective of the value ofO, ‘so that
output as a whole, in short, of effective demand ...
effective demand is incapable of setting a limit to
When one is trying to discover the volume of output
and employment, it must be this point of equilibrium employment which consequently depends on the
for which one is searching. relation between marginal product in wage- goods
While the Classics solved the problem by industries and marginal disutility of employment’.
assuming the identity of savings and expenditure on Thus, what Keynes later called ( , ch. 2) the
investment goods, neoclassical theory presumed two ‘classical’ postulates limit
Say’s Law ‘without giving the matter the slightest O at frill employment. In contrast,
discussion’ ( , p. 215). On my theory OW / OP for all values of O, and
entrepreneurs have to choose a value of O for which
it is equal - otherwise the equality of price and
 marginal prime cost is infringed. This is the real adjusted producing windfall profits or losses. The
starting point of everything. prices of investment goods were determined
The key point was thus the impact of different separately from this process, by means of the
levels of O on the difference between costs and interaction of the bearishness of the public
prices, that is on entrepreneurs’ profits. Keynes took reflecting their decisions to hold bank deposits or
up this question, in an undated exchange with Sraffa securities on the one hand, and the monetary policy
of about the same time ( , of the banking system on the other.
pp. 157ff). Keynes notes that a non-unitary mar- Investment goods are held because their present
ginal propensity to consume implies OP / OW for costs or supply prices are lower than the present
any O, and generates. value of their anticipated future earnings or demand
the general principle that any expansion of output prices; the larger this difference, the higher the
gluts the market unless there is a pari passu increase expected rate of return. Since any change in the
of investment appropriate to the community’s mar-
ginal propensity to consume; and any contraction price of a durable capital asset will influence its rate
leads to windfall profits to producers unless there is of return, a theory that explains the price of capital
an appropriate pari passu contraction of investment. assets also explains rates of return (which Keynes
The level of O at which OP = OW will be called marginal efficiency). With the demand price
determined by the level of investment and the of an asset based on the value of expected future
propensity to consume. Changes in the rate of earnings discounted by the rate of interest, it is clear
investment, based on entrepreneurs’ expectations of why a satisfactory theory of interest is crucial to the
their future profits, will determine O. explanation of effective demand.
In an early draft of the G e n e r a l But money was a durable asset like any other,
T h e o r y Keynes (1973a, p. 439) put it this and as such it has a spot or demand price and a
way: supply price or forward price, which determine the
Effective demand is made up of the sum of two money rate of interest. Keynes thus transformed his
factors based respectively on the expectation of what concept of bearishness into liquidity preference
is going to be consumed and on the expectation of
which, together with banking policy, would
what is going to be invested.
determine the rate of interest. For Keynes, ‘the
Thus the theory of effective demand required, in money rate of interest ... is nothing more than the
addition to explanation of consumption based on the percentage excess of a sum of money contracted for
propensity to consume, an explanation of variations forward delivery ... over what we may call the
in the level of investment. Since neoclassical theory “spot” or cash price of the sum thus contracted for
resolved this problem by presuming that investment forward delivery’ ( , p. 222),
was brought into balance with fitll employment it is:
saving by means of the rate of interest, Keynes
the premium obtainable on current cash over
located the ‘flaw being largely due to the failure of deferred cash ... No one would pay this premium
the Classical doctrine to develop a satisfactory unless the possession of cash served some purpose,
theory of the rate of interest’ ( , p. 489). that is had some efficiency. Thus we may conve-
Keynes concentrated his efforts to produce a niently say that interest on money measures the
marginal efficiency of money measured in ferms of
theory of interest compatible within this theory of itself as a unit ( , p. 101)
effective demand within what he called a monetary
production economy. The T r e a t i s e o n Since both money and capital assets had mar-
M o n e y ( ) had explained changes in prices ginal efficiencies representing their rates of return,
in terms of profit-maximizing individuals in a monetary
households’ consumption decisions relative to economy would demand money and capital assets
entrepreneurs’ production decisions. If these deci- in proportions which equated their respective
sions were incompatible, investment diverged from returns. The equilibrium level of output chosen by
saving and prices of consumption goods entrepreneurs would then be represented by
equality of the marginal efficiency of capital and the Keynes also notes that increased investment in
rate of interest (the marginal efficiency of money). particular capital assets increases supply prices and
The question of the effect of an increase in output reduces demand prices, causing a decline in mar-
on profit raised by a propensity to consume less ginal efficiencies; an increase in output thus leads to
than unity can now be seen as the effect of an investment in assets with lower rates of return. At
increase in investment on the marginal efficiency of some point die marginal efficiency of money will
money relative to the marginal efficiencies of make investment in money as profitable as die
capital assets. Since these marginal efficiencies purchase of capital assets. At this point die rate of
reflect pairs of spot and forward asset prices, the interest equals die marginal efficiency of capital,
question can also be put as the effect of an increase and any further increase in output would confirm
in investment on relative money prices. Thus Keynes’s ‘general principle’ that any further expan-
Keynes’s independent variables, the propensity to sion in output gluts the market, for increased
consume, the efficiency of capital and liquidity income is not spent but held in the form of money
preference, given expectations and monetary policy, which becomes a ‘generalised sink for purchasing
interact to determine effective demand. power’.
Since this equilibrium could be described by S I, The question that distinguishes Keynes’s theory
or equality between the rate of interest and the is thus why money’s liquidity premium does not fall
marginal efficiency of capital, the level of output as output expands, for this is what prevents
which equates aggregate demand and supply also investment from rising by just the amount to fill the
equates marginal efficiency with the rate of interest. gap created by the propensity to consume being less
To complete his theory of effective demand, Keynes than one. To describe these ‘essential properties of
faced the question first raised by Wicksell of the interest and money’, Keynes departs from Mill’s
causal relation between the natural and the money position that money is just another commodity.
rate of interest. Just as Keynes rejected the When money is the debt of the banking system its
determination of the level of O at which OP = OW price and quantity behaviour will differ from
by the equality of the marginal productivity and physical commodities, for it has no real costs of
disutility of labour, he rejected marginal production nor real substitutes. Thus an asset which
productivity as the determinant of marginal has a negligible elasticity of production and
efficiency and the real rate of interest determining substitution with respect to a change in effective
the money rate because it was based on ‘circular demand, will have a rate of return which responds
reasoning’ ( , p. 212). less rapidly to an expansion in demand. As long as
Keynes argues instead that it is the marginal the rate of interest falls less rapidly than the
efficiency of capital assets which adapts to the marginal efficiencies of capital assets, its rate will
money rate of interest rather than vice versa. These be the one which sets the point at which further
two points of departure are discussed in Chapters 16 expansion creates losses.
and 17 of the G e n e r a l T h e o r y , Thus the propensity to consume shows that
where Keynes points out that the money rate of investment will have to increase by the amount of
return to be expected from a capital asset depends the gap between incomes and expenditures as
on the relation of anticipated money receipts incomes rise if entrepreneurs are not to make losses,
relative to expected money costs, and that there is while the marginal efficiency of capital and
no reason to believe that these will be related in any liquidity preference in a monetary production
predictable way to the asset’s physical productivity. economy explain why the behaviour of the rate of
Wicksell’s natural rate, derived from physical interest relative to the marginal efficiency of capital
relations of production and exchange, has no makes it unlikely that the rate of investment should
application in a monetary economy; Keynes thus adjust by just that amount. Since entrepreneurs
substitutes the concept of marginal efficiency. maximize monetary returns, not employment or
physical output, there is no reason why their
investment decisions should lead to an equilibrium
at full employment. Keynes’s explanation
of the limit to the level of employment permits any
level as a stable equilibrium, including full Effective Protection
employment; it is thus more general than the clas-
sical Say’s Law position, in which the only stable W. M. Corden
equilibrium was the limit set by full employment as
given in the labour market.

See Also The effective rate of protection is the rate of pro-

tection provided to the value added in the produc-
► jay s .aw tion of a product. Let the effective price be defined
as the domestic price of a unit of value added. Then
the effective rate of protection (henceforth, ERP) is
Bibliography the proportional increase in the effective price made
possible by tariffs and other measures. It is to be
Keynes, J.M. 1930. A treatise on money. Reprinted in Keynes contrasted with the nominal tariff and (more
(1971).
generally) nominal rate of protection, which refers
Keynes, J.M. 1934a. Letter to R.F. Kahn, 13 April. Reprinted
in Keynes (1973b). to the proportional increase in the nominal price. If
Keynes, J.M. 1934b. Letter to P. Sraffa, undated. Reprinted in the only policy instruments are tariffs, the ERP
Keynes (1979). depends not only on the nominal tariff on the
Keynes, J.M. 1934c. Poverty in plenty: Is the economic
commodity concerned but also on the tariffs on the
system self-adjusting? Reprinted in Keynes (1973b).
Keynes, J.M. 1936a. The general theory of employment, inputs and on the input coefficients.
interest and money. Reprinted in Keynes (1973a). Consider the simple case of an importable
Keynes, J.M. 1936b. Letter to A. Lemer, 16 June. Reprinted product, j, which has only a single input, also an
in Keynes (197l>).
importable, i. There are no taxes and subsidies
Keynes, J.M. 1936c. Letter to R.F. Harrod, 30 August.
Reprinted in Keynes (1973c). affecting j and i other than the import tariffs. The
Keynes, J.M. 1937a. The theory of the rate of interest. formula for the ERP for the activity producing j is
Reprinted in Keynes (1973c). then
Keynes, J.M. 1937b. Alternative theories of the rate of
interest. Reprinted in Keynes (1973c). tj o. ft i *>=
Keynes, J.M. 1971-83. The collected writings of John —
Maynard Keynes, ed. D. Moggridge. London: Macmillan
for the Royal Economic Society: 1971. Vols. 5 and 6. A where gj is the ERP, tj is the tariff on j, ti is the
treatise on money (1930). 1973a. Vol. 7. The general tariff on i, and aij is the share of i in the cost of j in
theory of employment, interest and money (1936). 1973b.
Vol. 13. The general theory and after: Part I -
the absence of tariffs.
preparation. 1973c. Vol. 14. The general theory and This shows that if tj ti, then gj = tj. It is common
after: Part II - defence and development. 1979. Vol. 29. for input tariffs to be low relative to final goods
The general theory and after - a supplement. tariffs, that is, tj > ti, and in that case gj > tj, an
Malthus, T.M. 1821. Letter from Malthus to Ricardo, 7 July.
Reprinted in Ricardo (1952), 9-10. important result, since it shows that effective rates
Mill, J.S. 1874. On the influence of consumption on pro- tend to be higher than nominal rates. A rise in the
duction. Essays on some unsettled questions of political input tariff clearly reduces effective protection for
economy, 2nd ed, reprinted Clifton, ed J.S. Mill. Clifton:
the using industry, even though it raises protection
A.M. Kelley, 1974.
Ricardo, D. 1952. Works and correspondence of David for the input-producing activity.
Ricardo, vol. 9, ed. P. Sraffa with the collaboration of M. Actual measurements involve using a ' - ,
Dobb. Cambridge: Cambridge University Press. which is the input share that results after the tariffs
Say, J.B. 1855. A treatise on political economy, 6 American
ed. Philadelphia: J.B. Lippincott.
have raised both the domestic final good price and
Smith, A. 1776. An inquiry into the nature and causes of the the domestic input price. The connection between
wealth of nations. Oxford: Oxford University Press, the input share before tariffs are imposed (aij) and
1976. after («';) is as follows:
 ,_ 1+h trade the effective price would be negative. One
a
ij ~ a‘J ! | tj possible reason for this phenomenon is that trans-
port costs on inputs may be much higher than those
and from this, and the formula for the ERP given on the final product. There would then be no
above, one can obtain the formula which is com- production of the final good under free trade. But a
monly used in empirical studies, namely: sufficiently high tariff on the final good relative to
the tariff on the input could make the effective price
domestically positive, so that domestic production
begins. The rate of protection is then infinite, and
1+t j 1+t j algebraically the calculation of the ERP will yield a
negative figure. Clearly domestic production of a
The effective protection concept can be product where the cost of imported inputs exceeds
extended to allow for all taxes and subsidies the free trade price of the final product is an
affecting tradeable goods, i.e. all importables and extreme form of waste.
exportables. An export subsidy raises the domestic
price of an exportable; if the input is an exportable,
then ti represents the rate of subsidy, and if the
General Equilibrium
activity for which the ERP is being calculated is an
The next step is to put ERPs into a general equilib-
exportable, then tj can represent the subsidy.
rium framework. One can imagine a scale of effec-
Similarly, export taxes, production taxes, con-
tive rates, which will include ERPs for all traded
sumption taxes, and production and consumption
activities, including both exportables and import-
subsidies can be allowed for. A production tax or
ables. The scale will give some indication of the
subsidy for the final product will affect tj, while a
direction in which resources have been pulled by
consumption tax or subsidy for the input will affect
the protective structure. Of course, actual resource
ti. Thus the ERP measure allows a single figure to
movements will also depend on production substi-
sum up the net result of various trade and non-trade
tution elasticities, that is, on the whole general
taxes and subsidies affecting any particular activity.
equilibrium system, so that the scale is only indic-
The ERP measurements revealed at an early
ative of resources movement effects. The cmcial
stage the high protection that developed countries
point is that, in general equilibrium, relative ERPs
provided for final processing of primary products
matter, not absolute rates. This is simplest to see in
even in cases where nominal tariffs were low, the
a model with only two activities where both may be
reason being the duty-free entry of the basic mate-
obtaining positive ERPs (if one is an export, this
rials. The measurements also bring out the negative
implies it is getting an export subsidy), and
effective protection provided for exports in many
resources will then tend to move into the activity
countries: the exports receive no subsidies or other
with the relatively higher ERP.
assistance, i.e. tj = 0 for most exports, but import
There are complications, and it has been shown
tariffs on their inputs make their tis positive. It was
in the literature that one can produce paradoxes. For
also noted that tariff reductions are not always what
example, in a three-activity model, with A and B
they seem: an offer of tariff cuts at an international
complementary in a general equilibrium sense,
negotiation may actually raise the ERP for some
protection of A may expand B even though B may
domestic industries.
get a lower ERP than C. It must also be remem-
Much attention has been given in the literature
bered that relative nominal rates will determine the
to the discovery of negative value added, a dis-
direction in which consumption is pulled or
covery which was a by-product of effective pro-
distorted.
tection calculations. There are cases where the free
The idea of the scale of ERPs was first pre-
trade price of the final product is less than the free
sented in Corden ( ), where it was said that
trade price of its inputs, so that under free
Assuming normal non-zero substitution elasticities provided it with negative net effective protection.
in production, [the scale of effective rates] tells us Relative to non-tradeables, it has been anti-
the direction in which this structure causes protected. If its resources were primarily mobile
resources to be pulled as between activities pro- into and out ofnon-tradeables, it would expand as a
ducing traded goods. Domestic production will shift result of a movement towards free trade.
from low to high effective-protective-rate activities.
This was too strong. It is true in a rather special
model, later set out formally in Jones ( ), but Key Assumptions
more generally, there are various 'paradoxical'
circumstances where it need not be true. Several The theory of effective protection, at least in its
articles have explored such possibilities, and more formal version, makes a number of assump-
examples are expounded in Corden ( ). tions. The first is the small country assumption,
At the general equilibrium level the important namely the assumption that the country concerned
and somewhat complex issue also arises of whether faces given prices of its exports and imports (the
particular traded goods activities are protected terms of trade being exogenous). The second
relative to non-tradeables, and what the role of the assumption is that for all tradeable goods some
exchange rate is. The basic point is that the trade remains, so that domestic prices are deter-
imposition of a protective structure which is gen- mined by the given world prices as modified by
erally positive will tend to draw resources out of tariffs, export subsidies and other interventions.
non-tradeables, and if the nominal rates are also Thirdly, imports are assumed to be perfect sub-
mainly positive, divert consumption towards non- stitutes for the import-competing goods for which
tradeables. Assuming balance initially, protection the ERPs are calculated. Finally, it is assumed that
then results in excess demand for non-tradeables. there are fixed coefficients between final outputs
Balance would be restored by a rise in the price of and traded inputs, even though substitution between
non-tradeables, relative to the free trade prices of the domestic factors that contribute to value added
tradeables, this being a real appreciation. It could be can be allowed.
brought about with a fixed nominal exchange rate Much theoretical work has gone into exploring
combined with an absolute rise in the price of non- the implications of removing the last assumption,
tradeables, or by a nominal appreciation when the though all the others are also important. It does not
price of non-tradeables is constant, possibly because follow that calculations of ERPs are meaningless
the nominal wage is given. when these assumptions do not hold, but figures
The usual expositions assumed the average must be interpreted with care, as discussed in
price-level of non-tradeables constant, and stressed Corden ( ).
the exchange rate adjustment that then needs to be
associated with a change in protection levels. When
this adjustment is taken into account one can obtain Normative Implications
a net protective rate which shows whether a
particular activity is protected relative to non- Do ERPs have normative significance? The formal
tradeables. For example, a particular activity may theory of effective protection and tariff structure
obtain an ERP of 10 per cent but, if the protection was developed with the focus on a question of
for it and all other activities were removed, there positive economics: namely, how does a protective
might have to be a devaluation which is equivalent structure affect the allocation of resources? But the
to a uniform tariff and export subsidy of, say, 15 per great interest in the theory and the widespread
cent. In that case this activity would have obtained a activity in making calculations has been motivated
higher effective price under free trade, so that the by a concern with normative issues. It must be
system of protection has stressed again that only relative effective rates
matter. Knowing a single effective rate on its own
sheds no light on either positive or normative
implications. The frequent assumption, often only Practical Problems
implicit, has been that free trade with appropriate
exchange rate adjustment would be the optimal The calculation of ERPs and their use as a guide to
situation, and that non-uniform effective rates policy has become very widespread, especially in
therefore impose a production cost of protection - developing countries. But all sorts of practical
that is, a welfare loss through a distortion in problems arise in the calculations, essentially
resource use. Large divergences are then an because the assumptions of the formal theory do not
indication of a high cost of protection. Furthermore, hold, and many ways have been devised to deal
the structure of effective protection gives then a with these problems. The problems can only be
guide to the welfare (or efficiency) effects of tariff fisted here, but they are important for practitioners.
changes: a change that reduces a divergence For more details, see Corden ( ) and
between effective rates is likely to reduce the cost Balassa et al. ( ).
of protection. When quotas are the principal method of pro-
A practical implication is that if there is to be tection, comparisons between domestic and world
gradual tariff reduction without extra costs being market prices must be made in order to obtain the
imposed during the process, any increase of such implicit nominal rates of protection which must be
divergences should be avoided. This will be so, for the starting point for any calculations. When tariffs
example, if high effective rates are always reduced alone are relevant there may be tariff redundancy,
first. In a three-product model, with industry A so that, again, price comparisons must be made; a
getting 0 per cent, industry B 20 per cent and difficulty here is that the quality of the local product
industry C 50 per cent, a reduction in B's effective and the import may differ. Available input-output
rate first would increase the divergences between coefficients in most countries are rarely sufficiently
the ERPs on B and C, so that the ERP of C should disaggregated for the ERP calculations. There is a
be reduced first. This is the concertina method of need for tariff averaging, and this has built-in
tariff reduction, but may have quite complicated biases.
implications in terms of nominal tariffs. Radial A decision has to be made as to how to treat
(uniform across-the-board) reductions would also non-traded inputs into the tradeable products for
avoid divergences being increased. Finally, it must which ERPs are calculated. This last issue has given
be remembered that nominal tariffs affect the rise to much theoretical discussion (on which see
pattern of consumption whether by final users, or in Corden , ). The correct method
use of inputs, so that divergences in nominal tariffs appears to be very complicated: lump the non-
determine the consumption cost of protection. traded and primary-factor content of non-traded
If there are other (non-trade ) distortions in the inputs with value added, but group the traded-input
economy, a tariff distortion may actually be off- content of non-traded inputs with traded inputs.
setting. Thus, if an industry is established on the Tariffs on traded inputs into non-traded inputs then
basis of a very high tariff (relative to other indus- reduce the ERP for the final product.
tries), so that a positive cost of protection might be
expected, there may be a gain if (for example) the
industry uses labour for which it has to pay a wage The Substitution Problem
that exceeds its opportunity cost owing to distor-
By far the most sophisticated theoretical work has
tions in the labour market. When such non-trade
distortions are prevalent one cannot use effective gone into the ‘substitutionproblem’. This involves
rates on their own as indicators of which activities removing the assumption of fixed coefficients
should expand and which decline if resource allo- between the final output and the produced traded
cation is to improve. The broader concept of inputs. Thus substitution between traded inputs and
domestic resource cost has been developed to take the primary factor content of value added is allowed
all distortions into account. for. Two distinct issues then arise.
 First, suppose that the production functions are been analysed in the literature, but which deprive
separable, so that substitution between traded inputs the scale of effective rates of any simple signifi-
and the various primary factors, for example, labour cance. Various paradoxes have been shown to be
and capital, is ‘unbiased’. In that case, the concept possible - for example, that resources will be drawn
of value added retains a clear meaning. One can into a low ERP activity out of a high ERP one under
think of a ‘value added product’ which is combined particular factor-intensity and relative tariff
with traded inputs in varying proportions conditions. The conclusion of some critics has been
(depending on the input tariff and the final good either that no measurements are any use or that one
tariff, among other things), to make a final product. might as well use only nominal rates. Another view
Since the ERP is the proportional increase in the is that the best approach is to use computable
effective price, which is the price of this ‘value general equilibrium models, and these make ERPs
added product’. ERP also then has a clear meaning. redundant.
But the problem remains that measurements based The answer must be that if the data and esti-
on the coefficients after tariffs have been imposed mates for complete general equilibrium models are
(which is what the data yield) will have a bias, available - and sufficiently disaggregated with
reflecting the substitution effects. It can be shown respect to activities or industries to be policy-
that the tendency will always be to overstate the relevant - there is indeed no need to calculate ERPs.
‘true’ ERPs. The problem is then one of inevitable The latter contain some information, taking into
measurement error. Since one is interested in the account input tariffs, and so on, but pause half-way
relative position in the scale of effective rates and in to the complete answer. The case for ERPs
the divergences between ERPs, it is relevant that the calculations and their use for policy must be that the
measurement error will differ between ERPs, data and estimated functional relationships required
depending on production functions and for complete and detailed general equilibrium
relationships between final goods and input tariffs. models do not usually exist, and certainly not in
Fortunately, there is some possibility that this sufficiently disaggregated form, so that ERPs,
complication may not be important in practice. which are feasible to calculate, give some indication
The second issue is more fundamental. If of possible resource pulls and costs of protection.
production functions are not separable, so that The extensive theoretical work is designed to
substitution is ‘biased’, the whole concept of the indicate the direction of various probable biases and
‘value added product’ and hence of ERP is thrown to bring out the stringent assumptions required for
into doubt. The question is whether ‘value added’ firm conclusions to be reached from the data.
has a meaning. One really needs to assume that, on
a probability basis, the bias is generally zero.
The Literature

Are General Equilibrium Models Until the mid-1960s the vertical relationships
Preferable? between tariff rates derived from the input-output
relationships between products were completely
Another basic criticism of the ERP concept and of neglected in the literature of trade theory. In fact
all the resources that have gone into calculations of tariff theory was either narrowly partial equilibrium,
ERPs can be made. It has been pointed out that a focusing on just one vertically integrated product, or
scale of ERPs is an imperfect and possibly consisted of two-sector general equilibrium models.
misleading indicator of resource allocation move- A major feature of the theory of tariff structure was
ments. Actual resource pulls also depend on supply not just to bring out the relevance of input tariffs but
elasticities, on production functions, and on a whole also to focus on the horizontal general equilibrium
lot of complex interactions which have relationships when there are more than two
products.
 With regard to the ERP concept itself, while Basevi, G. 1966. The US tariff structure: Estimation of
there were early precursors, the first extended effective rates of protection of US industries and indus-
trial labor. Review of Economics and Statistics 48: 147-
exposition was in Barber ( ), the first system 160.
atic theoretical papers were a 1965 paper of Bruno, M. 1973. Protection and tariff change under general
Johnson's, reprinted in Johnson ( ), and equilibrium. Journal of International Economics 3(3):
Corden ( ). The latter paper opened up vari 205-225.
Bruno, M., C. Khang, A. Ray, J.N. Bhagwati, and T.
ous general equilibrium issues, the significance of Srinivasan. 1973. The theory of effective protection in
the scale of effective rates, the problem of non- general equilibrium: A symposium. Journal of Inter-
traded inputs, the substitution problem, and so on, national Economics 3(3): 205-281.
and later a systematic and more complete exposition Corden, W.M. 1966. The structure of a traiff system and the
effective protective rate. Journal of Political Economy 74:
was presented in Corden ( ), which 221-237.
also contains a history of the ERP concept and . 1971. The theoty of protection. Oxford: Oxford
references to various precursors. Pioneering University Press.
empirical work was done in Balassa ( ) and . 1975. The costs and consequences of protection:
A survey of empiricial work. In International trade and
Basevi ( ). Later Balassa became a sponsor of
finance: Frontiers for research, ed. P.B. Kenen. Cam-
major multi-country empirical studies (Balassa et al. bridge: Cambridge University Press.
, ), and these volumes also contain Ethier, W.J. 1972. Input substitution and the concept of the
extensive reviews by Balassa of theoretical and effective rate of protection. Journal of Political Economy
80(1): 34—47.
measurement issues.
. 1977. The theory of effective protection in general
The central theoretical issues of the meaning of equilibrium: Effective-rate analogues of nominal rates.
ERPs have been discussed in numerous papers Canadian Journal of Economics 10(2): 233-245.
subsequent to the early work. Particularly to be Gmbel, H.G., and H.G. Johnson (ed). 1971. Effective tariff
protection. Geneva: Graduate Institute of International
noted are Jones ( ) and Ethier ( ). In addi
Studies.
tion, there have been several articles on the 'sub- Johnson, H.G. 1971. Aspects of the theory of tariffs. London:
stitution problem', beginning with Jones ( ), a George Allen & Unwin.
paper reprinted in Corden ( ), and Ethier Jones, R.W. 1971. Substitution and effective protection.
Journal of International Economics 1(1): 59-81.
( ), followed by papers by Bruno, by Khang
. 1975. Income distribution and effective protection
and by Bhagwati and Srinivasan, all in the Journal in a multicommodity trade model. Journal of Economic
of International Economics of Theory 11(1): 1-15.

See Also
'Effectual Demand' in Adam Smith
► Free Trade at Protection
Carlo Panico
► International Trade
► Quotas and Tariffs

Bibliography
Smith’s notion of ‘effectual demand’ is still the
Balassa, B. 1965. Tariff protection in industrial countries: An subject of several discussions dealing with the role
evaluation. Journal of Political Economy 73(6): 573-594. of demand in classical and neoclassical theories of
Balassa, B., et al. 1971. The structure of protection in price and distribution and with the influence of
developing countries. Baltimore: Johns Hopkins Press.
—. 1982. Development strategies in semi-industrial
demand on ‘division of labour’ and economic
countries. Baltimore: Johns Hopkins Press. progress. Smith defined ‘effectual demand’ as the
Barber, C.L. 1955. Canadian tariff policy. Canadian Journal ‘demand of those who are willing to pay the natural
of Economics and Political Science 21 (November): 513- price of the commodity, or the whole value of rent,
530.
labour and profit, which must be paid in order to
bring it thither’ (Smith
vol. 1, p. 58). According to him, when the quantity different notion from that implied by demand-
of any commodity brought to market falls short of curves in neoclassical theory, which requires a
the effectual demand, those who demand it. specific ordering between e a c h price-quantity
Cannot be supplied with the quantity they want. point. ... The theory does not regard these points as
Rather than want it altogether, some of them will be results of accidental and temporary deviations of
willing to give more. A competition will the quantity supplied from the ‘normal’ level, but
immediately begin among them, and the market rather as determinate points likely to emerge from a
price will rise more or less above the natural price repetition of events (Garegnani , p. 310).
(ibid.). Smith’s notion of effectual demand has been
On the other hand, ‘when the quantity brought recalled by those who, following Sraffa’s rehabil-
to market exceeds the effectual demand,... the itation of the surplus approach of the classical
market price will sink more or less below the political economists (Sraffa ), have proposed to
natural price’ (p. 59), whereas ‘when the quantity separate the analysis of price and distribution from
brought to market is just sufficient to supply the that of the levels of output and demand. Within this
effectual demand and no more, the market price approach, g i v e n t h e l e v e l a n d
naturally comes to be... the same with the natural t h e c o m p o s i t i o n o f
price’ (ibid.). o u t p u t and one distributive variable, it is
‘Effectual demand’ is thus defined as the possible to determine the ‘socially necessary’
demand for any i n d i v i d u a l commodity, technique, the other distributive variables and
corresponding to the natural price for it. It was a natural prices. The levels of output and demand in
l o n g - p e r i o d concept, since it was each industry, taken as given, represent long-period
associated with those prices which allow the values, since they are associated with fully adjusted
payment of wages, rents and profits at their natural productive capacity and uniform rates of profit in
levels, and which hold when in all industries all industries.
productive capacity is fully adjusted and a uniform The analysis of the classical tradition is char-
rate of profits is earned (see Smith , vol. 1, pp. 59- acterized by integration between historical, insti-
65). tutional and economic factors. This approach is
The definition of ‘effectual demand’ was intro- applied to the analysis of the level and composition
duced in dealing with the adjustment process of demand. The analysis of the aggregate level is
between demand and supply. This process was related to Say’s law, whose acceptance is an open
conceived to occur on a s i n g l e market option in classical political economy. Among the
assuming as known the natural prices of that and all elements affecting the composition of demand, two
other commodities. The process of adjustment groups of factors appear to emerge in Smith’s
implies, therefore, a p r i o r determination of writings. First of all, o b j e c t i v e factors,
distributive variables and of all natural prices, like the degree of development of the economy and
a s s o c i a t e d w i t h g i v e n the distribution of income among different classes
l e v e l s o f e f f e c t u a l of society. Secondly, s u b j e c t i v e
d e m a n d i n e a c h factors, which are influenced by customs, social
i n d u s t r y . Smith’s notion of ‘effectual rales and fashion. The limited attention paid to
demand’ thus refers as much to a specific industry substitution within the bundle of commodities
as to the whole economy: it can be seen as a ‘micro’ demanded by different income groups suggests a
and a ‘macroeconomic’ concept. minor role attributed to this factor, without denying
The study of effectual demand involves a the possibility of its further analysis, carried out
description of how the working of competition case by case.
enforces natural prices but does not constitute a Marx analysed the factors influencing demand
theory of what determines them. Smith never in a similar way. His stress was on objective
derived demand-functions for any commodity. factors, that is on the ratio of total surplus-value to
‘Effectual demand’ represented a point, and no wages and the proportions in which the surplus-
attempt was made to determine the magnitude of the
rise (fall) in demand when the price falls below
value is split up among profits, interests, ground ‘include those psychological characteristics of
rents, taxes, etc. (see Marx , pp. 181—2). Given the human nature and those social practices and insti-
historically achieved degree of development of the tutions’ (p. 91), which are unlikely to change over
economy (whose analysis is not based on the limited periods of time except in abnormal or
acceptance of Say’s law) and the distribution of revolutionary circumstances, and which it is nec-
income, it is possible to determine the average level essary to consider ‘in an historical inquiry or in
of demand for different commodities from each comparing one social system with another of a
class or social group. The total consumption different type’ (ibid. ). Talking of the interest rate,
expenditure of each class is an increasing function Keynes concluded that its influence on consumption
of the income earned (Marx , pp. 188—9), while the is open to a great deal of doubt. .. .[Its influence] is
composition of its consumption is influenced by complex and uncertain, being dependent on
habits and rules which, over a certain historical conflicting tendencies ... Substantial changes in the
period, are dominant within that class. Limited rate of interest tend to modify social habits
possibilities of substitution within the bundle of considerably, thus affecting the subjective pro-
commodities demanded by each class are pensity to spend - though in which direction it
recognized, and again appear left to be studied case would be hard to say, except in the light of actual
by case. experience (p. 93).
The working class must find at least the same Thus, as in classical tradition, the actual influ-
quantity of necessities on hand if it is to continue ence of the factors considered is evaluated by
living in its accustomed average way, although they Keynes according to the historical circumstances
may be more or less differently distributed among considered, taking into account that their influence
the different kinds of commodities ... The same, may be uncertain in its intensity and direction. The
with more or less modification, applies to other integration between economic and institutional and
classes (Marx 1972a, pp. 188). social factors also emerges in the analysis of the
Besides, Marx pointed out that the analysis of influence of subjective factors (pp. 107-112), whose
demand has to recognize the distinction between the relative strength will vary enormously according to
part coming from consumers and that coming from the institutions and organisation of the economic
entrepreneurs requiring means of production in society which we presume, according to habits
order to meet what he called the need for formed by race, education, convention, religion and
commodities in the market, depending on the current moral, according to present hopes and past
‘actual social needs of the different classes and on experience, according to the scale and technique of
the income available to them’ (Marx , pp. 188-9). capital equipment, and according to the prevailing
Some remarkable similarities can be found distribution of wealth and the established standards
between this approach and that followed by Keynes of life (p. 109).
in the G e n e r a l T h e o r y . In chapters However, the principle of substitution and that
8 and 9 of this work, the factors affecting aggregate of diminishing marginal returns play a primary role
consumption are examined in an analysis which is in Keynes’s analysis of investment in the
separate from that determining prices and dis- G e n e r a l T h e o r y . In this respect,
tribution, and which pays hardly any attention to Keynes said, ‘I am simply accepting the usual
substitution within the bundle of commodities theory of the subject’ (Keynes , p. 615), ‘meaning
demanded for consumption, a factor to which a exactly the same as Marshall... means’ (p. 630). Yet,
secondary role appears to be attributed. According alongside this neoclassical element, Keynes referred
to Keynes (see , pp. 90-95), total consumption to other factors influencing investment, like the pre-
depends partly on total income, partly on other sent and expected level of effective demand (see
objective circumstances, like the interest rate, and Keynes , p. 147), which may come from the private
partly on subjective factors, which or the public sector and may affect what he
called ‘the state of long-term expectation’. The Bibliography
analysis of investment of the G e n e r a l
Eatwell, J.L. 1983. The long-period theory of employment.
T h e o r y may thus suggest some elements to
Cambridge Journal of Economics 7: 269-285.
develop a theory of demand within classical Garegnani, P. 1983. The classical theory of wages and the
tradition. role of demand schedules in the determination of relative
One element is that ‘the state of long-term prices. American Economic Review: Papers and
Proceedings 73: 309-313.
expectation is often steady’ (Keynes , p. 162), since
Keynes, J.M. 1936. The general theory of employment,
factors like the institutional environment and interest and money. London: Macmillan.
government policies do not only influence it, but Keynes, J.M. 1973. The general theory and after. Part I:
also ‘exert their compensating effects’ on its Preparation. Vol. XIII of The collected writings of J.M.
fluctuations, together with factors related to the Keynes, ed. D. Moggridge. London: Macmillan.
Marx, K 1894. Capital, vol. 3. London: Lawrence & Wishart,
maintenance of the efficiency of capital goods. 1972.
Within this line, government policies, and industrial Marx, K. 1910. Theories of surplus value, vol. 3. London:
policy in particular, relations between industry and Lawrence & Wishart, 1972.
finance, industrial relations and the history of Smith, A. 1776. An inquiry into the nature and the causes of
the wealth of nations, 2 vols, ed. E. Cannan. London:
competitiveness and technological changes are to be Methuen, 1930.
seen as relevant factors affecting the prevailing state Sraffa, P. 1960. Production of commodities by means of
of long-term expectation (see Eatwell , p. 283). commodities. Cambridge: Cambridge University Press.
Another element is that there may be ‘short-
period changes in the state of long-term expecta-
tion’ (Keynes , p. 164) due, among other things, to
reactions of investors during the transition process
from one state of long-term expectation, ‘which has
its definite corresponding level of long-period Efficiency Bounds
employment’ (ibid., p. 48) with fully adjusted
capacity, to another to which a new long- period Han Hong
position corresponds. This process was described by
Keynes in chapter 5 of the G e n e r a l
T h e o r y ( , pp. 46-50), where he concluded
that ‘a mere change in expectation is capable of
Abstract
producing an oscillation of the same kind of a shape
In large sample analysis, the performances of
as a cyclical movement, in the course of working
estimators can be approximated by the asymp-
itself out’ (p. 49). This chapter points out the
totic variances. In parametric models, maximum
possibility of presenting a long-period analysis of
likelihood estimators often achieve the efficient
demand and output, which is integrated with an
Cramer-Rao lower bound, while efficient GMM
analysis of the cyclical movements of the economy.
estimation can be achieved by choosing the
Smith’s notion of ‘effectual demand’ thus
weighting matrix and the instruments optimally.
appears a fruitful concept linking the classical
Semiparametric efficiency bound is defined by
theory of prices and distribution and that of output
the supremum of the Cramer-Rao bounds for all
and demand. The historical elements present in the
parametric models that satisfy the
latter theory underline an outstanding feature of
semiparametric restrictions. The efficiency
Smith’s and of classical political economists’ work,
bounds for asymptotically linear semiparametric
i.e. that the analysis of output and demand is part of
estimators are given by the variances of the
the analysis of concrete ‘historical processes’ of
efficient influence functions, which are the
accumulation which, as said above, can show
projections ofthe linear influence functions onto
cyclical fluctuations around the main trend.
the tangent spaces of the semiparametric
models.
 Keywords by their asymptotic distribution. Under suitable
Asymptotic efficiency; Asymptotic variance; regularity conditions, many estimators are consis-
Asymptotically linear estimators; Average risk tent and converge to the true parameter values at
optimality; Cramer-Rao lower bound; Delta s f n rate. These estimators can be compared
method; Efficiency bounds; Euler equations; based on their asymptotic variance. The notation of
Generalized method of moment; Hodges’ efficiency bound usually refers to the largest lower
estimator; Invariance principle; Maximum bound for the variances that can be achieved by
likelihood; Mean square errors; Measurement \ f n consistent and asymptotically normal
error models; Measures of; Closeness; Minimax estimators under suitable regularity conditions.
optimality; Parametric models; Partial linear
model; Semiparametric efficiency bound;
Semiparametric models; Unbiased estimators
Asymptotic Efficiency in Parametric
Models

JEL Classifications In parametric models, the variance of an unbiased

C14 estimator has to be larger than the Cramer-Rao
lower bound, which is defined as the inverse of the
Oftentimes we want to compare estimators. For a
information matrix:
given parameter in which we are interested, there
are typically many estimators that can estimate it -i
consistently. We need to choose the best estimator, y >
or the estimator that is the closest to the true
parameter value. The mean square error
(MSE), e ( & — ( i ' j , is frequently used as where L is the likelihood function. Proofs of this
result can be found, for example, in Amemiya (
a measure of closeness. However, there can be
, pp. 138-39; , pp. 14-17).
many other various measures of closeness, and
A consistent estimator is said to be asymptotically
often they do not agree with each other. See, for efficient if its asymptotic variance achieves the
example, Amemiya( , pp. 116-24). Cramer-Lao lower bound. Under suitable regularity
Even with a given measurement of closeness, assumptions such as those given in Theorem 4.1.3
such as the MSE, it is typically not possible to rank in Amemiya ( ), the maximum likeli
two estimators. For two estimators X and Y of 9 , hood estimator is asymptotically efficient.
X is better than Y only if E ( X — 0 ) 2 < There exist super-efficient estimators whose
E ( Y — 6 ) 2 for all 6 e 0. An estimator asymptotic variances are smaller than the Cramer-
that is not dominated by another estimator in the Rao lower bound on a set of parameter 0 with
above sense is called admissible. Lebesgue measure zero, such as Hodges’s estimator
A uniformly ‘most’ efficient estimator does not defined as
exist. To find an efficient estimator, one needs to
confine the analysis to a limited class of estimators,
such as unbiased estimators or equivariant 0 if § § <ri/4
Wjr
estimators. Alternatively, one can rely on a sub- if § > T~1/4
jective strategy such as average risk optimality
which requires a prior distribution over the param-
where \ f f ( j ) — d j ■ N ( 0,
eter space, or use a pessimistic and risk-averse v(0)). One can show
approach such as minimax optimality.
d
In large sample analysis, the performance that \/T(WT — 9)— -+ N(0, v(9)) if 9 ^ 0 and \ff
measures of estimators can often be approximated
behaviour when 6 is close to 0. See for example, Y Ym(=rJ>) O lY-Ym(z'; 0) •
vanderVaart( , p. 110).
A common alternative to maximum likelihood is
Many economic models, such as those based on
generalized method of moment estimators (GMM).
Euler equations, are stated in terms of conditional
Its asymptotic efficiency is extensively discussed in
moment conditions of the form E ( m ( z ;
Newey and McFadden ( ).
[ 1 ) \ x ) 0 for almost all x These conditional
While GMM estimators are less efficient than
moment conditions can be translated into exactly
maximum likelihood (see, for example, the proof in
identified unconditional moment conditions using
Newey and McFadden ( , p. 2163 ),
an instrument matrix A ( x ) :
oftentimes they are easy to compute, especially
E A ( x ) m ( z ; [ i ) = 0. The question
when maximum likelihood is computationally
infeasible. For a given set of unconditional moment arises as to what is the optimal instrument matrix
conditions, a proper choice of the weighting matrix A ( x ) . For a given choice of A ( x ) , the
or the linear combination matrix minimizes the resulting method of moment estimator that equates j
asymptotic variance. For a given set of conditional Y 2 ' i i f t ) = 0 has asymptotic
moment conditions, a proper choice of instruments variance
can also minimize the asymptotic variance. (EA(x)G(x)) 1EA(x)fl(x)A(x)' (EG(x)' A(xyy\ where
A GMM estimator can be formed from the over- G(x) = E(4^m(z\ 0)|x) and 0(r) = Var(in(z; /i )| ,r).
identified moment conditions E m { z \ 6 ) = We can then equate
0 by minimizing a quadratic form based on a
EA(x)G(x) = EA{x)Q,{x)A{x)’
weighting matrix W :
to obtain the optimal instrument matrix A ( x )
T T 1
= G ' ( x ) ' C l ( x ) . The resulting
f bb m
('
r ;w
f bb m
( • z,;
efficient asymptotic variance is therefore
( E G ( x ) ' C l ( x ) 1 G ( x ) ) 1.
The resulting estimator has asymptotic variance Formal proofs of these derivations can be found
( G / W G y 1 ( G ' W C l W G ) in, for example, Newey and McFadden ( ).
( G / W G y \ where G = E - Estimators that achieve these efficiency
^ m ( z \ 6 ) and Q = V a r ( m ( z \ 6 ) ) bounds typically involve two-step or multi-step
Hansen ( ) showed that the optimal choice of procedures and possibly nonparametric methods,
W = Q-1, which equates G ’ W G =
G ' W E I W G . In this case the asymptotic
variance is reduced to (G'Q_1G)_1. Asymptotic Efficiency in Semiparametric
Alternatively, a set of over-identified moment Models
conditions E m ( z ; 6 ) = 0 can be
translated into a set of exactly identified moment Semiparametric models are extensions of para-
conditions by a linear combination matrix metric models where some components are spec-
ified nonparametrically with unknown functional
A E m ( z ; 9 ) = 0. Given A , the
forms. Generalized method of moment models are
resulting method of moment estimator that equates
t0 zero semiparametric models if the data-generating pro-
A Y m = i has asymptotic
cess is not fully specified. A partial linear model is
variance ( A G ) ^ 1 ( A Q A ' )
another example. Other popular semiparametric
( G ' A ' ) ~ 1 . As a rule of thumb, the optimal
models are surveyed in Powell ( ).
choice of A should simplify this asymptotic
Intuitively, the variance of an estimator for a
variance, by equating A G = A Q A 1 =
semiparametric model should be larger than the
G ' A ' . The resulting optimal A = G'Q 1
Cramer-Rao lower bound for any parametric sub-
gives rise to the same asymptotic distribution as the
model that satisfies the semiparametric restrictions.
above optimally weighted GMM estimator of
The semiparametric efficiency bound is
Hansen ( ), which minimizes
therefore defined to be the supremum of the A starting point for calculating the semi-
Cramer-Rao bounds for all parametric models that parametric efficiency bound is to restrict attention
satisfy the semiparametric restrictions. Extensive to differentiable parameters ( > ( Q ) which
results for semiparametric efficiency bounds are satisfies = E (d S ' g ) for some d and all
developed in, among others, Bickel et al. ( ) parametric sub-models. Such d are not unique.
and Newey ( ). In this section we give a brief Adding a random vector that is orthogonal to S g
summary of some of the results presented in Newey preserves the validity of d . In fact, any linear
( ). The next section will apply these influence function if / can serve as a d . For
results to a particular estimation problem. differentiable parameters, if we use the invariance
Because of pathological cases such as the super- principle and the delta method, the Cramer-Rao
efficient estimator, the semiparametric efficiency lower bound for estimating ( 1 ( 0 ) is
bound is used to provide a lower bound only for
r e g u l a r estimators. Consider a parameter of
interest that is a smooth function of the underlying (fwi) (£M))-(|«»))'
parametric path: ( 1 ( 0 ) . A regular estimator
[ 1 is one where for each 0 o the limiting = E[dSf6](ESeSf6)-lE[Sed']
distribution of — P ( d T ) ^ does not depend
Obviously, this is the variance of d g =
on 0r as
E \ d S g \ ( E \ S g S g ])~1 S g , which is
long as \/T( 0 T — d o ) is bounded. The
the projection of d onto the linear space spanned
superefficient estimator is not regular.
by the score functions S g .
Most estimators in econometrics are asymptot-
As the class of parametric sub-models expands,
ically linear, in the sense that they have an influence
the linear space it spans also increases and the
function representation as
variance of d g also increases. The semiparametric
T
efficiency bound should be the limit of this progress
Vf^-(f0)=^=^(z,)+op(l). of increments. Formally, the tangent space is
defined to be the mean square closure of all linear
combinations of scores S g for smooth parametric
In particular, almost all econometric estimators
sub-models, and the efficiency bound is given by
asymptotically solve some moment conditions the variance of the projection of d onto the tangent
m
i { ^ h f j = o P ( 1), in which space T . In other words, the efficiency bound is
given by V = E [ 8 8 ' } where 8 e T
case the linear influence function is given by i//(z,)
and E [ d - S ) ' i ] = 0 for all i e T .
= — G 1 m ( - z ; fi) for G = E-§pm(z,; P).
t

Asymptotically linear estimators are regular if

and only if for all parametric sub-models -fy Application
( 1 ( 0 j = E \ j / S ' g . When i= —
G ]
» i ( z , ; f S ) , this follows from In this section we illustrate the computation of
differentiating E g m ( z ; ( 1 ( 0 ) ) = 0 with semiparametric efficiency bound using a model of
respect to 6 . The asymptotic variance of an non-classical measurement errors, studied in Chen
asymptotically linear estimator is E i j / i j / ' , et al. ( ) and Chen et al. ( ), where
which is apparently larger than that of the maximum information from a primary data-set and from an
likelihood estimator j l ( ^ o ' j of any auxiliary data-set need to be efficiently combined.
Their models extend the results in the treatment
parametric sub-model, which is given through
effect literature on the mean parameter (see Hahn ,
information matrix and the delta method as
Hirano et al. and Imbens et al. ), to measurement
error models where parameters
are genetically defined through nonlinear moment First we assume that the moment conditions
conditions. exactly identify (1
Consider the following model. The researcher is
interested in a parameter p defined by the moment S t e p 1 Consider a parametric path 0 of the
condition E m ( Y , //) 0 if and joint distribution of Y , X and D . Define
only if [ 1 [ 1 ( ) . The researcher has access p e ( x ) = P g ( D = 1| x ) . Under
to a assumption 1, the joint density function for Y , D
primary data-set which is a random sample from the and X can be factorized into
population of interest. However, the true variable Y
is not always observed in the primary data-set. fg(y,x,d) =fe{x)pg(x)d[l -Pg{x)]^dfg{y\x)^d.
Instead, a proxy variable X is observed throughout ( 1)
the primary data. For a subset of the primary data-
set, which we will call the auxiliary data-set, X is The resulting score function is then given by
validated so that both Y and X are observed. We
Sg(d,y,x) = (1 -d)sg(y\x)
will use the random variable D 0 to denote
observations in the auxiliary data-set where both X d-p0(x)
+ Pe(x) + tg(x),
and Y are observed, and will use D 1 to denote Pe (x)(1 ~Pe 0) )
the rest of the primary data-set where only X is
observed. Chen et al. ( ) call this the ‘verify-in- where
sample’
case. They make the following conditional inde- WW = = ■^Pg(x),tg(x)
pendence assumption:
=
We'nMx}-
Assumption 4.1 Y ± D \ X .
Under this assumption, we follow the frame-
work of Newey ( ) to show that the efficiency The tangent space of this model is therefore
given by:
bound for estimating ( i is given by
( j p S Y p , where for T = {(1 - d)sg(y\x) + a{x){d -pg{x)) + te(x)}
(2)
Jfs = QjjE[m(Y-, 0)] and Sip
where \ s e ( y ’ \ x ) f e ( y ’ \ x ) d y =
1 V[m(Y;P)\X\+E(X-,p)E(X-,py
=E ( ) J l g ( x ) f , ( x ) d x = 0, and a ( x ) is
U ~P(X)
any square integrable function.

To demonstrate this result, we follow the steps S t e p 2 As in the method of moment model in
in the efficiency framework of Newey ( ). Newey ( ), the differential form of the param
First we characterize the properties of the tangent eter j l can be written as
space under Assumption . Next we write the
parameter of interest in its differential form and dm = -(^rl£ <91og fg(Y,X)'
88 m(Y\ P)
therefore find a linear influence function d . 88'
Finally, we conjecture and verify the projection of d = - (Jp)-1 {E[m(Y-, P)(Se(Y\Xy + /„(*)')]}
onto the tangent space and the variance of this
= -(jp)~1{E[m(Y;P)se(Y |X)'] + E[S(X)tg(X)']}
projection gives rise to the efficiency bound. We
first go through these three steps under the (3)
assumption that the moment conditions exactly
identify /<. Finally, the results are extended to over- Therefore d = J p 1
m ( Y ; f f ) .
identified moment conditions by considering their Since J p is only a constant matrix of nonsingular
optimal linear combinations. transformation. The projection of d onto the tangent
space will be J p
multiplied by the projection of m ( Y ; [ l ) onto Finally, consider the extensions of these results
the tangent space. Therefore we only need to to the over-identified case. When d m > d p ,
consider the projection of m ( Y ; [ l ) onto the the moment condition is equivalent to the require-
tangent space. ment that for any matrix A of dimension d p x
d m the following exactly identified system of
S t e p 3 We conjecture that this projection moment conditions holds
takes the form of
t(T,X, D) = ^_®x) [m{Y-13) - £{X)) + £{X) AE ( m ( Y ; j8)] = 0.

Differentiating under the integral again, we have

To verify that this is the efficient influence
function we need to check that x ( Y , X , D )
lies in the tangent space and that
am dm(Y; [>,) l
= - AE
E[(m(Y;fi)-x(Y,X,D))sg(Y,X)] = 0. or oe 8f3
aiog/t,(T,X|D= 1)
that x E Am(Y; ft)
d d '

Therefore, any regular estimator for ( 3 will be

E\m(Y;p)sg(Y,X)\=E[T(Y,X,D)sg(Y,X)]. (4)
asymptotically linear with influence function of the
form
To see that x ( Y , X , D ) lies in the
tangent space, note that the first term in x ( Y , ’dm(Y; (3)’
X , D ) has mean zero conditional on X, and Am{Y\ (3).
corresponds to the first term of (1 — d ) s g
( y \ x ) in the tangent space. The second term in
Fora given matrix A, the projection of the above
T(K X , D ) , E ( x ) , has unconditional
influence function onto the tangent set follows from
mean zero and obviously corresponds to the
the previous calculations, and is given by
t e ( x ) in the tangent space.
To verify ( ), one can make use of the repre-
— [A/g] 1Az(y,x,d).
sentation of E [ m ( Y , ( 3 ) s g ( Y , X ) ]
in ( ), by verifying the two terms in x( X X D ) The asymptotic variance corresponding to this
separately. The second term is obvious and efficient influence function for fixed A is therefore
1D
E
.1 - P ( X ) [m{Y-13) - E(X)]se(Y,X) [A/^'AOA'^A']-1 (5)
= E[m(Y; (3)sg(Y,X)},
where
follows from the conditional independence
Assumption and the score function property Q = E[x(J,X,D)x(Y,X,D)']
fsITfffT X ) \ X \ 0. Therefore we have verified
that x ( Y , X , D ) is the efficient projection as calculated above. Therefore, the efficient influ-
and that the efficiency bound is given by ence function is obtained when A is chosen to
minimize this efficient variance. It is easy to show
V = ( j p ) 1E[x(Y,X,D)x(Y,X,D)'](jp) f-1
that the optimal choice of A is equal to J ) , O 1,
so that the asymptotic variance becomes
Var(m(Y; /S)\x)
Li - P ( X )
i -1 v=(jftpr1jpy1.
+£(x)£(xy(Je)
 Different estimation methods can be used to Bickel, P., C.A. Klaassen, Y. Ritov, and J. Wellner. 1993.
achieve this semiparametric efficiency bound. In Efficient and adaptive estimation for semiparametric
models. New York: Springer-Verlag.
particular, Chen et at. ( ) showed that both a Chen, X., H. Hong, and A. Tarozzi. 2004. Semiparametric
semiparametric conditional expectation projection efficiency in GMM models of nonclassical measurement
estimator and a semiparametric propensity score errors. Working paper: Duke University and New York
University.
estimator based on a sieve nonparametric first-
Chen, X., H. Hong, and E. Tamer. 2005. Measurement error
stage regression achieve this efficiency bound. models with auxiliary data. Review of Economic Studies
72: 343-366.
Chemozhukov, V., and H. Hong. 2004. Likelihood inference
Conclusion for a class of nonregular econometric models.
Econometrica 72: 1445-1480.
As discussed in Newey ( ), while the calcula Hahn, J. 1998. On the Role of propensity score in efficient
semiparametric estimation of average treatment effects.
tion of the tangent space and the efficient projection Econometrica 66: 315-332.
is easy in several important examples, including the Hansen, L. 1982. Large sample properties of generalized
one above, it can be difficult in general. A variety method of moments estimators. Econometrica 50: 1029-
of techniques are available to characterize the 1054.
Hirano, K., and J. Porter. 2003. Asymptotic efficiency in
tangent space and the efficient projection. Some of parametric structural models with parameter-dependent
these are discussed in details in Newey ( ) and support. Econometrica 71: 1307-1338.
Bickel et al. ( ). Hirano, K., G. Imbens, and G. Ridder. 2003. Efficient
Even in parametric models, the notion of estimation of average treatment effects using the esti-
mated propensity score. Econometrica 71: 1161-1189.
asymptotic efficiency is more complex when one Ibragimov, I., and R. Has’minskii. 1981. Statistical esti-
compares estimators that do not convene x « rate or mation: Asymptotic theory. New York: Springer.
are not asymptotically distributed. Comparing these finbens, G., W. Newey, and G. Ridder. 2005. Mean- squared-
estimators requires the choice of a loss function, error calculations for average treatment effects. Working
paper.
and different loss functions can lead to different Newey, W. 1990. Semiparametric efficiency bounds. Journal
efficiency rankings (see Ibragimov and Has’minskii of Applied Econometrics 5(2): 99-135.
). In econometrics, these estimators sometimes arise Newey, W., and D. McFadden. 1994. Large sample esti-
in structural models in labour economics and in mation and hypothesis testing. In Handbook of
econometrics, ed. R. Engle and D. McFadden, Vol. 4.
industrial organization. The efficiency properties of Amsterdam: North-Holland.
these estimators are analysed in Hirano and Porter ( Newey, W., and J. Powell. 1990. Efficient estimation of linear
) and Chemozhukov and Hong ( ). and type in censored regression models under conditional
quantile restrictions. Econometric Theory 6: 295-317.
Powell, J. 1994. Estimation of semiparametric models. In
Handbook of econometrics, ed. R. Engle and D.
McFadden, Vol. 4. Amsterdam: North-Holland.
See Also van der Vaart, A. 1999. Asymptotic statistics. Cambridge:
Cambridge University Press.
► Generalized Method of Moment
► Maximum Likelihood
► Measurement Error Models
► Non-parametric Structural Models Efficiency Wages
► Semiparametric Estimation
Andrew Weiss

Bibliography

Amemiya, T. 1985. Advanced econometrics. Cambridge, Abstract

MA: Harvard University Press. Efficiency wages capture the effect of compen-
Amemiya, T. 1994. Introduction to statistics and econo-
metrics. Cambridge, MA: Harvard University Press.
sation on the behaviour of workers, as well as on
the quality of workers attracted and retained
 by the firm. This effect has greater significance different firms, and why these observed wage
in some areas than others, and can be used to differentials are positively correlated with firm
explain wage differentials among firms and characteristics such as profitability, high
industries, as well as to explain why firms capital-labour ratios, and establishment size (Brown
respond to demand shocks by reducing then- and Medoff ). These market imperfections arise
labour force rather than cutting wages, and may because employers cannot costlessly observe the
ration jobs even in normal times. At the ability and productivity of workers or because of
macroeconomic level efficiency wages can capital market imperfections that prevent workers
explain persistent long-term unemployment as from ‘buying’ the high- wage jobs.
an equilibrium outcome in a competitive labour Efficiency wage models have one or more of the
market. following characteristics:

Keywords
1. Compensation levels and rules affect the types
Capital cost; Capital market imperfections; of workers who are attracted to, and retained by,
Efficiency wages; Firm size; Firm-specific the firm - this is normally referred to as the
human capital; Gift exchange; Involuntary sorting effect of wages.
unemployment; Labour supply; Layoffs; Low- 2. Compensation rules create incentives for
wage probation period; Monitoring; Nutrition workers to behave in ways that increase firm
models; Productivity; Retirement; Sorting effect profits.
of wages; Wage differentials 3. Wages affect the nutrition and health of workers
and thus higher wages directly increase
productivity (these ‘nutrition’ models are most
applicable in poor countries).
JEL Classifications
J310 Consequences of the use of efficiency wages
are:
‘Efficiency wages’ is a term used to express the
1. Compensation levels within a firm may not be
idea that labour costs can be described in terms of
proportionate to relative productivity.
efficiency units of labour rather than in terms of
2. Compensation could be a function of charac-
hours worked, and that wages affect the perfor-
teristics of the establishment employing the
mance of workers. In this respect, labour differs
worker.
from most other inputs (with the notable exception
3. Wages could rise more steeply with tenure than
of credit), in which inputs are well defined
does productivity.
independently of prices. Models of efficiency wages
4. Some firms could have an excess supply of
explore the implications of the interconnections
workers.
between compensation and productivity. On the
5. A frictionless economy could be in a long-run
macroeconomic level, efficiency wages can explain
equilibrium with unemployment.
persistent unemployment without relying on either
structural imperfections such as search costs or The sorting effects of wages enable a firm to
fixed-length contracts or irrational behaviour such benefit from private information that the employee
as money illusion, which would cause real wages to knows about himself and that is either not available
fail to adjust to market conditions. (For some of the to the firm or would be costly for the firm to
earliest such models, see Futia ; Salop ; Solow ; acquire. Fligh compensation enables the firm to
Shapiro and Stig- litz ; Weiss .) At the level of the draw from a larger and better pool of workers.
firm, efficiency wages can result in job queues Firms that test job applicants will also find that, by
(excess supply of labour) and can explain why offering a higher wage, the expected
seemingly identical workers may receive different
wages at
quality of the worker hired, conditional on the and to allocate the worker’s effort in ways that
applicants test score, will also be higher. benefit the firm. See Akerlof ( ) on gift
The test could be in the form of a low-wage exchange.
probation period for new hires. Using a low-wage Higher levels of compensation will also reduce
probation period, followed by a significant wage the time needed to fill vacancies (Lang ). In this
increase, followed by high wages for workers who case the behaviour being affected is the application
perform well during the probation period, the firm process.
can attract job applicants with positive private Wages directly affect the productivity of
information about their ability. If die test is imper- workers through their effect on the nutrition of
fect, the use of a low-wage probation period will workers as well as their access to clean water and
also discourage applications from risk-averse medical care and other goods and services that
applicants as well as applicants with a higher cost of directly improve their productivity. These ‘nutri-
capital. Wages that increase steeply with tenure will tion’ effects are strongest in poor countries and
attract workers who have low quit propensities could also possibly explain poverty traps for par-
(aside from their incentive effect of deterring quits). ticularly poor workers who do not have access to
Groshen and Loh ( ) have found that much of firms that are offering efficiency wages.
the return to tenure takes place at the end of low- The importance of these effects will vary across
wage probationary periods. firms. For instance, we would expect that capital-
Sorting effects of efficiency wages may also intensive firms will derive the greatest benefit from
explain why firms do not cut wages in response to a reductions in absenteeism and quits, and from
fall in demand. If a firm were to cut the wages, it increased productivity of their employees. Capital-
may find that its better workers are most likely to intensive firms will also tend to be most vulnerable
quit. Thus, a profit maximizing firm could find that to careless behaviour by workers that would
its best response to a fall in demand for its product damage the valuable property. Larger firms have
would be to fire workers rather than to cut wages. more difficulty monitoring individual effort and
Most of the efficiency wage models have directing the effort in ways that fit the needs of the
focused on the ways in which compensation affects firm. Consequently, the efficiency wage models
the behaviour of workers. would predict that compensation would be
The incentive effects of wages stem from the correlated with firm size. The direct effects of
effect of the level of compensation on the cost to the wages through better nutrition and health take some
worker of being fired. Thus, wages above the time to affect productivity, so we would expect that
market clearing level will increase effort, decrease firms with lower costs of capital will offer higher
employee theft, decrease absenteeism, and decrease wages - in poor countries these tend to be foreign
quits. See, for example, Salop and Salop ( ), firms. (In poor countries, in which the nutrition
Klein et al. ( ), and Weiss effects are strongest, we might see that wages
( ) on quits; Shapiro and Stiglitz ( ) on would be correlated with a firm’s cost of capital as
effort; Lazear and Rosen ( ), Weiss ( ) on well as with the ability of the firm to retain workers
absenteeism. after their productivity has been enhanced by the
Levels of compensation also affect the attitude higher wages. The nutrition effects of wages may
of the employee towards the firm. Thus, paying take some time to affect productivity. ) Finally, if
wages above the market clearing level may have high wages are used to attract better workers, then
multiple beneficial effects for the firm including: we would expect that when workers are laid off
reducing employee theft, increasing unobserved from firms in high-wage industries they will tend to
effort, and inducing higher levels of care, which get jobs in other high-wage industries (see Gibbons
will decrease costs incurred from damage to the and Katz ).
firm’s property. Greater loyalty to the firm will also All of these implications of the efficiency wage
encourage workers to acquire firm-specific human model have been confirmed by empirical studies
capital, to report theft of firm property,
of the relationship between firm characteristics and Groshen, E., and E.S. Loh. 1993. What do we know about
wages. (In cases in which wages directly affects probationary periods? In Proceedings of the 45th Annual
Meeting of the Industrial Relations Research Association,
productivity we would expect that firms that are Madison.
likely to be able to retain their workers will also pay Hein, R., R. Spady, and A. Weiss. 1991. Factors affecting the
higher wages. However, since wages directly affects output and quit propensities of production workers.
turnover, and prices vary according to the presence Review of Economic Studies 58: 929-954.
Landau, EL, and A. Weiss. 1984. Wages, hiring standards and
of competitive firms, this implication of the firm size. Journal of Labor Economics 2:477—499.
nutrition version of the efficiency wage model is Lang, K. 1991. Persistent wage dispersion and involuntary
more difficult to verify.) Of course, many if not all unemployment. Quarterly Journal of Economics 106:
of these empirical findings can be explained by 181-202.
Lazear, E., and S. Rosen. 1981. Rank-order tournaments as
other models. For example, the relationship between optimum labor contracts. Journal of Political Economy
prior and posterior industry wages for laid-off 89: 841-864.
workers can be explained by competitive models in Salop, J., and S. Salop. 1976. Self-selection and turnover in
which workers are being selected based on the labor market. Quarterly Journal of Economics 90:
619-627.
attributes, such as pulchritude, that are directly
Salop, S. 1979. A model of the natural rate of unemployment.
observed by the firm but not by the researchers. American Economic Review 69: 117-125.
Thus, efficiency wages can explain why empir- Shapiro, C., and J. Stiglitz. 1984. Equilibrium unemployment
ical studies of the relationship between wage and as a worker discipline device. American Economic
Review 74: 433-444.
characteristics of establishments find that large,
Solow, R. 1979. Another possible source of wage stickiness.
capital-intensive establishments are most likely to Journal of Macroeconomics 1: 79-82.
pay wages that are above market clearing levels - Weiss, A. 1981. Job queues and layoffs in labor markets with
and in the case of poor countries why foreign firms flexible wages. Journal of Political Economy 88: 526-
538.
tend to pay higher wages. The efficiency wage
Weiss, A. 1984. Determinants of quit behavior. Journal of
models also can explain why firms fire workers Labor Economics 2: 371-387.
rather than cutting wages, offer wages that attract an Weiss, A. 1985. Absenteeism and wages. Economics Letters
excess supply of workers, and pay some of their 19: 211-219.
Weiss, A., and R. Wang. 1998. Probation, layoffs, and wage-
workers to take early retirement or seek to impose
tenure profiles: A sorting explanation. Labour Economics
mandatory retirement. See, for instance, Brown and 5: 359-383.
Medoff ( ).
Finally, efficiency wage theory can explain the
persistence of involuntary unemployment in a free
market economy.
Efficient Allocation

Stanley Reiter

Bibliography

Akerlof, G.A. 1982. Labor contracts as partial gift exchange.

Quarterly Journal of Economics 97: 543-569. JEL Classifications
Akerlof, G.A. 1984. Gift exchange and efficiency-wage D5
theory: Four views. American Economic Review 74(2):
79-83. Analysis of efficiency in the context of resource
Brown, C., and J. Medoff. 1989. The employer size-wage
allocation has been a central concern of economic
effect. Journal of Political Economy 97: 1027-1059.
Futia, C. 1977. Excess supply equilibria. Journal of Economic theory from ancient times, and is an essential
Theory 14: 200-220. element of modem microeconomic theory. The ends
Gibbons, R., and L. Katz. 1992. Does unmeasured ability of economic action are seen to be the satisfaction of
explain inter-industry wage differentials? Review of human wants through the provision of goods and
Economic Studies 59: 515 535.
services. These are supplied by
production and exchange and limited by scarcity of role of information is ignored, or in which agents do
resources and technology. In this context efficiency not behave strategically on the basis of private
means going as far as possible in the satisfaction of information. In so doing, a large and important class
wants within resource and technological constraints. of models involving problems of efficient allocation
This is expressed by the concept of Pareto in the presence of incentive constraints is excluded.
optimality, which can be stated informally as The main ideas of efficient resource allocation
follows: a state of affairs is Pareto optimal if it is are present in their simplest form in the linear
within the given constraints and it is not the case activity analysis model of production. We begin
that everyone can be made better off in his own with that model.
view by changing to another state of affairs that
satisfies the applicable constraints.
Because knowledge about wants, resources and
technology is dispersed, efficient outcomes can be Efficiency of Production: Linear Activity
achieved only by coordination of economic activity. Analysis
Hayek ( ) pointed out the role of
knowledge or information, particularly in the con- The analysis of production can to some extent be
text of prices and markets, in coordinating eco- separated from that of other economic activity. The
nomic activity. Acquiring, processing and concept of efficiency appropriate to this analysis
transmitting information are costly activities descends from that of Pareto optimality, which
themselves subject to constraints imposed by refers to both productive and allocative efficiency in
technological and resource limitations. Hayek the full economy in which production is embedded.
pointed out that the institutions of markets and It is useful to begin with a model in which
prices function to communicate information dis- technological possibilities afford constant returns to
persed among economic agents so as to bring about scale, that is, with the (linear) activity analysis
coordinated economic action. He also drew model of production pioneered by Koopmans ( ,
attention to motivational properties of those , ), and closely
institutions, or incentives. In this context, the related to the development of linear programming
concept of efficiency takes account of the associated with Dantzig ( , ) and indepen
organizational constraints on information pro- dently with the Russian mathematician
cessing and transmission in addition to those on Kantorovitch ( , ) and Kantorovitch and
production of ordinary goods and services. The Gavurin ( ).
magnitude of resources devoted to business or The two primitive concepts of the model are
governmental bureaucracies, and to some of the c o m m o d i t y and a c t i v i t y . A list
functions performed by industrial salesmen, attests of n commodities is postulated; a commodity
to the importance of these constraints. Economic b u n d l e is given by specifying a sequence of
analysis of efficient allocation has formally imposed n numbers a \ , a 2 , ... , a „ .
only the constraints on production and exchange, Technological possibilities are thought of as
and until recently recognized organizational knowledge of how to transform commodities. Such
constraints only in an informal way. But it is these knowledge may be described in terms of collections
constraints that motivate the pervasive and enduring of activities called p r o c e s s e s , much as
interest in decentralized modes of economic knowledge of how to prepare food is described by
organization, particularly the competitive recipes. A recipe commonly has two parts, a list of
mechanism. ingredients or inputs and of the output(s) of the
It is necessary to limit the scope of this essay so recipe, and a description of how the ingredients are
that it is not coextensive with microeconomic to be combined to produce the output(s). In the
theory. The main limitation imposed here is to activity analysis model the description of productive
confine attention to models in which either the activity is suppressed. Only the specification of
inputs and outputs is retained; this defines the
production process.
 Commodities are classified into ‘desired', ‘pri- vector representing the basic activity that defines
mary’ and ‘intermediate' commodities. Desired the/th basic process, and let.r = (x1; x 2
commodities are those whose consumption or ...........................................................................
availability is the recognized goal of production; x „ )
they satisfy wants. Primary commodities are those be the vector whose /th component x , is the scale
available from nature. (A primary commodity that (level or intensity) of the /th basic process. Let y
is also desired is listed separately among the desired = ( y u y 2 . .y„) be the vector of commodi
commodities and must be transformed by an act of ties. Technology is represented by a linear trans-
production into its desired form). Intermediate formation mapping the space of activity levels into
commodities are those that merely pass from one the commodity space, i.e.
stage of production to another. Each commodity can
exist in any non-negative amount y = Ax x > 0.
(d i v i s i b i l i t y ). Addition and
subtraction of the numbers measuring the amount of With the properties assumed, a process can be
a commodity represent joining and separating represented geometrically in the commodity space
corresponding amounts of the commodity. by a halfline from the origin including all non-
An activity is characterized by a n e t negative multiples of some activity in that process.
o u t p u t n u m b e r for each commodity', The finite number of halflines representing basic
which is positive if the commodity is a net output, processes generate a convex polyhedral cone
negative if it is a net input and zero if it is neither. consisting of all activities that can be expressed as
The term i n p u t - o u t p u t v e c t o r sums of activities in the basic processes, or
is also used for this ordered array of numbers. equivalently, as non-negative linear combinations
Activity' analysis postulates a finite number of basic of the basic activities, sometimes called a
activities from which all technologically possible b u n d l e o f b a s i c
activities can be generated by suitable combination. a c t i v i t i e s . This cone is called the
Allowable combinations are as follows. If two p r o d u c t i o n s e t , or set of
activities are known to be possible, then the activity p o s s i b l e p r o d u c t i o n s .
given by their algebraic sum is also possible, i.e. if Two other assumptions are made about the
a - - ( a x , a 2 , . . . , a „ ) and production set itself, rather than just the individual
b = ( b u b 2 , . . . , b „ ) , then activities. First, there is no activity', whether basic
a + b = { a ,+h u a 2 + b 2 , •• or derived, in the production set with a positive net
• , a „ + b „ ) is also possible. Thus, output of some commodity and non-negative net
additivity embodies an assumption of non- outputs of all commodities. This excludes the
interaction between productive activities, at least at possibility of producing something from nothing,
the level ofknowledge. Furthermore, if an activity is whether directly or indirectly. Second, it is assumed
possible, then so is every nonnegative multiple of it that the production set contains at least one activity
( p r o p o r t i o n a l i t y ) , i.e. if a = with a positive net output of some commodity.
( a i, a 2 , ... , a „ ) is possible, then so is p a If the availability of primary commodities is
= ( p a i, p a 2 , ... , p a , , ) for any non- subject to a bound, the technologically possible
negative real number p . This expresses the productions described by the production set are
assumption of constant returns to scale. The family subject to another restriction; only those possible
of activities consisting of all non-negative multiples productions that do not require primaiy inputs in
of a given one forms a process. Since there is a amounts exceeding the given bounds can be pro-
finite number of basic activities, there is also a duced. Furthermore, because intermediate com-
finite number of basic processes, each intended to modities are not desired in themselves, their net
describe a basic method of production capable of output is required to be zero. (Strictly speaking, the
being carried out at different levels, or intensities. technological constraint on intermediate com-
The assumptions of additivity' and proportion- modities is that their net output be non-negative.
ality deteimine a linear model of technology that The requirement that they be zero can be viewed as
can be given the following form. Let A be an n by one of elementary efficiency, excluding
accumulation or necessity to dispose of unwanted maximize profit for suitably chosen prices. The
goods.) With these restrictions the model can be profit returned by a process carried out at the level x
written is

y = A x , x > 0, X
J2i P‘ai'
y t = 0 if i is an intermediate
where the prices are p =
commodity, and ( p \ , . . . , / > , , ) ■ and a = («!, ...
yt > ri , a „ ) is the basic activity defining theprocess; the
profit on the bundle of activities A x at prices p is
if i is a primary commodity, where r t is the (non- given by the inner product
positive) limit on the availability of primary py = pAx.
commodity i . This leads to the concept of an This characterization is the economic expression
a t t a i n a b l e activity. of an important mathematical fact about convex sets
A bundle of basic activities is in n — 1 dimensional Euclidean space, namely
a t t a i n a b l e if the resulting net outputs that through every point of the space not interior to
are non-negative for all desired commodities, zero the convex set in question there passes a hyperplane
for intermediate commodities and non-positive for that contains the set in one of its two halfspaces
primary commodities, and if the total inputs of (Fenchel ; Nikaido , ).
primary commodities do not exceed (in absolute (A hyperplane in n dimensional space is a level set
amount) the prescribed bounds of availability of of a linear function of n variables, and thus is a
those commodities. The set of activities satisfying translate of an n 1 dimensional linear subspace. A
these conditions is a truncated convex polyhedral hyperplane is given by an equation of the form
cone in the commodity space called the s e t o f c \ X \ + c 2 X 2 +•••+c „ x n = k ,
a t t a i n a b l e p r o d u c t i o n s . where the x’s are variables, the c’s are coefficients
The concept of productive efficiency in this defining the linear function and A: is a constant
model is as follows. An activity (a bundle of basic identifying the level set. A hyperplane divides the
activities) is e f f i c i e n t if it is attainable space into two halfspaces corresponding to the two
and if every activity that provides more of some inequalities C|X| + c2x2 + • • • + c p x n f k
desired commodity and no less of any other is not respectively.) It can also be seen that a point of a
attainable. convex set is a boundary point if and only if it
This concept can be seen to be a specialization maximizes a linear function on the (closure of the)
of Pareto optimality. If for each desired commodity set. These facts can be used to characterize efficient
there is at least one consumer who is not satiated in production because the attainable production set is
that commodity, at least in the range of production convex and efficient activities are boundary points
attainable within the given resource limitations, of it. Because the efficient points are those, roughly
then increasing the amount of any desired speaking, on the ‘north-east’ frontier of the set, the
commodity without decreasing any other can linear functions associated with them have non-
improve the state of some non-satiated consumer negative coefficients, interpreted as prices. On the
without worsening that of any other. other hand, if a point of the attainable set maximizes
a linear function with strictly positive coefficients
(prices), then it is on the ‘north-east’ frontier of the
Characterizing Efficient Production in set.
Terms of Prices In Fig. the set enclosed by the broken line and
the axes is the projection of the attainable set on the
Efficient production can be characterized in terms output coordinates; inputs are not shown. The pointy
of i m p l i c i t p r i c e s , also called in the figure is efficient; the pointy is not; both y
s h a d o w p r i c e s , or in the context of and y " maximize a linear function with
linear programming, d u a l
Efficient Allocation,
Fig. 1

non-negative coefficients (the level set containing / profitability of a process is not zero or negative,
is labelled a and also contains y " ) . However, then, in the eyes of its manager, who does not know
y ' maximizes a linear function with positive the aggregate resource constraints, it can be made
coefficients (one such, whose level set through / is infinite. Therefore, the systems of prices that can be
labelled b , is shown), while y " does not. considered for the role of efficiency prices must be
These implicit, or efficiency prices arise from restricted to those c o m p a t i b l e w i t h
the logic of efficiency or maximization when the t h e g i v e n t e c h n o l o g y ,
relevant sets are convex, not from any institutions namely prices such that no process is profitable and
such as markets or exchange. An important reason at least one process breaks even). Two propositions
for interest in them is the possibility of achieving characterize efficient production by prices and
efficient performance by decentralized methods. As provide the basis for an interpretation in terms of
described above, under the assumptions of additivity decentralized control of production.
and constant returns to scale the production set can In a given linear activity analysis model, if there is a
be seen to be generated by a finite number of basic given system of prices compatible with the technol-
processes, each of which consists of the activities ogy, in which the prices of all desired commodities
are positive, then any attainable bundle of basic
that are non-negative multiples of a basic activity,
activities selected only from processes that break
the multiple being the scale (level, or intensity) at even and which utilizes all positively priced primary
which the process is operated. Following the commodities to the limit of their availability and
presentation of Koopmans ( ), does not use negatively priced primary commodities
at all, is an efficient bundle of activities.
each basic process is controlled by a manager, who
In a given linear activity analysis model, each
decides on its level. The manager of a process is efficient bundle of activities has associated with it at
assumed to know only the input-output coefficients least one system of prices compatible with the tech-
of his process. Each primary resource is in the nology such that every activity in that bundle breaks
even and such that prices of desired commodities are
charge of a resource holder, who knows the limit of
positive, and the price of a primary commodity is
its availability. Efficiency prices are used to guide non-negative, zero or non-positive, according as its
the choices of managers and resource holders. available supply is full, partly, or not used at all
(Under constant returns to scale, if an activity yields (Koopmans ).
positive profit at a given system of prices, then
increasing the scale of the process containing that These propositions are stated in a static form. There
activity increases the profit. Since the scale can be is no reference to managers raising or lowering the
increased without bound, if the levels of the processes they control, or to
resource holders adjusting prices. A dynamic inputs. In this case the (vector-valued) function F
counterpart of these propositions would be of can be written
interest, but because of the linearity of the model
such dynamic adjustments are unstable F(x) = \f(x),gl(x),g2(x),... ,gm(x)],
(Samuelson ).
where the value of/is the output, and g l , ... , g „ ,
It should also be noted that the concept of
correspond to the various inputs. Resource con-
decentralization is not explicitly defined in this
straints are expressed by the conditions
literature; the interpretation is by analogy with the
competitive mechanism. Nevertheless, the interest g j ( x ) > 0, f o r j = 1,2, . . . , m ,
in characterizing efficiency by prices and their
interpretation in terms of decentralization is an and non-negativity of process levels by the con-
important theme in the study of efficient resource dition, x > 0. (Here the resource constraints T j <
allocation. h j ( x ) < 0 are written more compactly as
The linear activity analysis model has been h j ( x ) - r j = g / x ) > 0.)
generalized in several directions. These include In this model the definition of efficient produc-
dropping the assumption of proportionality, tion given in the linear model amounts to maxi-
dropping the restriction to a finite number of basic mizing the value of/subject to the resource and non-
activities, dropping the restriction to a finite number negativity constraints just mentioned.
of commodities and dropping the restriction to a Problems of constrained maximization are inti-
finite number of agents. Perhaps the most directly mately related to saddle-point problems. LetZ be a
related generalization is to the nonlinear activity real valued function defined on the set A x Tin
analysis, or nonlinear programming, model. R " . A point (x*, y * ) in A x Tis a
s a d d l e p o i n t of L if

Efficiency of Production: Nonlinear L(x,y*) <L(x*,y*) <L(x*,y),

Programming
for all x in A and all y in Y . The concept of a
In the nonlinear programming model there is, as in concave function is also needed. A real valued
the linear model, a finite number of basic processes. function / defined on a convex set A in R " is a
Their levels are represented by a vector x = (xi, x2, c o n c a v e f u n c t i o n if for all x and y
■ ■ ■ , Ay), where k is the number of in A and all real numbers 0 < a < 1
basic processes. Technology is represented by a
f(ax + (1 - a)y) > of (pc) + (1 - a)f(y).
nonlinear transformation from the space of process
levels to the commodity space (still assumed to be The following mathematical theorem is
finite dimensional), written fundamental.
y = F(x), x > 0- Theorem (Kuhn and Tucker ; Uzawa ): Let/and g \
, g 2 , ... , g m be real valued concave
The production set in this model is the image in the
ftinctions defined on a convex set A in R " . If /
commodity space of the non-negative orthant of the
achieves a maximum on A subject to g / x ) > 0, j
space of process levels. Under the assumptions
= 1 , 2 , . . . , m at the pointx in A, then there exist
usually made about k \ the production set is
non-negative numbers p f p f ■ ■ ■
convex, though, of course, not a polyhedral cone.
, p * „ , not all zero, such thatp * { f (x) +
In this model as in the linear activity analysis
p * g ( x ) < p f f ( x * ) for all x in A, and
model a central result is the characterization of
furthermore, p * g ( x ) * = 0. (Here the
efficient production in terms of prices. The simplest
case to begin with is that of one desired commodity, vectors p * = ( p \ , p * 2 , ■ ■
say, one output, with perhaps several ■ , P * m ) , and g(x) = \ g / x ) ,
g 2 ( x ) , , g j x ) ] ) . The vector
p * may be
 / subject to g/x) > 0 for/ 1 , 2 , . . . , m if and
l>; = >•
0 only if there exists numbers X \ , X f . . .
, X * m such that the first-order conditions for a
An additional condition (Slater ) is important. (It saddle point of L ( x , X ) = f i x ) +
ensures that the coefficient p 0 of/is not 2g(x) are satisfied at (x*, A,*).
zero.) If there are non-negativity conditions on the x’s,

Slater’s Condition There is a point x' in X at g j ( x ) >0, x > 0, x in R n

which g / x ' ) > 0 for ally = 1 , 2 , ... , m .
If attention is restricted to concave functions, as and the first-order conditions can be written
in the Kuhn-Tucker-Uzawa Theorem, the relation
/:+ r g * x < o, (/; + r § ;y = o,
between constrained maxima and saddle points can
X * g ( x * ) = 0, g ( x * ) > 0 , g ( x * ) > 0, r>0
be summarized in the following theorem.
and !/(/) = 0,
Theorem If / and g j , j = 1 , 2 , . . . , m are
where/* denotes the derivative of/evaluated at x*. In
concave functions defined on a convex subset X in
more explicit notation, the conditions /* + X * g *
R " , and if Slater’s Condition is satisfied, thenx in
= 0 can be written as
X maximizes / subject to g / x ) > 0 , j =
1 , 2 , . . . , m , if and only if there exists X * = m
(/-P-2 ’ • • •. K , ) ’ V > 0 for/ = 1 , 2 , . . . , m , such df/dxi + E X*dgJdxi = 0, i = 1,2, ... ,n
j= 1 JJ
that (x*, X * ) is a saddle point of L ( x , X )
= f i x ) + / . g ( x ) on A x R n _ . When the assumption of concavity is dropped, it
This theorem is easily seen to cover the case is no longer possible to ensure that the local
where some constraints are equalities, as in the case maximum is also a global one. However, it is still
of intermediate commodities. The sufficiency half of possible to analyse local constrained maxima in
this theorem holds for functions that are not terms of local saddle-point conditions. In this case a
concave. condition is needed to ensure that the first-order
T h e a u x i l i a r y conditions for a saddle point are indeed necessary
v a r i a b l e s X \ , i2 , • • • , called conditions. The Kuhn-Tucker Constraint Qualifi-
L a g r a n g e m u l t i p l i e r s , play cation is such a condition. Arrow et al. ( )
the role of efficiency prices, or shadow prices; they have found a number of conditions, more useful in
evaluate the resources constrained by the condition application to economic models, that imply the
g(x) > 0. The maximum characterized by the Constraint Qualification.
theorem is a global one, as in the case of linear The case of more than one desired commodity
activity analysis. leads to what is called the v e c t o r
If the functions involved are differentiable, a m a x i m u m p r o b l e m , Kuhn and
saddle point of the Lagrangean can be studied in Tucker ( ). This may be
terms of first-order conditions. The first-order defined as follows. Let f i , f i , ... , f i and gi ,
conditions are necessary conditions for a saddle g2 , ... , g m be real valued functions defined on a
point of L . If the functions /and the g’s are con- set X in R ” . We say x* in X achieves a
cave on a convex set X, then the first-order condi- (global) v e c t o r m a x i m u m off =
tions at a point (x*, X * ) are also sufficient; that • • • , f k ) subject
is, they imply that (,Y*. X * ) is a saddle point ofZ. to
Thus, g f i x ) > 0 , j = 1 , 2 , ... , m if,

Theorem I f f gi , g2 , ... , g m arc concave and (!) g j CO > 0 J = 1 , 2 , ... , m ,

differentiable on an open convex set X in R " , (II) there does not exist x ! in X satisfying f ( x )
and if Slater’s Condition is satisfied, then x * > f i ( x * ) for i = l , 2 , . . . , k with
maximizes f ( x ) > f ( x * ) for some value of i ,
 This is just the concept of an efficient point maximum of/subject to the constraints g(x) > 0 and
expressed in the present notation. x in A is a Pareto optimum, and vice versa Hence
A vector maximum has a saddle-point charac- the saddle-point theorems give a characterization of
terization similar to that for a scalar valued function. Pareto optima by prices. The interpretation of prices
in terms of decentralized resource allocation
Theorem f e t f , f 2 , described in the linear activity analysis model also
■ ■ ■ , f k w d g l , g 1 , . . . , g , „ be applies in this nonlinear model. The proofs of these
real valued concave functions defined on a convex theorems reveal an important logical role played by
Aset in if". Suppose there is x° in A such that the principle of marginal cost pricing.
g j ( x ° ) > 0 , j = 1,2 , ... , m , (Slater’s The basic theorems of nonlinear programming,
Condition). If x* achieves a vector maximum o f f especially the Kuhn-Tucker-Uzawa Theorem in the
subject to g(x) > 0 then there exist a = (a1( a 2 , setting of the vector maximum problem, have been
... , a k ) and X * = ( X \ , X 2 , . . . , extended to the case of infinitely many commodi-
X * m ) with a } > 0 for all j , a f 0 and ties. (Hurwicz , first obtained the basic results in
X > 0 such that (x*, X * ) is a saddle point of this field.) Technicalities aside, the theorems carry
the Lagrangean L ( x , X ) = a f { x ) over to certain infinite dimensional spaces, namely
+ 2g(x). linear topological spaces, or in the case of first-
Several different ‘converses’, to this theorem order conditions, Banach spaces.
are known. One states that if x* maximizes L ( x , Dropping the restriction to a finite number of
X * ) for some strictly positive vector a and basic processes leads to classical production or
non-negative X * , and if X * g ( x * ) = 0 transformation function models of production,
and g(x*) > 0, then x* gives a vector maximum off whose properties depend on the detailed
subject to g(x) > 0, and x in A. Another, parallel to specifications made.
the result for the case of one desired commodity, is Samuelson ( ) used Lagrangean methods
the following. to analyse interior maxima subject to equality
constraints in the context of production function
Theorem Let/and g be functions as in the theorem models, as well as that of optimization by con-
above. If there are positive real numbers c i i , sumers. He also gave the interpretation of Lagrange
a 2 , ... , a k and if (z , X ) is a saddle point of multipliers as shadow prices.
the Lagrangean L (defined as above) then (I) x*
achieves a maximum off subject to g(x) > 0 onX ,
and (II) X * g (x*) 0.
Efficient Allocation in an Economy with
The positive numbers a y , ... , a k are Consumers and Producers
interpreted as prices of desired commodities, and In an economy with both consumption and produc-
the non-negative numbers X * are prices of the tion decisions, efficiency is concerned with distri-
remaining commodities. The condition bution as well as production. Data about restrictions
/ . “ g ( x “) = 0 which arises in these theorems on consumption and the wants of consumers must
states that the value of unused resources at die be specified in addition to the data about produc-
efficiency prices X * is zero; that is, resources not tion. The elements of the models are as follows.
fully utilized at a vector maximum have a zero The commodity space is denoted A; it might
price. be /-dimensional Euclidean space, or a more
The connection between vector maxima and abstract space such as an additive group in which,
Pareto optima is as follows. Because a vector max- for example, some coordinates are restricted to have
imum is an efficient point (for die vectorial ordering integer values. There is a (finite) list of consumers,
of the commodity space), it is a Pareto optimum for 1, 2 , . . . , n , and a similar list of producers, 1,
appropriately specified (non-satiated) utility func- 2 , . . . , m . A s t a t e of the economy is an
tions, as was already pointed out in the case of the array consisting of a commodity bundle for
linear activity analysis model. Furthermore, if the
functions /i , ... , f k are themselves utility func-
each agent in the economy, consumer or producer. Explicitly, they are the states ((x* 7), (y*7)) that are
This may be written ((x7), (/)), where ( x ‘ ) = feasible in the given environment, and such that if
(x1, x2, ... , x") and (y7) = (y1, y 2 , . . . , any other state ((x7), (y7)) has the property that (x7)
y m ) and x7' and y are commodity bundles. >-(x*7) for all i with (x7) > , ( x * ' ) for some
Absolute constraints on consumption are expressed i , then ((x7), (y7)) is not feasible in the given
by requiring that the allocation (x7) belong to a environment.
specified subset X of the space A" of allocations. It is important to note that the set of feasible
Examples of such constraints are: states and the set of Pareto optimal states are
completely determined by the environment; spec-
1. The requirement that the quantity of a certain ification of economic organization is not involved.
commodity be non-negative. At this level of generality, where externalities in
2. The requirement that a consumer requires certain consumption and production are admitted as
minimum quantities of commodities in order to possibilities, and where commodities may be indi-
survive. visible, no general characterization of Pareto optima
in terms of prices is possible. (Indeed, Pareto
Each consumer i has a preference relation, optima may not exist. Conditions that make the set
denoted X, defined onX. This formulation admits of feasible allocations non-empty and compact and
externalities in consumption, including physical preferences continuous suffice to ensiue the
externalities and externalities in preferences; for existence of Pareto optima. ) In environments with
example, preferences that depend on the con- externalities, or other non- neoclassical features,
sumption of other agents, termed non-selfish pref- Pareto optima are generally not attainable by
erences. The consumption set of the rth consumer is decentralized processes.
the projection X of X onto the space of commodity If the class of environments under consideration
bundles whose coordinates refer to the holdings of is restricted to the neoclassical environments, the
the /th consumer. fundamental theorems of welfare economics
Technology is specified by a production set Y , provide a characterization of Pareto optimal states
a subset of X”, consisting of those arrays (y7) of via efficiency prices. That characterization has a
input-output vectors that are jointly feasible for all natural interpretation in terms of a decentralized
producers. The production set of the /th producer, mechanism for allocation of resources.
denoted F, is the projection of Y onto the subspace The framework for these results is obtained by
of X” whose coordinates refer to the /th producer. restricting the class of environments specified above
The (aggregate) initial endowment of the econ- as follows. The commodity space is to be Euclidean
omy is denoted by w, a commodity bundle inX. space of l dimensions, i.e. X = X. The
These specifications define an consumption set for the economy is to be the
e n v i r o n m e n t , a term introduced by product of its projections, i.e. X = X x X x • • • x
Hurwicz ( ) in this usage X7. This expresses the fact that if each agent’s
and according to him suggested by Jacob Marschak. consumption is feasible for him, the total array is
This term refers to the primitive or given data from jointly feasible. Furthermore, each agent is
which analysis begins. Each environment restricted to having selfish preferences; that is,
determines a set of f e a s i b l e states. These agent f s preference relation depends only on the
are the states ( ( x ) , (y7)) such that (x7) is inX, (y7) coordinates of the allocation that refer to his
is in Y and holdings. In that case the preference relation X
may be defined only on X, for each i . Similarly,
< w- externalities are mled out in production, i.e. Y =
Y 1 x Y 2 x ■ ■ ■ x F".
An environment determines the set of states that The concept of an e q u i l i b r i u m
are Pareto optimal for that environment. r e l a t i v e t o a p r i c e
s y s t e m (Debreu ) serves to characterize
Pareto optima by prices. A price system, denoted
p , is an
element of R 1 ; the environment e = [ ( X ) , satiated at x * ' . Then there is a price system p ,
(F), w ] is of the restricted type specified above with not all components equal to 0, such that -
(free of externalities and indivisibilities). except for Arrow’s ( ) ‘exceptional case’,
A state \(x‘), (y*7)] of e is an equilibrium where p is such that for some i the expenditure
relative to price system p if: p x * 1 is a minimum on the consumption set X
- the state [(x*'), (y*7)] is an equilibrium relative to
1. For every consumer i , x * ‘ maximizes p .
preference X , on the set of consumption (The condition that preferences are convex and
bundles whose value at the prices p does not not satiated is sufficient to exclude ‘thick’ indif-
exceed the value of x * ‘ at those prices, i.e., if ference sets. A preference relation on A' is convex if
X is in { X in X : p X whenever X and x" are points of X with X strictly
< p x * 1 } then X < i x l . preferred to X ' then the line segment connecting
2. For every producer j , y * J maximizes profit them (not including the point x") is strictly preferred
p y ? on F. to X . The consumption set X must be convex for
3. Aggregate supply and demand balance, i.e. this property to make sense. A preference relation is
not satiated if there is no consumption preferred to
all others.)
- Y . f ’ = »■
i i Hurwicz ( ) has given an alternative for
malization of the competitive mechanism in which
Arrow’s exceptional case presents no difficulties.
An equilibrium relative to a price system differs
If the exceptional case is not excluded, then it
from a competitive equilibrium (see below) in that
can still be said that:
the former does not involve the budget constraints
applying to consumers in the latter concept. In an 1. x*' minimizes expenditure at prices p on the
equilibrium relative to a price system the distribu- upper contour set of x*', for every i , and
tion of initial endowment and ofthe profits offirms 2. y * J
maximizes ‘profit’ p y ' on the
among consumers need not be specified. production set
The first theorem of neoclassical welfare eco- F, for every j .
nomics states, subject only to the exclusion of
externalities and a mild condition that excludes The state (x\ y * ) together with the prices p ,
constitute
preferences with thick indifference sets, that a state a v a l u a t i o n
of an environment e that is an equilibrium relative e q u i l i b r i u m (Debreu ).
to a price systemp is a Pareto optimum of e As in the case of efficiency prices in pure pro-
(Koopmans ). duction models, these prices have in themselves no
The second welfare theorem is deeper and holds institutional significance. They are, however, in the
only on a smaller class of environments, sometimes same way as other efficiency prices, suggestive of
an interpretation in terms of decentralization.
referred to in the literature as the c l a s s i c a l
e n v i r o n m e n t s (called neoclassical If, in addition to the restriction to classical
above). One version of this theorem is as follows. environments, the economic organization is spec-
Let e = [(A1), (£,•), (F), w ] be an environment ified to be that of a system of markets in a private
such that for each i ownership economy, and if agents are assumed to
take prices as given, then the welfare theorems can
1. A* is convex. translate into the assertion that the set of Pareto
2. The preference relation X ,• is continuous. optima of an environment e and the set of com-
3. The preference relation X ,• is convex. petitive equilibria for e (subject to the possible
4. The set X, is convex. redistribution of initial endowment and ownership
shares) are identical. More precisely, the specifi-
Let [(x*'), ( \ - ' ) ] be a Pareto optimum of e
cation of the environment given above is augmented
such that there is at least one consumer who is not
by giving each consumer a bundle of commodities,
his initial endowment, denoted w'.
The total endowment is w = X,u '. Furthermore, each into theorems stated in terms of competitive equi-
consumer has a claim to a share of the profits of librium. Briefly, every competitive equilibrium
each firm; the claims for the profit of each firm are allocation in a given classical environment is Pareto
assumed to add up to the entire profit. When prices optimal in that environment, and every Pareto
and the production decisions of the firms are given, optimal allocation in a given classical environment
the profits of the firms are determined and so is the can be made a competitive equilibrium allocation of
value of each consumer’s initial endowment. an environment that differs from the given one only
Therefore, the income of each consumer is in the distribution of the initial endowment. (Arrow
determined. Hence, the set of commodity bundles a ( ), Koopmans ( ),
consumer can afford to buy at the given prices, Debreu ( ) and Arrow and Hahn ( ) give
called his b u d g e t s e t , is determined; this modem and definitive treatment of the classical
consists of all bundles in his consumption set whose welfare theorems.)
value at the given prices does not exceed his income It should be noted that the equilibria involved
at the given prices. Competitive behaviour of must exist for these theorems to have content.
consumers means that each consumer treats the Sufficient conditions for existence of competitive
prices as given constants and chooses a bundle in equilibrium, which, since a competitive equilibrium
his budget set that maximizes his preference: that is, is automatically an equilibrium relative to a price
a bundle .r' that is in X 1 and such that if any other system, are also sufficient for existence of an
bundle x " is preferred to it, then x " is not in his equilibrium relative to a price system, include
budget set. convexity and continuity of consumption sets and
Competitive behaviour of firms is to maximize preferences and of production sets, as well as some
profits computed at the given prices p , regarded assumptions which apply to the environment as a
by the firms as constants; that is, a firm chooses a whole, restricting the ways in which individual
production vector / in its production set with the agents may fit together to form an environment
property that any other vector affording higher (Arrow and Debreu ; Debreu ; McKenzie ).
profits than p \ J is not in the production set of The second welfare theorem involves redistri-
firmj . bution of initial endowment. This is essential
A c o m p e t i t i v e because the set of competitive equilibria from a
e q u i l i b r i u m is a specification of a given initial endowment is small (essentially finite)
commodity bundle for each consumer, a production (Debreu ), while the set of Pareto optima is
vector for each firm, and a price system, together generally a continuum. The set of Pareto optima
denoted [(r*')> 0 where p * has cannot in general be generated as competitive
no negative components, satisfying the following allocations without varying the initial point. If
conditions: redistribution is done by an economic mechanism,
then it should be a decentralized one to support the
1. For each consumer i the bundle x * ’
interpretation given of the second welfare theorem.
maximizes preference on the budget set of i .
No such mechanism has been put forward as yet.
2. For each firm j the production vector y '
Redistribution of initial endowment by lump-sum
maximizes profitP y on the production set F.
taxes and transfers has been discussed. A customary
3. For each commodity, the total consumption
interpretation views these as brought about by a
does not exceed the net total output of all firms
process outside economics, perhaps by a political
plus the total initial endowment, i.e. Epr*' -
process; no claim is made that such processes are
’ L J y v < w = w ' ;
decentralized. Some economists consider
4. For those commodities k for which the inequal-
dependence on redistribution unsatisfactory because
ity in 3 is strict; that is, the total consumption is
information about initial endowment is private;
less than initial endowment plus net output, the
only the individual agent knows his own
price p \ is zero.
endowment. Consequently the
The welfare theorems stated in terms of equi-
librium relative to a price system translate directly
expression of that information through political or Increasing returns to scale in production gen-
other action can be expected to be strategic. The erally results in non-existence of competitive
theory of second-best allocations has been proposed equilibrium, because of unbounded profit when
in this context. Redistribution of endowment is prices are treated as given. Nash equilibrium, a
excluded, and the mechanism is restricted to be a concept from the theory of games, can exist even in
price mechanism, but the price system faced by cases of increasing returns. The difficulty is that
consumers is allowed to be different from that faced such equilibria need not be optimal. Similar diffi-
by producers; all agents behave according to the culties occur in cases of externalities.
rules of the (static) competitive mechanism. The Failure of the competitive price mechanism to
allocations that satisfy these conditions, when the extend the properties summarized in the classical
price systems are variable, are maximal allocations welfare theorems to nonclassical environments has
in the sense that they are Pareto optimal within the led economists to look for alternative ways of
restricted class just defined. These are so-called achieving optimal allocation in such cases. Such
s e c o n d - b e s t allocations. This analysis attempts have for the most part sought institutional
was pioneered by Lipsey and Lancaster ( ) arrangements that can be shown to result in optimal
and Diamond and allocation. Ledyard ( , )
Mirrlees ( ). analysed a mechanism for achieving Pareto optimal
performance in environments with externalities.
The use of taxes and subsidies advocated by Pigou (
Efficient Allocation in Non(Neo)Classical ) to achieve Pareto optimal outcomes
Environments in cases of externalities is such an example. In a
similar spirit Davis and Whinston ( ) distin
The term n o n c l a s s i c a l refers to those
guish externalities in production that leave marginal
environments that fail to have the properties of
costs unaffected from those that do change marginal
classical ones; there may be indivisible
costs. In the former case they propose a pricing
commodities, nonconvexities in consumption sets,
scheme, but one that involves lump-sum transfers.
preferences or production sets, or externalities in
Marginal cost pricing, including lumpsum transfers
production or consumption. An example of
to compensate for losses, which was extensively
nonconvex preference would arise if a consumer
discussed as a device to achieve optimal allocation
preferred living in either Los Angeles or New York
in the presence of increasing returns (Lemer ;
to living half the time in each city, or living halfway
Hotelling ; and many others) is another example of
between them, depending on the way the
a scheme to realize optimal outcomes in
commodity involved is specified. A production set
nonclassical environments in a way that seeks to
representing a process that affords increasing
capture the benefits associated with decentralized
returns to scale is an example of nonconvexity in
resource allocation. In the case of production under
production. A large investment project such as a
conditions of increasing returns, the use of
road system is an example of a significant
nonlinear prices has been suggested in an effort to
indivisibility. Phenomena of air or water pollution
achieve optimality with at least some of the benefits
provide many examples of externalities in
of decentralization. (See Arrow and Hurwicz ;
consumption and production.
Heal ; Brown and Heal ; Brown et al. ; Jennergren ;
The characterization of optimal allocation in
Guesnerie .)
terms of prices provided by the classical welfare
In the case of indivisibilities, and in the context
theorems does not extend to nonclassical environ-
of productive efficiency, integer programming
ments. If there are indivisibilities, equilibrium
algorithms exist for finding optima in specific
prices may fail to exist. Lemer ( , 1947) has
problems, but a general characterization in terms of
proposed a way of optimally allocating resources in
prices such as exists for the classical environments
the presence of indivisibilities, ft would typically
is not available. A decentralized process,
require adding up consumers’ and producers’
surplus.
involving the use of randomization, whose equilibria When there are externalities, an array of individual
coincide with the set of Pareto optima has been put characteristics, each component of which cor-
forward by Hurwicz et al. ( ). This responds to a possible environment, may not
process has the property that the counterparts of the together constitute a possible environment. In more
classical welfare theorems hold for environments in technical language, when there are externalities the
which all commodities are indivisible, and the set of set of environments is not the Cartesian product of
feasible allocations is finite, or in which there are no its projections onto the sets of individual
indivisible commodities, or externalities, but there characteristics.
may be nonconvexities in production or The goal of economic activity, whether effi-
consumption sets, or in preferences. This, of course, ciency, Pareto optimality or some other desideratum
includes the possibility of increasing returns to scale such as fairness, can be represented by a relation
in production. between the set of environments and the set of
The schemes and processes that have been pro- allocations, or outcomes. This relation assigns to
posed, including many not described here, are quite each environment the set of allocations that meet
different from one another. If attention is confined the criterion of desirability. In the case of the Pareto
to pricing schemes without additional elements, criterion, the set of allocations that are Pareto
such as lump-sum transfers, it may be satisfactory to optimal in a given environment is assigned to that
proceed on the basis of an informal intuitive notion environment. Formally, this relation is a
of decentralization. This amounts in effect to correspondence (a set-valued function) from the set
identifying decentralization with the competitive of environments to the set of allocations.
mechanism, or more generally with price or market An allocation process, or mechanism, is
mechanisms. If a broader class of processes is to be modelled as an explicitly dynamic process of
considered, including some already mentioned in communication, leading to the determination of an
this discussion, then a formal concept of outcome. In formal organizations standardized
decentralized resoiuce allocation process is needed. forms are frequently used for communication; in
organized markets like the Stock Exchange, these
include such things as order forms; in a business,
Efficient Allocation Through forms on which weekly sales are reported; in the
Informationally Decentralized Processes case of the Internal Revenue Service, income tax
forms. A form consists of entries or blanks to be
A formal definition of a concept of filled in a specified way. Thus, a form can be
a l l o c a t i o n p r o c e s s was first regarded as an ordered anay of variables whose
given by Hurwicz ( ). He values come from specified sets. In the Hurwicz
also gave a definition of model, each agent is assumed to have a
i n f o r m a t i o n a l d e c e n t r a l - l a n g u a g e , denoted M for the /th agent,
i z a t i o n applying to a broad class of from which his (possibly multi-dimensional)
allocation mechanisms, based in part on a discussion m e s s a g e , m , is chosen. The j o i n t
by Hayek ( ) of the advantages of the competi m e s s a g e of all the agents, m = ( m 1 ,
tive market mechanism for communicating , m " ) is in the m e s s a g e
knowledge initially dispersed among economic s p a c e M =
agents so that it can be brought to bear on the M 1 x ... x M " . Communication takes place in
decisions that determine the allocation of resources. time, which is discrete; the message m , =
Hurwicz’s formulation is as follows. ( m j , ..., m ") denotes the message at time t .
There is an initial dispersion of information The message an agent emits at time t can depend
about the environment; each agent is assumed to on anything he knows at that time. This consists of
observe directly his own characteristic, e \ but to what the agent knows about the environment by
know nothing directly about the characteristics of direct observation, by assumption, (p r i v a c y )
any other agent. In the absence of externalities, his own characteristics, e ' for agent i , and
specifying the array of individual characteristics what he has learned from others via the messages
specifies the environment, i.e. e = ( e \ . . . received from them. The agents’ behaviour
is represented by r e s p o n s e consists of the triple ( M , f h ). Since no
f u n c t i o n s , which show how the current production or consumption takes place until all
message depends on the information at hand. communication is completed, these processes are
Agent /’s message at time t is t a t o n n e m e n t processes.
A more compact and general formulation was
m\ = f .. -,e‘),i = 1, ... ,n, given by Mount and Reiter ( ) by looking
t = 0 , 1, 2, ... only at message equilibria when attention is
restricted to static properties. A correspondence is
If it is assumed that memory is finite, and defined, called the e q u i l i b r i u m
bounded, it is possible without loss of generality to m e s s a g e c o r r e s p o n d e n c e .
take the number of past periods remembered to be It associates to each environment the set of
one. (If memory is unbounded, taking the number of equilibrium messages for that environment. In order
periods remembered to be one excludes the to satisfy the requirement of privacy, namely that
possibility of a finite dimensional message space.) each gent’s message depend on the environment
In that case the response equations become a system only through the agent’s characteristic, the
of first order temporally homogeneous difference equilibrium message correspondence must be the
equations in the messages. Thus: intersection of individual message correspondences,
m 1
each associating a set of message acceptable to the
\ = l i e ) i = 1, = 0, ..., individual agent as equilibria in the light of his own
characteristic. Thus the equilibrium message
which can be written more compactly as
correspondence
(*)m, =f(mt- i;e).
(This formulation can accommodate the case of /t: £ —> M,

directed communication, in which some agents do

is given by
not receive some messages; if agent i is not to
receive the message of j , then/ is independent of
g(e) = n/.i‘(e'),
n f , although i n ' appears formally as an i
argument.) Analysis of informational properties of
mechanisms is to begin with separated from that of where // : E ‘ > M , is the individual message
incentives. When the focus is on communication correspondence of agent i . Note that here the
and complexity qsts, the response functions are not message space Mneed not be the Cartesian product
regarded as chosen by the agent, but rather by the of individual languages. In the case of an
designer of the mechanism. adjustment process, the equilibrium message cor-
The iterative interchange of messages modelled respondence is defined by the conditions
by the difference equation system (*) eventually
comes to an end, by converging to a stationary l
/i ( e l) = { m i n M \ f
message. (It is also possible to have some stopping
rule, such as to stop after a specified number of e ‘ ) =nf}, i = 1, ..., n
iterations.) The stationary message, which will be
together with the condition that /< is the intersec-
referred to as an e q u i l i b r i u m
tion of the /('. Specification of the outcome function
m e s s a g e , is then translated into an
h ' . M ■ Z completes the model, ( M ,
outcome, by means of the o u t c o m e
g , h ) .
f u n c t i o n ' .
The performance of a mechanism of this kind
h:M->Z, can be characterized by the mapping defined by the
composition of the equilibrium message correspon-
where Z is the space of outcomes, usually alloca- dence /< and the outcome function h . The
tions or trades. An allocation mechanism so mapping /;/<; E ■ Z , possibly a
modelled is called an a d j u s t m e n t correspondence, specifies the outcomes that the
p r o c e s s ' , it mechanism ( M , / i , h ) generates in each
the form of an adjustment process, or in die equi-
librium form, is called P a r e t o -
s a t i s f a c t o r y (Hurwicz ) if for each
environment in the class under consideration, the
set of outcomes generated by the mechanism
coincides with die set of Pareto optimal outcomes
for that environment. Allowance must be made for
Efficient Allocation, Fig. 2
redistribution of initial endowment, as in the case of
die second welfare theorem. (A formulation in the
framework of mechanisms is given in Mount and With welfare theorems as a guide, the class of
Reiter .) environments E c can be replaced by some other
The competitive mechanism formalized as a class E , and the Pareto correspondence can be
static mechanism is as follows. (Hurwicz has given replaced by a correspondence, P , embodying
a different formulation, and Sonnenschein , has another criterion of optimality, and one can ask
given an axiomatic characterization of the whether there is a mechanism, (M, / i , h ) that
competitive mechanism from a somewhat different makes the diagram commute, or, in other words,
point of view. ) The message space M is the space r e a l i z e s P ? Without further restrictions
of prices and quantities of commodities going to on the mechanism, this is a triviality, because one
each agent (it has dimension r i d — T) when agent can act as a central agent to whom all others
there are n agents and l commodities, taking communicate their environmental characteristics;
account of budget constraints and Walras’ Law), the the central agent then has the information required
individual message correspondence /(' maps to evaluate P .
agent /’s characteristic e l to the graph of his The concept of an
excess demand function. The equilibrium message i n f o r m a t i o n a l l y
is the intersection of the individual ones, and is d e c e n t r a l i z e d m e c h a n i s m
therefore the price-quantity combinations that solve defined by Hurwicz ( ) makes
the system of excess demand equations. The explicit intuitive notions underlying the view that
outcome function h is the projection of the the price mechanism is decentralized.
equilibrium message onto the quantity components Informationally decentralized processes are a
of M . Thus h j i ( e ) is a competitive subclass of so-called c o n c r e t e
equilibrium allocation (or trade) when the p r o c e s s e s , introduced by Hurwicz ().
environment is e . The classical welfare theorems These are processes
state that for each e in E c , h [/t(e)l = that use a language and response rules that allow
p ( e ) , where E c denotes the set of classical production and distribution plans to be specified
environments and P is the Pareto correspondence. explicitly. The informationally decentralized pro-
(Allowance must be made for redistribution of cesses are those whose response rules permit agents
initial endowment in connection with the second to transmit information only about their own
welfare theorem. Explicit treatment of this is actions, and which in effect require each agent to
omitted to avoid notational complexity. The treat the rest of the economy either as one
decentralized redistribution of initial endowment is, aggregate, or in a symmetrical way that, like the
as in the case of the second welfare theorem, not aggregate, gives anonymity to the other agents.
addressed.) The welfare theorems can be In the case of static mechanisms, the require-
summarized in the Mount-Reiter diagram (Fig. ) ments for informational decentralization boil down
(Reiter ). to the condition that the message space have no
The welfare theorems state that this diagram more than a certain finite dimension, and in some
c o m m u t e s in the sense that starting from cases only that it be of finite dimension. In the case
any environment e in E c one reaches the same of classical environments this can be seen to include
allocations via the mechanism, that is, via /i/i, as via the competitive mechanism, and to exclude the
the Pareto correspondence P . obviously centralized one mentioned above.
the consequences of constraints on economic time horizon in the model is not bounded or when
organization that come from limitations on the time is continuous, or according to location when
capacity of economic agents to observe, commu- there is more than a finite number of possible
nicate and process information. One important locations; differentiated commodities provide other
result in this field is that there is no mechanism (M, examples, and so does the case of uncertainty with
n , h ) where /< preserves privacy, that uses infinitely many states. The bulk of the literature
messages smaller (in dimension) than those of the deals with the infinite horizon model of allocation
competitive mechanism (Hurwicz ; over time, though recently more attention is given to
Mount and Reiter ; Walker ; Osana ). Similar results models of product differentiation. Ramsey ( )
have been obtained for environments with public studied the problem of saving in a
goods, showing that the Lindahl mechanism uses continuous time infinite horizon model with one
the minimal message space (Sato ). Another consumption good and an infinitely lived consumer.
objective is to analyse effects on incentives arising He used as the criterion of optimality the infinite
from private motivations in the presence of private sum (integral) of undiscounted utility. Ramsey’s
information; that is, information held by one agent contribution was largely ignored, and rediscovered
that is not observable by others, except perhaps at a when attention returned to problems of economic
cost. (There is a large literature on this subject growth. A model of maximal sustainable growth
under the rubric ‘incentive compatibility’, or based on a linear technology with no unproduced
‘strategic implementation’ (Dasgupta et al. ; inputs was formulated by von Neumann ( in
Hurwicz , ). The informational requirements of German; English translation, 1945-6). This
achieving a specified performance taking some contribution was unknown among English-speaking
aspects of incentive compatibility into account have economists until after World War II. Study of
been studied by Hurwicz ( ), Reichelstein ( , intertemporal allocation by Anglo-American
) and by Reichelstein and Reiter ( ). economists effectively began with the contributions
Some important results for non-neoclassical of Harrod ( ) and
environments can be mentioned. Hurwicz ( , Domar ( ). These models were concerned
) has shown that there can be no informa- with stationary growth at a constant sustainable rate
tionally decentralized mechanism that realizes (stationary growth paths) rather than full
Pareto optimal performance on a class of environ- intertemporal efficiency. Malinvaud ( ) first
ments that includes those with externalities. addressed this problem in a pioneering model of
Calsamiglia ( , ) has shown in a model intertemporal allocation with an infinite horizon.
of production that if the set of environments Efficient allocation over (discrete) time would
includes a sufficiently rich class of those with be covered by the finite dimensional models
increasing returns to scale in production, then the described above if the time horizon were finite. It
dimension of the message space of any mechanism might be thought that a model with a sufficiently
that realizes efficient production cannot be large but still finite horizon would for all practical
bounded. purposes be equivalent to one with an infinite
horizon, while avoiding the difficulties of infinity,
but this is not the case, because of the dependence
Efficient Allocation with Infinitely Many of efficient or optimal allocations on the value given
Commodities to final stocks, a value that must depend on their
uses beyond the horizon.
An infinite dimensional commodity space is needed
Malinvaud ( ) formulated an important
when it is necessary to make infinitely many
infinite horizon model, which is the infinite
distinctions among goods and services. This is the
dimensional counterpart of the linear activity
case when commodities are distinguished according
analysis model of Koopmans. In Malinvaud’s model
to time of availability and the
time is discrete. The time horizon consists of an
infinite sequence of time periods. At each
date there are finitely many commodities. All - a t for t > 1, and 0 < y ° = b 1 —
commodities are desired in each time period, and no a 0 , b 1 > 0, where /is a real-valued
distinction is made between desired, intermediate continuous concave function on the non-negative
and primary commodities. As in the activity analysis real numbers (the production function), /(0) = 0, and
model, there is no explicit reference to preferences b 1 is the given initial stock. The set Y is the set
of consumers. Productive efficiency over time is of all feasible programmes. A programme y - y
analysed in terms of the output available for >0. A price system is an infinite sequence p =
consumption, rather than the resulting utility levels. ( p ‘ ) of non-negative numbers. Denote by P
Technology is represented by a production set the set of all price systems.
A* for each time period t = 1 , 2 , . . . , an ele- Malinvalud recognized the possibility that an
ment of X 1 being an ordered pair ( a , H + ') of efficient net output programme (/) need not have an
commodity bundles where a represents inputs to a associated system of non-zero prices ( p ‘ ) rela-
production process in period t , and b l + 1 tive to which the production programme generating
represents the outputs of that process available at the y satisfies the condition of intertemporal profit
beginning of period / +1. Here both a and b * + 1 maximization, namely that
are nonnegative. The set A* is the aggregate
production set for the economy during period t . Pt+lf{a‘) -p‘a‘ > p‘1 'f(a) - p'a
The net outputs available for consumption are given
by for all / and every a > 0. (Here ( a 1 ) is the
sequence of inputs producing y . ) A condition
/=b ‘ - a', for t > 1, introduced by Malinvaud, called
n o n t i g h t n e s s , is sufficient for the
where h ] is the initial endowment of resources existence of such non-zero prices. Alternative
available at the beginning of period 1. A p r o - proofs of Malinvaud’s existence theorem were
g r a m m e is an infinite sequence ( U i ‘ , given by Radner ( ) and Peleg and Yaari
t > )); it is a f e a s i b l e ( ). (An example showing the possibility of
p r o g r a m m e if ( a , h ' + ); is in non-existence given by Peleg and Yaari ( ) is
J f , and // — a * > 0 for each t > 1, as follows. Suppose/is as shown in Fig. .
given b l . The sequence y (y') is called the n e t At an interior efficient, and therefore value
o u t p u t p r o - g r a m m e associated maximizing, programme the first-order necessary
with the given programme; it is a . conditions for a maximum imply p ‘ + 1 f
f e a s i b l e n e t o u t p u t ( a 1 ) = p ‘ . If there is a time at which a '
p r o g r a m m e if it is the net output = a * , in an efficient programme, then, since/
programme of a feasible programme. A programme (a*) = 0 it follows that prices at all prior and future
is e f f i c i e n t if it is (1) feasible and (2) times are 0. (Nontightness mles out such examples.)
there is no other programme that is feasible, from
the same initial resources b , and provides at least
as much net output in every period and a larger net
y
output in some period. This is the concept of
efficient production, already seen in the linear
activity analysis model, now extended to an infinite
horizon model. The main aim of this research is to
extend to the infinite horizon model the
characterization of efficient production by prices
seen in the finite model. This goal is not quite
reached, as is seen in what follows.
The main difficulties presented by the infinite
horizon are already present in a special case of the
Malinvaud model with one good and no consumers. Efficient Allocation, Fig. 3
Let Y be the set of all non-negative sequences y =
 On the side of sufficiency, Malinvaud showed commodity space. Radner showed, technical matters
that intertemporal profit maximization relative to a aside, that:
strictly positive price system p is not enough to
ensure that a feasible programme is efficient. An 1. If a feasible programme maximizes the value of
additional (transversality) condition is needed. In the net output (consumption) relative to a strictly
present model the following to such a condition; positive continuous linear functional, then it is
efficient.
2. If a given programme is efficient, then there is a
lim p ‘ y ‘ = 0.
t—XX) nonzero non-negative continuous linear func-
tional such that the given programme maximizes
Cass ( ) has given a criterion that the value of net output relative to that functional
completely characterizes the set of efficient pro- on the set of feasible programmes.
grammes in a one-good model with strictly concave
and smooth production technology that satisfies These propositions seem to be the precise coun-
endpoint conditions 0 </'(oo) < 1 < f ' ( x ) < DC terparts of the ones characterizing efficiency in the
for some x > 0. Cass’s criterion, states that a finite horizon model. Unfortunately, a linear func-
programme is i n e f f i c i e n t if and only if tional may not have a representation in the form of
the associated competitive prices - that is, satisfying the inner product of a price sequence with a net
p t +
= p * - also satisfy 2“j(l/^') < oo. This output sequence. (The production function f ( a )
criterion may be interpreted as requiring the terms of = a ^ , with 0 < [ 1 < 1 provides an
example. It is known that the programme with
trade between present and future to deteriorate
constant input sequence x t = (1//I)W< “ 1 and
sufficiently fast. Other similar conditions have been
output sequence y, = ( . v p f , p - 1 - (1/JS)1//!
presented (Benveniste and Gale ; Benveniste ; l
- t = 1 , 2 , . . . , is efficient, and therefore
Majumdar ; Mitra ). It is hard to see how any
there is a continuous linear functional relative to
transversality condition can be interpreted in terms
which it is value maximizing. But there is no price
of decentralized resource allocation.
sequence ( p ‘ ) that represents that linear
An alternate approach to characterizing efficient
functional.) This presents a serious problem,
programmes was taken by Radner ( ),
because in the absence of such a representation it is
based on value functions as introduced in con-
unclear whether this characterization has an
nection with valuation equilibrium by Debreu ().
interpretation in terms of decentralized allocation
(Valuation equilibrium was discussed in
processes; profit in any one period can depend on
connection with Arrow’s exceptional case, above.) ‘prices at infinity’.
The value function approach was followed up by This approach has the advantage that it is appli-
Majumdar ( , ) and by cable not only to infinite horizon models, but to a
Peleg and Yaari ( ). A price system defines a broader class in which the commodity space is
continuous linear functional, (a real-valued linear infinite dimensional. Bewley ( ), Mas-Colell
function) on the commodity space. This function ( ) and Jones ( ) among others discuss
assigns to a programme its present value. The Pareto optimality and competitive equilibrium in
present value may not be well-defined, because the economies with infinitely many commodities.
infinite sequence that gives it diverges. This creates Hurwicz ( ) and others analysed optimal
certain technical problems passed over here. A more allocation in terms of nonlinear programming in
important difficulty is that linear functionals exist infinite dimensional spaces. Theorems of pro-
that are not defined by price systems. Radner’s gramming in infinite dimensional spaces are also
approach was to characterize efficient programmes used in some of the models mentioned in this
in terms of maximization of present value relative to discussion.
a linear functional on the The basic difficulties encountered in the one-
good model, apart from the numerous technical
problems that tend to make the literature large and
diverse as different technical structures are inves- A transversality condition is made part of the
tigated, are on the one hand the fact that trans- definition of competitive equilibrium in order to
versality conditions are indispensable, and on the obtain the result that an equilibrium is optimal. A
other the possibility that linear functionals, even partial converse requires some additional
when they exist, may not be representable in terms assumptions on the technology (reachability) and on
of price sequences. These problems raise strong the way the economy fits together
doubt about the possibility of achieving efficient (nondecomposability). These results certainly
intertemporal resource allocation by decentralized illuminate the infinite horizon model with over-
means, though they leave open the possibility that lapping generations of consumers and producers,
some other decentralized mechanism, not using but the possibility of efficient or optimal resource
prices, might work. Analysis of this possibility has allocation by decentralized means is not different
just begun, and is discussed below. from that in the one-good Malinvaud model.
The difficulties seen in the one-good production Hurwicz and Majumdar in an unpublished
model persist in more elaborate ones, including manuscript dated 1983, and later Hurwicz and
multisectoral models with efficiency as the Weinberger ( ), have addressed this issue
criterion, and models with consumers in which directly, building on the approach of mechanism
Pareto optimality is the criterion. McFadden et al. ( theory.
) studied a model in which there are Hurwicz and Majumdar have studied the prob-
firms, and overlapping generations of consumers, as lem of efficiency in a model with an infinite number
in the model first investigated by Samuelson ( ). of periods. In each period there are finitely many
Each consumer lives for a finite time and commodities, one producer who is alive for just one
has a consumption set and preferences like the period, and no consumers’ choices. The criterion is
consumers in a finite horizon model. A model with the maximization of the discounted value of the
overlapping generations of consumers presents the programme (well-defined in this model). The
fundamental difficulty that consumers cannot trade producer alive in any period knows only the
with future consumers as yet unborn. This difficulty technology in that period. The question is whether
can appear even in a finite horizon model if there there is a (static) privacy preserving mechanism
are too few markets. The economy is closed in the using a finite dimensional message space whose
sense that there are no non- produced resources; the equilibria coincide with the set of efficient
von Neumann growth model is an example of such programmes. The question can be put as follows. In
a model. Building on the results of an earlier each period a message is posted. The producer alive
investigation (Majumdar et al. ), these authors in that period responds ‘Yes’ or ‘No’. If every
introduced several notions of price systems, of producer over the entire infinite horizon answers
competitive equilibrium, efficiency and optimality, ‘Yes’, the programme is an outcome corresponding
and sought to establish counterparts of the classical to the equilibrium consisting of the infinite
welfare theorems. To summarize, in the 1976 paper succession of posted messages. Since each producer
they strengthen an earlier result of Bose ( ) to the knows only the technology prevailing in the period
effect that the problem of proper distribution of when he is alive, the process preserves privacy. If in
goods in essentially a short-run problem, and that addition the message posted in each period is finite
the only long-run problem, one created by the dimensional, the process is informationally
infinite horizon, is that of inefficiency through decentralized. Period-by-period profit maximization
overaccumulation of capital. In the 1980 paper the using period-by-period prices is a mechanism of this
focus is on the relationships among various notions type; the message posted in each period consists of
of equilibrium and Pareto optimality. The force of the vector of prices for that period, and the
their results is, as might be expected, that the production plan for that period, both finite dimen-
difficulties already seen in one-good model without sional. The object is to characterize all efficient
consumers persist in this model. programmes as equilibria of such a mechanism.
This would be an analogue of the classical welfare See Also
theorems, but without the restriction to mechanisms
that use prices in their messages. ► Incentiv
The main result is in the nature of an impos- ► Linear F
sibility theorem. If the technology is constant over ► Welfare
time, and that fact is common knowledge at the
beginning, the problem is trivial since knowledge of
the technology in the first period automatically
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Radner, R. 1967. Efficiency prices for infinite horizon Abstract
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66. The efficient markets hypothesis (EMH) main-
Ramsey, F. 1928. A mathematical theory of saving. Economic tains that market prices fully reflect all available
Journal 38: 543-559. information. Developed independently by Paul
Reichelstein, S. 1984a. Dominant strategy implementation, A. Samuelson and Eugene F. Fama in the 1960s,
incentive compatibility and informational requirements.
Journal of Economic Theory 34 (1): 32-51. this idea has been applied extensively to
Reichelstein, S. 1984b. Information and incentives in eco- theoretical models and empirical studies of
nomic organizations. PhD dissertation, Northwestern financial securities prices, generating consider-
University. able controversy as well as fundamental insights
into the price-discovery process. The
most enduring critique comes from psychologists There is an old joke, widely told among economists,
and behavioural economists who argue that the about an economist strolling down the street with a
EMH is based on counterfactual assumptions companion. They come upon a $100 bill lying on
regarding human behaviour, that is, rationality. the ground, and as the companion reaches down to
Recent advances in evolutionary psychology and pick it up, the economist says, ‘Don’t bother - if it
the cognitive neurosciences may be able to were a genuine $100 bill, someone would have
reconcile the EMH with behavioural anomalies. already picked it up’. This humorous example of
economic logic gone awry is a fairly accurate
rendition of the efficient markets hypothesis
Keywords (EMH), one of the most hotly contested
Adaptive markets hypothesis; Agent-based propositions in all the social sciences. It is
models; Altruism; Arbitrage; Asset price disarmingly simple to state, has far-reaching
anomalies; Behavioural biases; Behavioural consequences for academic theories and business
economics; Behavioural finance; Bid-ask practice, and yet is surprisingly resilient to empir-
bounce; Biology and economics; Bounded ical proof or refutation. Even after several decades
rationality; Capital asset pricing model; Con- of research and literally thousands of published
sumer choice; Creative destruction; Deductive studies, economists have not yet reached a con-
inference; Dividend smoothing; Dividend- sensus about whether markets - particularly finan-
discount model; Dutch books; Economic com- cial markets - are, in fact, efficient.
plexity; Efficient markets hypothesis; Emotions; The origins of the EMH can be traced back to
Equilibrium; Equity risk premium; Evolutionary file work of two individuals in the 1960s: Eugene F.
economics; Evolutionary game theory; Fama and Paul A. Samuelson. Remarkably, they
Evolutionary psychology; Fama, E. F.; Financial independently developed the same basic notion of
economics; Herding; Hyperbolic discounting; market efficiency from two rather different research
Inductive inference; Information aggregation; agendas. These differences would propel the them
Informational efficiency; January effect; Joint along two distinct trajectories leading to several
hypotheses; Learning; Long-term memory; Loss other breakthroughs and milestones, all originating
aversion; Market efficiency; Martingales; from their point of intersection, the EMH.
Miscalibration of probabilities; Natural Like so many ideas of modem economics, the
selection; EMH was first given form by Paul Samuelson (
Neuroeconomics; Noise traders; Optimization; ), whose contribution is neatly summarized
Overconfidence; Overreaction; Post-earnings by the title of his article: ‘Proof that Properly
announcement drift; Preferences; Present value; Anticipated Prices Fluctuate Randomly’. In an
Price reversals; Psychological accounting; informationally efficient market, price changes must
Punctuated equilibrium; Random walk be unforecastable if they are properly anticipated,
hypothesis; Rational expectations; Regret; that is, if they fully incorporate the information and
Relative efficiency; Risk aversion; Risk pref- expectations of all market participants. Having
erences; Risk-reward relation; Samuelson, P. A.; developed a series of linear- programming solutions
Satisficing; Serial correlation; Simon, H.; Size to spatial pricing models with no uncertainty,
effect; Social norms; Sociobiology; Statistical Samuelson came upon the idea of efficient markets
inference; Stock price volatility; Survival of the through his interest in temporal pricing models of
fittest; Uncertainty; Utility maximization; storable commodities that are harvested and subject
Variance bounds; Variance decomposition to decay. Samuelson’s abiding interest in the
mechanics and kinematics of prices, with and
without uncertainty, led him and his students to
several fruitful research agendas including solutions
for the dynamic asset-allocation and consumption-
JEL Classifications
GO
savings problem, the fallacy of time diversification information. Therefore, no profits can be garnered
and log-optimal investment policies, warrant and from information-based trading because such
option-pricing analysis and, ultimately, the Black profits must have already been captured (recall the
and Scholes ( ) and Merton ( ) $100 bill on the ground). In mathematical terms,
option-pricing models. prices follow martingales.
In contrast to Samuelson’s path to the EMH, Such compelling motivation for randomness is
Fama’s ( , , , ) seminal papers unique among the social sciences and is reminiscent
were based on his interest in measuring the statis- of the role that uncertainty plays in quantum
tical properties of stock prices, and in resolving the mechanics. Just as Heisenberg’s uncertainty prin-
debate between technical analysis (the use of geo- ciple places a limit on what we can know about an
metric patterns in price and volume charts to fore- electron’s position and momentum if quantum
cast future price movements of a security) and mechanics holds, this version of the EMH places a
fundamental analysis (the use of accounting and limit on what we can know about future price
economic data to determine a security’s fair value). changes if the forces of economic self- interest
Among the first to employ modem digital com- hold.
puters to conduct empirical research in finance, and A decade after Samuelson’s ( ) and Fama’s
the first to use the term ‘efficient markets’ (Fama ), ( ,, ) landmark papers, many others
Fama operationalized the EMH hypothesis - extended their framework to allow for risk-averse
summarized compactly in the epigram ‘prices fully investors, yielding a ‘neoclassical’ version of the
reflect all available information’ - by placing EMH where price changes, properly weighted by
structure on various information sets available to aggregate marginal utilities, must be
market participants. Fama’s fascination with unforecastable (see, for example, Leroy ;
empirical analysis led him and his students down a Rubinstein ; Lucas ). In markets where, according
very different path from Samuelson’s, yielding to Lucas ( ), all investors
significant methodological and empirical have ‘rational expectations’, prices do fully reflect
contributions such as the event study, numerous all available information and marginal-utility-
econometric tests of single-and multi-factor linear weighted prices follow martingales. The EMH has
asset-pricing models, and a host of empirical been extended in many other directions, including
regularities and anomalies in stock, bond, currency the incorporation of non-traded assets such as
and commodity markets. human capital, state-dependent preferences,
The EMH’s concept of informational efficiency heterogeneous investors, asymmetric information,
has a Zen-like, counter-intuitive flavour to it: the and transactions costs. But the general thrust is the
more efficient the market, the more random the same: individual investors form expectations
sequence of price changes generated by such a rationally, markets aggregate information
market, and the most efficient market of all is one in efficiently, and equilibrium prices incorporate all
which price changes are completely random and available information instantaneously.
unpredictable. This is not an accident of nature, but
is in fact the direct result of many active market
participants attempting to profit from their informa- The Random Walk Hypothesis
tion. Driven by profit opportunities, an army of
The importance of the EMH stems primarily from
investors pounce on even the smallest informational
its sharp empirical implications many of which
advantages at their disposal, and in doing so they
have been tested over the years. Much of the EMH
incorporate their information into market prices and
literature before LeRoy ( ) and Lucas
quickly eliminate the profit opportunities that first
( ) revolved around the random walk hypoth
motivated their trades. If this occurs instanta-
esis (RWH) and the martingale model, two statis-
neously, which it must in an idealized world of
tical descriptions of unforecastable price changes
‘frictionless’ markets and costless trading, then
that were initially taken to be implications of the
prices must always frilly reflect all available
EMH. One of the first tests of the RWH was Finally, Lo ( ) considers another aspect of
developed by Cowles and Jones ( ), who stock market prices long thought to have been a
compared the frequency of s e q u e n c e s departure from the RWH: long-term memory. Time
and r e v e r s a l s in historical stock returns, series with longterm memory exhibit an unusually
where the former are pairs of consecutive returns high degree of persistence, so that observations in
with the same sign, and the latter are pairs of the remote past are non-trivially correlated with
consecutive returns with opposite signs. Cootner ( observations in the distant future, even as the time
, ), Fama span between the two observations increases.
( , ), Fama and Blume ( ), and Nature’s predilection towards long-term memory
Osborne ( ) perform related tests of the has been well-documented in the natural sciences
RWH and, with the exception of Cowles and Jones such as hydrology, meteorology, and geophysics,
(who subsequently acknowledged an error in their and some have argued that economic time series
analysis - Cowles ), all of these articles indicate must therefore also have this property.
support for the RWH using historical stock price However, using recently developed statistical
data. techniques, Lo ( ) constructs a test for long
More recently, Lo and MacKinlay ( ) term memory that is robust to short-term correla-
exploit the fact that return variances scale linearly tions of the sort uncovered by Lo and MacKinlay (
under the RWH - the variance of a two-week return ), and concludes that, despite earlier evi
is twice the variance of a one-week return if the dence to the contrary, there is little support for long-
RWH holds - and construct a variance ratio test term memory in stock market prices. Departures
which rejects the RWH for weekly US stock returns from the RWH can be fully explained by
indexes from 1962 to 1985. In particular, they find conventional models of short-term dependence.
that variances grow faster than linearly as the
holding period increases, implying positive serial
correlation in weekly returns. Oddly enough, Lo Variance Bounds Tests
and MacKinlay also show that individual stocks
generally do satisfy the RWH, a fact that we shall Another set of empirical tests of the EMH starts
return to below. with the observation that in a world without uncer-
French and Roll ( ) document a related tainty the market price of a share of common stock
phenomenon: stock return variances over weekends must equal the present value of all future dividends,
and exchange holidays are considerably lower than discounted at the appropriate cost of capital. In an
return variances over the same number of days uncertain world, one can generalize this
when markets are open. This difference suggests d i v i d e n d - d i s c o u n t m o d e l
that the very act of trading creates vola- tility, or p r e s e n t - v a l u e r e l a t i o n
which may well be a symptom of Black’s ( ) in the natural way: the market price equals the
noise traders. conditional expectation of the present value of all
For holding periods much longer than one week future dividends, discounted at the appropriate risk-
- for example, three to five years - Fama and French adjusted cost of capital, and conditional on all
( ) and Poterba and Summers available information. This generalization is
( ) find negative serial correlation in US explicitly developed by Grossman and Shiller ().
stock returns indexes using data from 1926 to 1986. LeRoy and Porter ( ) and Shiller ( )
Although their estimates of serial correlation take this as their starting point in comparing the
coefficients seem large in magnitude, there is variance of stock market prices to the variance of
insufficient data to reject the RWH at the usual e x p o s t present values of future dividends.
levels of significance. Moreover, a number of If the market price is the conditional expectation of
statistical artifacts documented by Kim et al. present values, then the difference between the two,
( ) and Richardson ( ) cast serious doubt that is, the forecast error, must be uncorrelated with
on the reliability of these longer-horizon inferences. the conditional expectation by constmction.
But this implies that the variance of the e x studies: tests of the EMH are always tests of joint
p o s t present value is the sum of the variance hypotheses. In particular, the phrase ‘prices fully
of the market price (the conditional expectation) reflect all available information’ is a statement
and the variance of the forecast error. Since about two distinct aspects of prices: the information
volatilities are always non-negative, this variance content and the price formation mechanism.
decomposition implies that the variance of stock Therefore, any test of this proposition must concern
prices cannot exceed the variance of e x p o s t the k i n d of information reflected in prices, and
present values. Using annual US stock market data h o w this information comes to be reflected in
from various sample periods, LeRoy and Porter ( prices.
) and Apart from issues regarding statistical inference,
Shiller ( ) find that the variance bound is the empirical violation of variance bounds may be
violated dramatically. Although LeRoy and Porter interpreted in many ways. It may be a violation of
are more circumspect about the implications of such EMH, or a sign that investors are risk averse, or a
violations, Shiller concludes that stock market symptom of dividend smoothing. To choose among
prices are too volatile and the EMH must be false. these alternatives, more evidence is required.
These two papers ignited a flurry of responses
which challenged Shiller’s controversial conclusion
on a number of fronts. For example, Flavin ( ), Overreaction and Underreaction
Kleidon ( ), and Marsh and Merton
A common explanation for departures from the
( ) show that statistical inference is rather
EMH is that investors do not always react in proper
delicate for these variance bounds, and that, even if
proportion to new information. For example, in
they hold in theory, for the kind of sample sizes
some cases investors may overreact to performance,
Shiller uses and under plausible data-generating
selling stocks that have experienced recent losses or
processes the sample variance bound is often vio-
buying stocks that have enjoyed recent gains. Such
lated purely due to sampling variation. These issues
overreaction tends to push prices beyond their ‘fair’
are well summarized in Gilles and LeRoy ( ) and
or ‘rational’ market value, only to have rational
Merton ( ).
investors take the other side of the trades and bring
More importantly, on purely theoretical grounds
prices back in line eventually. An implication of this
Marsh and Merton ( ) and Michener
phenomenon is price reversals: what goes up must
( ) provide two explanations for violations of
come down, and vice versa. Another implication is
variance bounds that are perfectly consistent with
that c o n t r a r i a n investment strategies -
the EMH. Marsh and Merton ( ) show that if
strategies in which ‘losers’ are purchased and
managers smooth dividends - a well-known
‘winners’ are sold - will earn superior returns.
empirical phenomenon documented in several
Both of these implications were tested and
studies of dividend policy - and if earnings follow a
confirmed using recent US stock market data. For
geometric random walk, then the variance bound is
example, using monthly returns of New York Stock
violated in theory, in which case the empirical
Exchange (NYSE) stocks from 1926 to 1982,
violations may be interpreted as s u p p o r t
DeBondt and Thaler ( ) docu
for this version of the EMH.
ment the fact that the winners and losers in one 3 6-
Alternatively, Michener constructs a simple
month period tend to reverse their performance over
dynamic equilibrium model along the lines of Lucas
the next 36-month period. Curiously, many of these
( ) in which prices do fully reflect all
reversals occur in January (see the discussion below
available information at all times but where indi-
on the ‘January effect’). Chopra et al. ( )
viduals are risk averse, and this risk aversion is
reconfirm these findings after
enough to cause the variance bound to be violated
correcting for market risk and the size effect.
in theory as well.
These findings highlight an important aspect of
the EMH that had not been emphasized in earlier
And Lehmann ( ) shows that a zero-net- announcement takes several days to become fully
investment strategy in which long positions in impounded into market prices. Although such
losers are financed by short positions in winners effects are indeed troubling for the EMH, their
almost always yields positive returns for monthly economic significance is often questionable - while
NYSE/AMEX stock returns data from 1962 to they may violate the EMH in frictionless markets,
1985. very often even the smallest frictions - for example,
However, Chan ( ) argues that the profit positive trading costs, taxes - can eliminate the
ability of contrarian investment strategies cannot be profits from trading strategies designed to exploit
taken as conclusive evidence against the EMH them.
because there is typically no accounting for risk in
these profitability calculations (although Chopra et
al. do provide risk adjustments, their focus Anomalies
was not on specific trading strategies). By risk-
adjusting the returns of a contrarian trading strategy Perhaps the most common challenge to the EMH is
according to the capital asset pricing model, Chan ( the anomaly, a regular pattern in an asset’s returns
) shows that the expected returns are which is reliable, widely known, and inexplicable.
consistent with the EMH. The fact that the pattern is regular and reliable
Moreover, Lo and MacKinlay ( ) show implies a degree of predictability, and the fact that
that at least half of the profits reported by Lehmann the regularity is widely known implies that many
( ) are not due to overreach on but rather investors can take advantage of it.
the result of positive cross-autocorrelations between For example, one of the most enduring anoma-
stocks. For example, suppose the returns of two lies is the ‘size effect’, the apparent excess expected
stocks A and B are both serially uncorrelated but returns that accrue to stocks of small-capitalization
are positively cross- autocorrelated. The lack of companies - in excess of their risks - which was first
serial correlation implies no overreaction (which is discovered by Banz ( ). Keim ( ), Roll
characterized by negative serial correlation), but ( ), and Rozeff and Kinney ( ) document a
positive cross-autocorrelations yields positive related anomaly: small capitalization stocks tend to
expected returns to contrarian trading strategies. outperform large capitalization stocks by a wide
The existence of several economic rationales for margin over the turn of the calendar year. This so-
positive cross-autocorrelation that are consistent called ‘January effect’ seems robust to sample
with EMH suggests that the profitability of period, and is difficult to reconcile with the EMH
contrarian trading strategies is not sufficient because of its regularity and publicity. Other well-
evidence to conclude that investors overreact. known anomalies include the Value Line enigma
The reaction of market participants to informa- (Copeland and Mayers ), the profitability of short-
tion contained in earnings announcements also has term return-reversal strategies in US equities
implications for the EMH. In one of the earliest (Rosenberg et al. ; Chan ; Lehmann ; and Lo and
studies of the information content of earnings, Ball MacKinlay ), the profitability of medium-term
and Brown ( ) show that up to 80 per cent momentum strategies in US equities (Jegadeesh ;
of the information contained in the earnings ‘sur- Chan et al. ; and Jegadeesh and Titman ), the
prises’ is anticipated by market prices. relation between price/eam- ings ratios and
However, the more recent article by Bernard expected returns (Basu ), the volatility of orange
and Thomas ( ) argues that investors some juice futures prices (Roll ), and calendar effects
times underreact to information about future earn- such as holiday, weekend, and tum-of-the-month
ings contained in current earnings. This is related to seasonalities (Lakonishok and Smidt ).
the ‘post-eamings announcement drift’ puzzle first What are we to make of these anomalies? On
documented by Ball and Brown ( ), in the one hand, their persistence in the face of public
which the information contained in earnings scrutiny seems to be a clear violation of the EMH.
After all, most of these anomalies can be exploited number of ‘searches’ conducted on the same set of
by relatively simple trading strategies, and, while data. Such d a t a - s n o o p i n g biases are
the resulting profits may not be riskless, they seem illustrated in Brown et al. ( ) and Lo and
unusually profitable relative to their risks (see, MacKinlay
especially, Lehmann ). ( ) - even the smallest biases can translate
On the other hand, EMH supporters might argue into substantial anomalies such as superior invest-
that such persistence is in fact evidence in favour of ment returns or the size effect.
EMH or, more to the point, that these anomalies
cannot be exploited to any significant degree
because of factors such as risk or transactions costs. Behavioural Critiques
Moreover, although some anomalies are currently
inexplicable, this maybe due to a lack of The most enduring critiques of the EMH revolve
imagination on the part of academics, not around the preferences and behaviour of market
necessarily a violation of the EMH. For example, participants. The standard approach to modelling
recent evidence suggests that the January effect is preferences is to assert that investors optimize
largely due to ‘bid-ask bounce’, that is, closing additive time-separable expected utility functions
prices for the last trading day of December tend to from certain parametric families - for example,
be at the bid price and closing prices for the first constant relative risk aversion. However, psychol-
trading day of January tend to be at the ask price. ogists and experimental economists have
Since small-capitalization stocks are also often low- documented a number of departures from this
price stocks, the effects of bid-ask bounce in paradigm, in the form of specific behavioural biases
percentage terms are much more pronounced for that are ubiquitous to human decisionmaking under
these stocks - a movement from bid to ask for a uncertainty, several of which lead to undesirable
$5.00 stock on the NYSE (where the minimum bid- outcomes for an individual’s economic welfare - for
ask spread was $0.125 prior to decimalization in example, overconfidence (Fischoff and Slovic ;
2000) represents a 2.5 per cent return. Barber and Odean ; Gervais and Odean ),
Whether or not one can profit from anomalies is overreaction (DeBondt and Thaler ), loss aversion
a question unlikely to be settled in an academic (Kahneman and Tversky ; Shefrin and Statman ;
setting. While calculations of ‘paper’ profits of Odean ), herding (Huberman and Regev ),
various trading strategies come easily to academics, psychological accounting (Tversky and
it is virtually impossible to incorporate in a realistic Kahneman ), miscalibration of probabilities
manner important features of the trading process (Lichtenstein et al. ), hyperbolic discounting
such as transactions costs (including price impact), (Laibson ), and regret (Bell ). These critics of the
liquidity, rare events, institutional rigidities and EMH argue that investors are often - if not always -
non-stationarities. The economic value of anomalies irrational, exhibiting predictable and financially
must be decided in the laboratory of actual markets minous behaviour.
by investment professionals, over long periods of To see just how pervasive such behavioural
time, and even in these cases superior performance biases can be, consider the following example
and simple luck are easily confused. which is a slightly modified version of an exper-
In fact, luck can play another role in the inter- iment conducted by two psychologists, Kahneman
pretation of anomalies: it can account for anomalies and Tversky ( ). Suppose you are
that are not anomalous. Regular patterns in offered two investment opportunities, A and B: A
historical data can be found even if no regularities yields a sure profit of $240,000, and B is a lottery
exist, purely by chance. Although the likelihood of ticket yielding $1 million with a 25 per cent
finding such spurious regularities is usually small probability and $0 with 75 per cent probability. If
(especially if the regularity is a very complex you had to choose between A and B , which
pattern), it increases dramatically with the would you prefer? Investment B has an expected
value of $250,000, which is higher than A’s payoff, be simply a matter of personal risk preferences - but
but this may not be all that meaningful to you the globally consolidated financial statement for the
because you will receive either $1 million or zero. entire institution will tell a very different story.
Clearly, there is no right or wrong choice here; it is From that perspective, there i s a right and wrong
simply a matter of personal preferences. Faced with answer, and the empirical and experimental
this choice, most subjects prefer A, the sure profit, evidence suggests that most individuals tend to
to B, despite the fact that B offers a significant select the wrong answer. Therefore, according to the
probability of winning considerably more. This behaviourafists, quantitative models of efficient
behaviour is often characterized as ‘risk aversion’ markets - all of which are predicated on rational
for obvious reasons. Now suppose you are faced choice - are likely to be wrong as well.
with another two choices, C and D: C yields a sure
loss of $750,000, and D is a lottery ticket yielding
$0 with 25 per cent probability and a loss of $1 Impossibility of Efficient Markets
million with 75 per cent probability. Which would
Grossman and Stiglitz ( ) go even farther -
you prefer? This situation is not as absurd as it
they argue that perfectly informationally efficient
might seem at first glance; many financial decisions
markets are an i m p o s s i b i l i t y for, if
involve choosing between the lesser of two evils. In
markets are perfectly efficient, there is no profit to
this case, most subjects choose D, despite the fact
gathering information, in which case there would be
that D is more risky than C. When faced with two
little reason to trade and markets would eventually
choices that both involve losses, individuals seem to
collapse. Alternatively, the degree of market
be ‘risk seeking’, not risk averse as in the case of A
i n e f f i c i e n c y determines the effort
versus B.
investors are willing to expend to gather and trade
The fact that individuals tend to be risk averse in
on information, hence a non-degenerate market
the face of gains and risk seeking in the face of
equilibrium will arise only when there are sufficient
losses can lead to some very poor financial deci-
profit opportunities, that is, inefficiencies, to
sions. To see why, observe that the combination of
compensate investors for the costs of trading and
choices A and D is equivalent to a single lottery
information gathering. The profits earned by these
ticket yielding $240,000 with 25 per cent prob-
attentive investors may be viewed as ‘economic
ability and $760,000 with 75 per cent probability,
rents’ that accrue to those willing to engage in such
whereas the combination of choices B and C is
activities. Who are the providers of these rents?
equivalent to a single lottery ticket yielding
Black ( ) gave us a provocative answer: ‘noise
$250,000 with 25 per cent probability and —
traders’, individuals who trade on what they con-
$750,000 with 75 per cent probability. The B and C
sider to be information but which is, in fact, merely
combination has the same probabilities of gains and
noise.
losses, but the gain is $ 10,000 higher and the loss is
The supporters of the EMH have responded to
$10,000 lower. In other words, B and C is formally
these challenges by arguing that, while behavioural
equivalent to A and D plus a sure profit of $10,000.
biases and corresponding inefficiencies do exist
In fight of this analysis, would you still prefer A and
from time to time, there is a limit to their prevalence
D?
and impact because of opposing forces dedicated to
A common response to this example is that it is
exploiting such opportunities. A simple example of
contrived because the two pairs of investment
such a limit is the so-called ‘Dutch book’, in which
opportunities were presented sequentially, not
irrational probability beliefs give rise to guaranteed
simultaneously. However, in a typical global
profits for the savvy investor. Consider, for
financial institution the London office may be faced
example, an event E , defined as ‘the S&P 500
with choices A and B and the Tokyo office may be
index drops by five per cent or more next Monday’,
faced with choices C and D. Locally, it may seem as
and suppose an individual has the following
if there is no right or wrong answer - the choice
irrational beliefs: there is
between A and B or C and D seems to
a 50 per cent probability that E will occur, and a 75 equivalently that irrational beliefs are not so per-
per cent probability that E will n o t occur. This vasive as to overwhelm the capacity of arbitrage
is clearly a violation of one of the basic axioms of capital dedicated to taking advantage of such irra-
probability theory - the probabilities of two tionalities. This is an empirical issue that cannot be
mutually exclusive and exhaustive events must sum settled theoretically, but must be tested through
to 1 - but many experimental studies have careful measurement and statistical analysis. The
documented such violations among an over- classic reference by Kindleberger ( ) - where
whelming majority of human subjects. a number of speculative bubbles, financial panics,
These inconsistent subjective probability beliefs manias, and market crashes are described in detail -
imply that the individual would be willing to take suggests that the forces of irrationality can
both of the following bets B t and B 2 : overwhelm the forces of arbitrage capital for
months and, in several well-known cases, years.
B= ( $ U f E B = f $1 if Ec 1 \ —$\ otherwise ’ 2 So what does this imply for the EMH?
\ —51 otherwise

where E c denotes the event ‘not E ' Now The Current State of the EMH
suppose we take the opposite side of both bets,
placing $50 on B j and $25 on B2. If E occurs, we Given all of the theoretical and empirical evidence
lose $50 on B j but gain $75 on B 2 , yielding a for and against the EMH, what can we conclude?
profit of $25. If E c occurs, we gain $50 on B I Amazingly, there is still no consensus among
and lose $25 on B 2 , also yielding a profit of economists. Despite the many advances in the
$25. Regardless of the outcome, we have secured a statistical analysis, databases, and theoretical
profit of $25, an ‘arbitrage’ that comes at the models surrounding the EMH, the main result of all
expense of the individual with inconsistent of these studies is to harden the resolve of the
probability beliefs. Such beliefs are not sustainable, proponents of each side of the debate.
and market forces - namely, arbitrageurs such as One of the reasons for this state of affairs is the
hedge funds and proprietary trading groups - will fact that the EMH, by itself, is not a well-defined
take advantage of these opportunities until they no and empirically refutable hypothesis. To make it
longer exist, that is, until the odds are in line with operational, one must specify additional structure,
the axioms of probability theory. (Only when these for example, investors’ preferences or information
axioms are satisfied is arbitrage ruled out. This was structure. But then a test of the EMH becomes a test
conjectured by Ramsey , and proved rigorously by of several auxiliary hypotheses as well, and a
de Finetti , and Savage .) Therefore, proponents of rejection of such a joint hypothesis tells us little
the classical EMH argue that there are limits to the about which aspect of the joint hypothesis is
degree and persistence of behavioural biases such as inconsistent with the data. Are stock prices too
inconsistent probability beliefs, and substantial volatile because markets are inefficient, or due to
incentives for those who can identify and exploit risk aversion, or dividend smoothing? All three
such occurrences. While all of us are subject to inferences are consistent with the data. Moreover,
certain behavioural biases from time to time, new statistical tests designed to distinguish among
according to EMH supporters market forces will them will no doubt require auxiliary hypotheses of
always act to bring prices back to rational levels, their own which, in turn, may be questioned.
implying that the impact of irrational behaviour on More importantly, tests of the EMH may not be
financial markets is generally negligible and, the most informative means of gauging the effi-
therefore, irrelevant. ciency of a given market. What is often of more
But this last conclusion relies on the assumption consequence is the efficiency of a particular market
that market forces are sufficiently powerful to r e l a t i v e to other markets - for example,
overcome any type of behavioural bias, or futures vs. spot markets, auction vs. dealer markets.
The advantages of the concept of relative efficiency,
as
opposed to the all-or-nothing notion of absolute Agent-based models are meant to capture complex
efficiency, are easy to spot by way of an analogy. learning behaviour and dynamics in financial
Physical systems are often given an efficiency markets using more realistic markets, strategies, and
rating based on the relative proportion of energy or information structures. And applications of
fuel converted to useful work. Therefore, a piston evolutionary psychology provide a reconciliation of
engine may be rated at 60 per cent efficiency, rational expectations with the behavioural findings
meaning that on average 60 per cent of the energy that often seem inconsistent with rationality.
contained in the engine’s fuel is used to turn the For example, in one agent-based model of
crankshaft, with the remaining 40 per cent lost to financial markets (Farmer ), the market is modelled
other forms of work, such as heat, light or noise. using a non-equilibrium market mechanism, whose
Few engineers would ever consider performing a simplicity makes it possible to obtain analytic
statistical test to determine whether or not a given results while maintaining a plausible degree of
engine is perfectly efficient - such an engine exists realism. Market participants are treated as
only in the idealized frictionless world of the computational entities that employ strategies based
imagination. But measuring relative efficiency - on limited information. Through their (sometimes
relative, that is, to the fhctionless ideal - is suboptimal) actions they make profits or losses.
commonplace. Indeed, we have come to expect Profitable strategies accumulate capital with the
such measurements for many household products: passage of time, and unprofitable strategies lose
air conditioners, hot water heaters, refrigerators, and money and may eventually disappear. A financial
so on. Therefore, from a practical point of view, and market can thus be viewed as a co-evolving ecology
in light of Grossman and Stiglitz ( ), the EMH is of trading strategies. The strategy is analogous to a
an idealization that is biological species, and the total capital deployed by
economically unrealizable, but which serves as a agents following a given strategy is analogous to the
useful benchmark for measuring relative efficiency. population of that species. The creation of new
The desire to build financial theories based on strategies may alter the profitability of pre-existing
more realistic assumptions has led to several new strategies, in some cases replacing them or driving
strands of literature, including psychological them extinct.
approaches to risktaking behaviour (Kahneman and Although agent-based models are still in their
Tversky ; Thaler ; Lo ), evolutionary game theory infancy, the simulations and related theory have
(Friedman ), agent- based modelling of financial already demonstrated an ability to understand many
markets (Arthur et al. ; Chan et al. ), and direct aspects of financial markets. Several studies
applications of the principles of evolutionary indicate that, as the population of strategies evolves,
psychology to economics and finance (Lo , , , the market tends to become more efficient, but this
; Lo and Repin ). Although substantially is far from the perfect efficiency of the classical
different in methods and style, these emerging sub- EMH. Prices fluctuate in time with internal
fields are all directed at new interpretations of the dynamics caused by the interaction of diverse
EMH. In particular, psychological models of trading strategies. Prices do not necessarily reflect
financial markets focus on the manner in winch ‘true values’; if we view the market as a machine
human psychology influences the economic whose job is to set prices properly, the inefficiency
decision-making process as an explanation of of this machine can be substantial. Patterns in the
apparent departures from rationality. Evolutionary price tend to disappear as agents evolve profitable
game theory studies the evolution and steady-state strategies to exploit them, but this occurs only over
equilibria of populations of competing strategies in an extended period of time, during which
highly idealized settings. substantial profits may be accumulated and new
patterns may appear.
The Adaptive Markets Hypothesis fact, his notions of ‘creative destruction’ and
‘bursts’ of entrepreneurial activity are similar in
The methodological differences between main- spirit to natural selection and Eldredge and Gould’s
stream and behavioural economics suggest that an ( ) notion of ‘punctuated equilib
alternative to the traditional deductive approach of rium’. More recently, economists and biologists
neoclassical economics may be necessary to have begun to explore these connections in several
reconcile the EMH with its behavioural critics. One veins: direct extensions of sociobiology to
particularly promising direction is to view financial economics (Becker ; Hirshleifer ); evolutionary
markets from a biological perspective and, game theory (Maynard Smith ); evolutionary
specifically, within an evolutionary framework in economics (Nelson and Winter ); and economics as
which markets, instruments, institutions and a complex system (Anderson et al. ). And
investors interact and evolve dynamically according publications like the J o u r n a l o f
to the ‘law’ of economic selection. Under this view, E v o l u t i o n a r y E c o n o m i c s
financial agents compete and adapt, but they do not and the E l e c t r o n i c J o u r n a l
necessarily do so in an optimal fashion (see Farmer o f E v o l u t i o n a r y
and Lo ; Farmer ; Lo , , ). M o d e l i n g a n d E c o n o m i c
This evolutionary approach is heavily D y n a m i c s now provide a home for
influenced by recent advances in the emerging research at the intersection of economics and
discipline of ‘evolutionary psychology’, which biology.
builds on the seminal research of E.O. Wilson ( Evolutionary concepts have also appeared in a
) in applying the principles of competition, number of financial contexts. For example, Luo (
reproduction, and natural selection to social inter- ) explores the implications of natural selec
actions, yielding surprisingly compelling explana- tion for futures markets, and Hirshleifer and Luo (
tions for certain kinds of human behaviour, such as ) consider the long-run prospects of over
altruism, fairness, kin selection, language, mate confident traders in a competitive securities market
selection, religion, morality, ethics and abstract The literature on agent-based modelling pioneered
thought (see, for example, Barkow et al. ; by Arthur et al. ( ), in which interactions
Gigerenzer ). ‘Sociobiology’ is the rubric that among software agents programmed with simple
Wilson ( ) gave to these powerful ideas, heuristics are simulated, relies heavily on evolu-
which generated a considerable degree of contro- tionary dynamics. And at least two prominent prac-
versy in their own right, and the same principles titioners have proposed Darwinian alternatives to
can be applied to economic and financial contexts. the EMH. In a chapter titled ‘The Ecology of
In doing so, we can frilly reconcile the EMH with Markets’, Niederhoffer ( , ch. 15) likens finan
all of its behavioiual alternatives, leading to a new cial markets to an ecosystem with dealers as ‘her-
synthesis: the adaptive markets hypothesis (AMH). bivores’, speculators as ‘carnivores’, and floor
Students of the history of economic thought will traders and distressed investors as ‘decomposers’.
no doubt recall that Thomas Malthus used And Bernstein ( ) makes a compelling case for
biological arguments - the fact that populations active management by pointing out that the notion
increase at geometric rates whereas natural of equilibrium, which is central to the EMH, is
resources increase at only arithmetic rates - to rarely realized in practice and that market dynamics
arrive at rather dire economic consequences, and are better explained by evolutionary processes.
that both Darwin and Wallace were influenced by Clearly the time is now ripe for an evolutionary
these arguments (see Hirshleifer , for further alternative to market efficiency. To that end, in the
details). Also, Joseph Schumpeter’s view of busi- current context of the EMH we begin, as Samuel-
ness cycles, entrepreneurs and capitalism have an son ( ) did, with the theory of the individual
unmistakeable evolutionary flavour to them; in consumer. Contrary to the neoclassical postulate
that individuals maximize expected utility and have
rational expectations, an evolutionary perspective
makes considerably more modest claims, viewing
have been honed, through generations of natural microeconomics (that is, optimize until the marginal
selection, to maximize the survival of their genetic benefits of the optimum equals the marginal cost of
material (see, for example, Dawkins ). While such a getting there), this assumes the optimal solution is
reductionist approach can quickly degenerate into known, which would eliminate the need for
useless generalities - for example, the molecular satisficing. As a result, the idea of bounded
biology of economic behaviour - nevertheless, there rationality fell by the wayside, and rational expec-
are valuable insights to be gained from the broader tations has become the de facto standard for model-
biological perspective. Specifically, this perspective ling economic behaviour under uncertainty.
implies that behaviour is not necessarily intrinsic An evolutionary perspective provides the miss-
and exogenous, but evolves by natural selection and ing ingredient in Simon’s framework. The proper
depends on the particular environment through response to the question of how individuals deter-
which selection occurs. That is, natural selection mine the point at which their optimizing behaviour
operates not only upon genetic material but also is satisfactory is this: such points are determined not
upon social and cultural norms in H o m o analytically but through trial and error and, of
s a p i e n s ' , hence Wilson’s term course, natural selection. Individuals make choices
‘sociobiology’. based on past experience and their ‘best guess’ as to
To operationalize this perspective within an eco- what might be optimal, and they leam by receiving
nomic context, consider the idea of ‘bounded ratio- positive or negative reinforcement from the
nality’ first espoused by Nobel-prize-winning outcomes. If they receive no such reinforcement,
economist Herbert Simon. Simon ( ) suggested they do not leam. In this fashion, individuals
that individuals are hardly capable of the kind of develop heuristics to solve various economic chal-
optimization that neoclassical economics calls for in lenges, and, as long as those challenges remain
the standard theory of consumer choice. Instead, he stable, the heuristics will eventually adapt to yield
argued that, because optimization is costly and approximately optimal solutions to them.
humans are naturally limited in their computational If, on the other hand, the environment changes,
abilities, they engage in something he called then it should come as no surprise that the heuristics
‘satisficing’, an alternative to optimization in which of the old environment are not necessarily suited to
individuals make choices that are merely the new. In such cases, we observe ‘behavioural
satisfactory, not necessarily optimal. In other words, biases’ - actions that are apparently ill-advised in
individuals are bounded in their degree of the context in which we observe them. But rather
rationality, which is in sharp contrast to the current than labelling such behaviour ‘irrational’, it should
orthodoxy - rational expectations - where individ- be recognized that sub- optimal behaviour is not
uals have unbounded rationality (the term ‘hyper- unlikely when we take heuristics out of their
rational expectations’ might be more descriptive). evolutionary context. A more accurate term for such
Unfortunately, although this idea garnered a Nobel behaviour might be ‘maladaptive’. The flopping of
Prize for Simon, i t had relatively little impact on a fish on dry land may seem strange and
the economics profession. (However, his work is unproductive, but under water the same motions are
now receiving greater attention, thanks in part to the capable of propelling the fish away from its
growing behavioural literature in economics and predators.
finance. See, for example, Simon ; Sargent ; By coupling Simon’s notion of bounded ratio-
Rubinstein ; Gigerenzer and Selten .) Apart from the nality and satisficing with evolutionary dynamics,
sociological factors discussed above, Simon’s many other aspects of economic behaviour can also
framework was commonly dismissed because of be derived. Competition, cooperation, market-
one specific criticism: what determines the point at making behaviour, general equilibrium, and
which an individual stops optimizing and reaches a disequilibrium dynamics are all adaptations
satisfactory solution? If such a point is determined designed to address certain environmental chal-
by the usual cost-benefit calculation underlying lenges for the human species, and by viewing them
much of through the lens of evolutionary biology
we can better understand the apparent contradic- Under the AMH, behavioural biases abound.
tions between the EMH and the presence and The origins of such biases are heuristics that are
persistence of behavioural biases. adapted to non-financial contexts, and their impact
Specifically, the adaptive markets hypothesis is determined by the size of the population with
can be viewed as a new version of die EMH, such biases versus the size of competing
derived from evolutionary principles. Prices reflect populations with more effective heuristics. During
as much information as dictated by the combination the autumn of 1998, the desire for liquidity and
of environmental conditions and the number and safety by a certain population of investors over-
nature of ‘species’ in the economy or, to use the whelmed the population of hedge funds attempting
appropriate biological term, the e c o l o g y . to arbitrage such preferences, causing those arbi-
By ‘species’ I mean distinct groups of market trage relations to break down. However, in the years
participants, each behaving in a common manner. prior to August 1998 fixed-income relative- value
For example, pension funds may be considered one traders profited handsomely from these activities,
species; retail investors, another; market-makers, a presumably at the expense of individuals with
third; and hedge-fund managers, a fourth. If seemingly ‘irrational’ preferences (in fact, such
multiple species (or the members of a single highly preferences were shaped by a certain set of evolu-
populous species) are competing for rattier scarce tionary forces, and might be quite rational in other
resources within a single market, that market is contexts). Therefore, under the AMH, investment
likely to be highly efficient - for example, the strategies undergo cycles of profitability and loss in
market for 10-Year US Treasury Notes reflects response to changing business conditions, the num-
most relevant information very quickly indeed. If, ber of competitors entering and exiting the industry,
on the other hand, a small number of species are and the type and magnitude of profit opportunities
competing for rather abundant resources in a given available. As opportunities shift, so too will the
market, that market will be less efficient - for affected populations. For example, after 1998 the
example, the market for oil paintings from the number of fixed-income relative- value hedge funds
Italian Renaissance. Market efficiency cannot be declined dramatically - because of outright failures,
evaluated in a vacuum, but is highly context- investor redemptions, and fewer start-ups in this
dependent and dynamic, just as insect populations sector - but many have reappeared in recent years as
advance and decline as a function of the seasons, performance for this type of investment strategy has
the number of predators and prey they face, and improved.
their abilities to adapt to an ever-changing Even fear and greed - the two most common
environment. culprits in the downfall of rational thinking
The profit opportunities in any given market are according to most behaviouralists - are the product
akin to the amount of food and water in a particular of evolutionary forces, adaptive traits that enhance
local ecology - the more resources present, the less the probability of survival. Recent research in the
fierce the competition. As competition increases, cognitive neurosciences and economics, now
either because of dwindling food supplies or an coalescing into the discipline known as
increase in the animal population, resources are ‘neuroeconomics’, suggests an important link
depleted which, in turn, causes a population decline between rationality in decision-making and emotion
eventually, decreasing the level of competition and (Grossberg and Gutowski ; Damasio ; Elster ; Lo
starting the cycle again. In some cases cycles and Repin ; and Loewenstein ), implying that the
converge to comer solutions, that is, certain species two are not antithetical but in fact complementary.
become extinct, food sources are permanently For example, contrary to the common belief that
exhausted, or environmental conditions shift emotions have no place in rational financial
dramatically. By viewing economic profits as the decisionmaking processes, Lo and Repin ( )
ultimate food source on which market participants present
depend for their survival, the dynamics of market preliminary evidence that physiological variables
interactions and financial innovation can be readily associated with the autonomic nervous system are
derived.
highly correlated with market events even for be derived through a combination of deductive and
highly experienced professional securities traders. inductive inference -for example, theoretical
They argue that emotional responses are a signif- analysis of evolutionary dynamics, empirical
icant factor in the real-time processing of financial analysis of evolutionary forces in financial markets,
risks, and that an important component of a pro- and experimental analysis of decisionmaking at the
fessional trader’s skills lies in his or her ability to individual and group level.
channel emotion, consciously or unconsciously, in For example, one implication is that, to the
specific ways during certain market conditions. extent that a relation between risk and reward
This argument often surprises economists exists, it is unlikely to be stable over time. Such a
because of the link between emotion and relation is determined by the relative sizes and
behavioural biases, but a more sophisticated view preferences of various populations in the market
of the role of emotions in human cognition shows ecology, as well as institutional aspects such as the
that they are central to rationality (see, for example, regulatory environment and tax laws. As these
Damasio ; Rolls ). In particular, emotions are the factors shift over time, any risk-reward relation is
basis for a reward-and- punishment system that likely to be affected. A corollary of this implication
facilitates the selection of advantageous behavioiu, is that the equity risk premium is also time- varying
providing a numeraire for animals to engage in a and path-dependent. This is not so revolutionary an
‘cost-benefit analysis’ of the various actions open idea as it might first appear - even in the context of
to them (Rolls , eh. 10.3 ). From an evolutionary a rational expectations equilibrium model, if risk
perspective, emotion is a powerful adaptation that preferences change over time, then the equity risk
dramatically improves the efficiency with which premium must vary too. The incremental insight of
animals learn from their environment and then- past the AMH is that aggregate risk preferences are not
(see Damasio ). These evolutionary underpinnings immutable constants, but are shaped by the forces
are more than simple speculation in the context of of natural selection. For example, until recently US
financial market participants. The extraordinary markets were populated by a significant group of
degree of competitiveness of global financial investors who had never experienced a genuine bear
markets and the outsize rewards that accrue to the market - this fact has undoubtedly shaped the
‘fittest’ traders suggest that Darwinian selection - aggregate risk preferences of the US economy, just
‘survival of the richest’, to be precise - is at work in as the experience since the bursting of the
determining the typical profile of the successful technology bubble in the early 2000s has affected
trader. After all, unsuccessful traders are eventually the risk preferences of the current population of
eliminated from the population after suffering a investors. In this context, natural selection
certain level of losses. determines who participates in market interactions;
The new paradigm of the AMH is still under those investors who experienced substantial losses
development, and certainly requires a great deal in the technology bubble are more likely to have
more research to render it ‘operationally meaning- exited the market, leaving a markedly different
ful’ in Samuelson’s sense. However, even at this population of investors. Through the forces of
early stage it is clear that an evolutionary frame- natural selection, history matters. Irrespective of
work is able to reconcile many of the apparent whether prices fully reflect all available
contradictions between efficient markets and information, the particular path that market prices
behavioural exceptions. The former may be viewed have taken over the past few years influences
as the steady-state limit of a population with current aggregate risk preferences. Among the three
constant environmental conditions, and the latter fundamental components of any market equilibrium
involves specific adaptations of certain groups that - prices, probabilities, and preferences - preferences
may or may not persist, depending on the particular is clearly the most fundamental and least under-
evolutionary paths that the economy experiences. stood. Several large bodies of research have
More specific implications may developed around these issues - in economics
and finance, psychology, operations research (also See Also
called ‘decision sciences’) and, more recently, brain
and cognitive sciences - and many new insights are ► inar Mark?, t Anomalie
likely to flow from synthesizing these different ► Ratio ons
strands of research into a more complete ► Ration; E led
understanding of how individuals make decisions Acknowledgment I thank John Cox, Gene Fama, Bob
(see Starmer , for an excellent review of this Merton, and Paul Samuelson for helpful discussions.
literature). Simon’s ( )
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egalitarian. Theories of distributive equality concern
themselves with the relative standing of individuals
Egalitarianism
in the distribution of benefits and burdens; theories
Harry Brighouse and Adam Swift of relational equality concern themselves with the
relative standing of individuals when they face each
other in the public sphere.

Abstract
The Metric
This article surveys a variety of egalitarian
theories. We look at a series of different answers One key question concerns the metric of equality:
to the question of what the metric of justice what, precisely, is it that egalitarians should seek to
should be. Then we survey different equalize? The literature falls into three main camps.
interpretations of the egalitarian distributive Resourcists argue that people should be equal in the
rule, including 'equality’, ‘prioritizing benefit to space of resources, meaning that they should have
the least advantaged’ and ‘sufficiency’. Theories equal opportunity for achieving holdings of
also differ by whether they see equality' as alienable goods. How are holdings priced? Ronald
properly holding within social instimtions or Dworkin imagines a hypothetical auction in which
being a principle that applies more cosmically. persons with equal holdings of some
Finally, we observe that egalitarian theories
currency bid for available goods until markets clear is no reason for people to moderate their prefer-
(Dworkin ). The distribution after the auction is ences; since welfare is a direct target, those with
equal if no one prefers anyone else’s bundle of expensive tastes receive more resources than those
goods to her own; the distribution is then said to with inexpensive tastes, which is widely regarded as
pass the ‘envy test’. The intuitive idea is that the intuitively unfair. An alternative view - equality of
price of some good is set by the opportunity cost to opportunity for welfare - deals with this problem by
others of that good. We have to tailor our seeking equality of welfare except when inequalities
preferences to our resources; equality is achieved are the result of voluntary well-informed choices
when all face the same budget constraint, not when rather than bad luck or circumstances outside the
all achieve equal satisfaction. agent’s control (Ameson ). Again, the less talented
Equality of resources has difficulty with the are straightforwardly compensated for the way in
intuition that those with less socially valued talent, which they find it harder than others to derive
and in particular those with serious impairments, satisfaction, but those who cultivate expensive
should receive compensation. Two strategies are tastes are not. However, those with non-cultivated
available. One is to adopt a view that talent is expensive preferences are also compensated, even if
socially constructed, so that much of the disad- they could easily be overcome; this view does not
vantage faced by the less talented and the impaired see lack of talent, and disability in particular, as
is a consequence not of their lack of talent but of the morally more urgent than expensive preferences.
fact that social institutions are maladapted to their (See Roemer for an argument that equality of
natural endowments (Pogge ). This view allows
resources implies equality of welfare. )
resourcists to call for the reform of social
All of the views deploying an ‘opportunity’
institutions in the name of equality, without
metric, including Dworkin’s resourcist view, pre-
demanding compensation for impairments. The
sume the desirability of holding people accountable
problem with this strategy is that some mental and
for their voluntary choices, but compensating them
physical impairments i n t r i n s i c a l l y
for deficits that are beyond their control. Views of
cause disadvantage; there is no feasible set of social
this kind are sometimes referred to as varieties of
arrangements that would not make it more difficult
‘luck egalitarianism’. Inequalities resulting from
for people with the impairments to derive
voluntary choice are acceptable because they reflect
satisfaction from resources. So an alternative
a deeper sense in which we are equal as moral
strategy is to make the cut between persons and
agents; choice legitimizes inequality, brute luck
resources in a different place, regarding talents as
resources and disabilities as resource-deficits. does not. (For an elegant attempt both to
Dworkin’s own version of this strategy proposes conceptualize and operationalize equality of
compensating the less talented with additional opportunity t o u t c o u r t , see Roemer •)
income, the amount calculated by looking at the The main rival account - namely, the capabil-
insurance that talented individuals would have ities approach developed by Amartya Sen and
bought against a lack of talents if they had no Martha Nussbaum - focuses on the
knowledge of their probability of having the talents. p r e c o n d i t i o n s of agency (Sen ;
An alternative metric is welfare; egalitarians of Nussbaum ). Equality of capabilities demands that
welfare would seek to equalize levels of welfare people be equal in the space of the functionings or
(understood sometimes as idealized preference livings that they are substantively able to achieve.
satisfaction, sometimes in terms of internal states Walking is a functioning, so are eating, reading,
such as happiness). This view handles talent- mountain climbing, and chatting. ‘The concept of
inequality in a straightforward manner; the less functionings... reflects the various things a person
talented and the disabled should be compensated up may value doing or being - varying from the basic
to the level where they enjoy as much welfare as (being adequately nourished) to the very
anyone else. But it faces the problem that there
complex (being able to take part in the life of the their theories with more details. According to Fraser
community)’ (Sen , p. 75). But when we make ( , p. 24), ‘It is unjust that some indi
interpersonal comparisons of well-being we should viduals and groups are denied the status of full
find a measure that incorporates references to partners in social interaction, simply as a conse-
functionings but also reflects the intuition that what quence of institutionalized patterns of interpretation
matters is not merely achieving the functioning but and evaluation in whose construction they have not
being free to achieve it. So we should look at ‘the equally participated and that disparage their
freedom to achieve actual livings that one can have distinctive characteristics or the distinctive
a reason to value’ (Sen , p. 73) or, to put it another characteristics assigned to them’. A third variant of
way, ‘substantive freedoms - the capabilities - to relational egalitarianism spells it out specifically in
choose a life one has reason to value’. The idea is terms of political equality, the idea being that it is
that people should be equal in this space. particularly important that people enjoy equal
The capabilities approach avoids the problems availability of or opportunity for political power or
of the standard welfarist approaches by focusing on influence (Christiano ). This variant
c h o i c e (thus treating inequalities arising is typically less hostile than other variants to luck
from voluntary choices differently from those egalitarianism.
arising from circumstances). It avoids the difficulty Each of the views reviewed in this section
resourcist accounts have with unequal talent by allows inequality along some dimensions. Rela-
focusing on f u n c t i o n i n g s ' , talent tional egalitarianisms allow such inequalities of
deficits are compensated for by looking not at what income, wealth, welfare or capabilities as are
others would pay to avoid them but at the valuable compatible with equal political influence, or inter-
activities the deficits deprive people of access to. action as peers, or ‘equal opportunity for partici-
Some theorists place the capabilities account in the pation as a peer’. These permitted inequalities may
welfarist camp (Williams ) but it is not implausible be great or very small, and how great or small may
to think of it as a variant of resourcism, vary by social context. Principles demanding
distinguished by its approach to the valuation of equality of opportunity are consistent with great
talents. inequalities in outcome, and consistent also with
A major recent development in the debates about some being very badly off in absolute terms. While
egalitarianism has involved criticisms of luck equality of opportunity conceptions place no limit
egalitarianism. Each of the luck egalitarian on how badly off someone may be as a result of her
principles, taken alone, imposes heavy costs on own imprudent choices, equality of social standing
those who endure misfortunes for which they can be demands that no one fall below the threshold
held responsible, even if those costs place the agent needed for equal participation, even if she makes
below the threshold for full participation in social numerous imprudent choices.
affairs. An alternative has developed which is best
described as ‘relational egalitarianism’. Relational
egalitarianism is not directly concerned with The Distributive Rules
equality in terms of the distribution of any particular
Do egalitarians even care about e q u a l i t y l
currency, but endorses the idea that individuals
Principles demanding equality of X seem vulnerable
should have equal standing in the public sphere.
to an obvious objection. In some dynamic situations
This vague idea has several instantiations. Elizabeth
it is possible to produce more of X by distributing X
Anderson ( , p. 304) talks
unequally, and to ensure that even those with least
of seeking ‘a social order in which persons stand in
have more than under an equal distribution. For
relations of equality’; Nancy Fraser ( ,
example, we can sometimes produce more wealth
p. 30) says that ‘Justice requires social arrange-
by judiciously attaching higher income to more
ments that permit all (adult) members of society to
productive positions in the economy, and to
interact with one another as peers’. Both fill out
longer work hours; the higher income acts both as a eschew any fundamental concern with relativities.
signal and as an incentive to produce more. That Relativities may matter in determining what is
greater production can be turned to the benefit of enough for people to live a decent life in any given
those with least. But, the objection goes, it would be social environment, but ultimately what matters is
perverse to prefer an equal situation in which not where someone ranks in the distribution of
everyone has less to one in which everyone has resources (or anything else) but whether she has
more, even if we have to sacrifice equality for the enough. However, as suggested above,
sake of that additional product. sufficientarian principles also have a place in some
This is known as the ‘levelling down’ objection variants of egalitarianism. While relational
to equality. Egalitarians make two distinct egalitarianism places no principled limits on the
responses. The first is to concede the argument, level of material or welfare inequality, and gives no
abandoning ‘equality’ and replacing it with ‘giving general priority to the least advantaged, it does set a
priority to the interests of the least advantaged’. floor - all must have sufficient resoiuces to be full
John Rawls’s difference principle, which states that participants in social interaction. Equality of
‘social and economic inequalities are to be arranged political influence demands that all have sufficient
to the maximum benefit of the least advantaged’, resoiuces, personal and financial, to play an equal
embodies one variant ofthis response, a variant that role in political life, but, as long as it is possible to
gives a b s o l u t e priority to the prospects of insulate politics from residual inequalities of wealth,
the least advantaged (Rawls , ). A weaker it is not concerned with equalizing or prioritizing
variant in this family of benefit to the least advantaged.
views, usually known as ‘prioritarianism’, simply Many theories of justice that do not fit the above
says that it is more urgent to provide benefits to characterizations of egalitarianism nevertheless
those with less advantage than to those with more incorporate some elements of egalitarian thinking.
(Parfit ). John Rawls’s theory of justice, for example, prior-
An alternative response is to assert value plu- itizes the principle that certain basic liberties (not
ralism. This response acknowledges that priority to including strong property rights) be equally distrib-
the least advantaged is an important value and uted, then demands that within that constraint fair
perhaps more important than equality, so that when equality of opportunity should be implemented, and
it comes to policy or action prioritarian principles then that social and economic inequalities be
should govern. But it says that equality nevertheless arranged to the greatest benefit of the least
matters some; there is one way in which an unequal advantaged in so far as that is possible without
distribution is worse than an equal distribution, jeopardizing the equal liberty and fair equality of
even if, all things considered, it is better; the way in opportunity principle (Rawls , ). Michael
which it is worse is that it is unequal and for that Walzer’s ( ) theory of ‘complex equality’ takes
reason unfair (Temkin ). seriously widely shared intuitions that different
This response is bolstered by the observation that goods are subject to different distributive rules. For
there is nothing eccentric about endorsing a prin- example, while income should be distributed
ciple that values distributions that benefit nobody; according to productive contribution, as will tend to
the retributive principle of proportionality between result from market interactions, the inequalities this
punishment and crime, for example, calls for norm generates should be prevented from translating
harming the criminal even when there is no gain to into unequal access to certain key goods like health
anyone else in harming him. care and educational opportunities, the distribution
Some reject principles of equality and priority of which should be governed by need and the
on the grounds that all that matters for the purposes requirements of equal opportunity respectively. It is
of justice is that all have enough. Sufficientarian unclear in what sense Walzer’s ‘complex equality’
theories are not usually counted as within the is genuinely an egalitarian position, since it is in
egalitarian family, because they principle consistent with unequal
and coinciding distributions of all goods that are not motivationally inert, since the people in B do not
themselves governed by egalitarian norms. have the relevant knowledge. But, if they did,
Priority and equality coincide in practice for one cosmic egalitarianism would give them a reason to
class of goods: positional goods. These have the try to find a way to contact and interact with the
property that the contribution an individual’s share people on A, while intra-societal egalitarianism
of the good makes to her absolute position is would provide them with no such reason.
determined by how much of the good she has The divided world case brings out another dif-
relative to others. The credentialing aspect of edu- ference in orientation. Where members of A and B
cation is a paradigm case; how useful a degree is in have no interaction, or even knowledge of each
landing a job (as opposed to the learning one other, equality can be valued only intrinsically
achieved in the process of getting the degree) rather than because of its effects on members of A
depends entirely on the credentials of one’s com- or Often, however, inequality with respect to some
petitors for that job. (Other cases are detailed in goods is devalued, and equality valued,
Hirsch .) Those who give priority to the worst-off instrumentally, because of its absolute effects on
will countenance inequalities in positional goods those subject to the unequal distribution - usually its
only in so far as they are required by or result in the effects on the relatively disadvantaged. Thus, for
least advantaged benefiting overall (Brighouse and example, economic inequalities are thought to
Swift ). undermine the fairness of legal or political pro-
cesses, or occupational or other status hierarchies
are claimed to harm the health of those on the lower
The Scope of Equality rungs. Those who value equality intrinsically would
hold that there is a reason to level down for the sake
Whatever the right distribuendum, and whatever the
of equality or fairness, whereas instrumental
appropriate distributive principle, it is a further
egalitarians might seek the more equal distribution
question who should be equal to whom. Some limit
of some goods, not for egalitarian reasons
the application of their egalitarianism to members
s t r i c t o s e n s u , but to eliminate the
of the same society or system of cooperation, or to
bad effects of certain kinds of inequality.
those subject to the same coercive structure (Nage I
), or hold that it is states that
owe their citizens a particular duty to treat them
The Subject of Justice
with equal concern and respect (Dworkin ). Others
believe that egalitarian principles should apply to all A further dividing line between egalitarians con-
human beings, irrespective of the relations that cerns the subject of justice. Rawls stipulates that the
obtain between them. If we restrict the application subject is the ‘basic structure of society’, which
of egalitarian principles to schemes of cooperation, consists of some of the central, interaction-shaping
that does not exclude the possibility of a global institutions of a society: for example, the constitu-
egalitarianism, since most now accept that in the tion, the legally recognized forms of property, the
modem world social cooperation extends well structure of the economy, the design of the legisla-
beyond national boundaries (Julius ). But consider ture, and the judiciary. The idea is that these insti-
this version of Derek Parfit’s divided world case. tutions govern the division of the advantages that
All the people in A are half as well off as all the accrue from social cooperation, and they assign the
people in B, but A and B have no knowledge of or basic rights and responsibilities to citizens. So a
contact with each other (Parfit ). Is there anything society is just when those institutions are arranged
regrettable from the perspective of injustice about according to the correct principles.
this inequality? If so, then the scope of justice is Rawls officially exempts individual actions and
cosmic, not simply social. In the stated version of motives from evaluation from the perspective of
the divided world case this difference is egalitarian justice, as long as individuals obey the
rules set by a just basic structure. But this has
the consequence that a society in which talented See Also
individuals take advantage of the prerogatives not to
serve the least advantaged that are built into the ► Equ
principles that he thinks justice requires of coercive ► Ethics ai
institutions is no less just than one in which they are ► Liberal);
►
much more strongly motivated by the desire to
►
benefit the least advantaged through their choices
► ; isfici
regarding work. A society with an egalitarian
► :>a, An
governing ethos, on this view, is no more just than
one without, even when the least advantaged are
much better off. But the motivations and actions of
talented individuals affect the prospects and status
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influence on persons’ (Rawls , p. 55), which is Anderson, E. 1999. What is the point of equality? Ethics 109:
Rawls’s central reason for focusing on the basic 287-337.
structure. So some egalitarians regard justice as Arneson, R. 1989. Equality and equal opportunity for welfare.
Philosophical Studies 56: 77-93.
commenting not only on the broad coercive outline
Arneson, R. 2002. Egalitarianism. In: Stanford encyclopedia
of society, but also on less officially coercive of philosophy. Online. Available at
institutions such as a society’s ethos (Cohen ). For a . Accessed 14 Oct
powerful defence of an account intermediate 2006.
Brighouse, H., and A. Swift. 2006. Equality, priority and
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Christiano, T. 1995. The rule of the many. Boulder: Westview
Press.
Other Values Cohen, G.A. 1997. Where the action is: On the site of
distributive justice. Philosophy and Public Affairs 26:
3-30.
Most egalitarian theorists are value pluralists; they Dworkin, R. 1981. What is equality? Part 2: Equality of
believe that equality (or priority) of their preferred resources. Philosophy and Public Affairs 10: 283-345.
metric matters, but so do other principles. Dworkin, R. 2000. Sovereign virtue. Cambridge, MA:
Observing that equality or priority is sometimes in Harvard University Press.
Fraser,N. 1998. Social justice in the age of identity politics.
conflict with liberty or privacy or efficiency does In: The Tanner lectures on human values. Stanford
not require us to reject one of the conflicting values. University, 29 April-2 May. Online. Available at
It requires us, instead, to evaluate reasons for
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considering one of the values more morally Hirsch, F. 1976. Social limits to growth. London: Routledge
important than the others, and, in the light of that & Kegan Paul.
evaluation, to establish which should give way in Julius, A.J. 2003. Basic structure and the value of equality.
different conflicts. Unless the relationship between Philosophy and Public Affairs 31: 321-355.
Julius, A.J. 2006. Nagel’s atlas. Philosophy and Public
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prior value always trumps subordinate values, Nagel, T. 2005. The problem of global justice. Philosophy
which can be pursued only when there is no and Public Affairs 33: 113-147.
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mandated in different conflicts. But lexical priority Parfit, D. 2000. Equality or priority? In The ideal of equality.,
is unlikely to hold between genuine values. If a ed. M. Clayton and A. Williams. London/ New York:
value matters a t a l l , it is hard to believe it Palgrave Macmillan/St Martin’s Press. Pogge, T. 2003. Can
could never be the case that a very large amount of the capability approach be justified?
Philosophical Topics 30(2): 167-228.
it was greater than a very small amount of a Rawls, J. 1971. A theory of justice. Cambridge, MA: Harvard
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t h a t c o n f l i c t i n g v a l u e Rawls, J. 2001. Justice as fairness. Cambridge, MA: Harvard
i s . University Press.
Roomer, J.E. 1986. Equality ofresources implies equality of held up relatively well during the global financial
welfare. Quarterly Journal of Economics 101: 751-784. crisis, with a decline in remittances and external
Roomer, J.E. 1998. Equality of opportunity. Cambridge, MA:
Harvard University Press. demand partially offset by resilient domestic
Sen, A. 1999. Development as freedom. New York: Knopf demand and strong performances in the construc-
Temkin, L. 2002. Equality, priority, and the levelling down tion, communications and trade sectors.
objection. In The ideal of equality, ed. M. Clayton and A. In 2009 agriculture accounted for 13.7% of
Williams. London/New York: Palgrave Macmillan/ Si
Martin’s Press.
GDP, industry 37.3% and services 49.0%.
Walzer, M. I‘)X3. Spheres of justice. New York: Basie GDP fell by 9% in the first quarter of 2011
Books. following the revolution in January of that year.
Williams, A. 2002. Dworkin on capability. Ethics 113: 23 39. Revenues from tourism collapsed, triggering a slide
in foreign reserves. Unemployment climbed to 13%
and gross public debt rose to nearly 100% of GDP
by late June 2013. Long-term stability is likely to
Egypt, Economy of remain elusive as the country struggles through its
political transition.
Barry Turner

Currency

The monetary unit is the E g y p t i a n

Keywords p o u n d (EGP) of 100 p i a s t r e s .
Foreign direct investment; International Mon- Inflation rates (based on IMF statistics) for fiscal
etary Fund; Mubarak; Piasters years:
Faced with slowing economic activity', the
country devalued the Egyptian pound four times in
JEL Classification 2001. In January 2003 the Egyptian pound was
053; Rll
allowed to float against the dollar after years of a
government- controlled foreign exchange regime. In
Overview June 2009 foreign exchange reserves were
US$29,278 m„ gold reserves totalled 2.43 m. troy
Egypt, one of the most economically diversified oz and total money supply was £E 182,991 m.
countries in the Middle East, has been embroiled in
economic turmoil since the overthrow of Hosni
Mubarak in 2011. Budget
The 1980s was a decade of macroeconomic
The financial year runs from 1 July. Budgetary
disorder in Egypt before an IMF-backed reform
central government revenues in 2008-09
programme in the 1990s helped it achieve economic
(provisional) were £E282,505 m. and expendi- tures
stability'. However, the late 1990s saw a downturn
£E308,070 m. Taxes on income, profits and capital
and privatization efforts stalled in the early 2000s.
gains accounted for 28.4% of revenue and taxes on
In 2004 an economically liberal cabinet was
goods and services 22.2%. Main items of
appointed and the reform agenda was revived, with
expenditure were subsidies (30.5%) and compen-
President Mubarak investing political capital in
sation of employees (24.7%).
structural reforms to generate jobs and promote
foreign investment.
Growth in Egypt averaged 6.4% per year Performance
between 2005 and 2008, underpinned by record
levels of foreign direct investment and a favourable
external environment. The economy
3003 3003 3004 3005 3006 3007 3008 3009 3010 3011
2.4% 3.2% 8.1% 8.8% 4.2% 11.0% 11.7% 16.2% 11.7% 11.1%
3003 3003 3004 3005 3006 3007 3008 3009 3010 3011
3.2% 3.2% 4.1% 4.5% 6.8% 1.1% 1.2% 4.7% 5.1% 1.8%

Banking and Finance

Einaudi, Luigi (1874-1961)
The Central Bank of Egypt (founded 1960 ) is the
central bank and bank of issue. The Governor is F. Caffe
Hisham Ramez.
In 2003, four major public-sector commercial
banks accounted for some 77% of all banking
assets: the National Bank of Egypt (the largest Keywords
bank, with assets of £E299 bn. in June 2010), the Economic liberalism; Einaudi, L.; Mill, J. S.;
Banque Misr, the Bank of Alexandria and the Public finance; Tax incentives for saving; Tax-
Banque du Carre. There were 40 banks in total in able income
2008. Foreign banks have only been allowed to
operate since 1996.
Foreign direct investment inflows, which were JEL Classifications
just US$237 m. in 2003, rose to US$11.6 bn. in B31
2007, but declined to US$6.4 bn. in 2010.
In 2010 external debt totalled US$34,844 m., An outstanding Italian economist and influential
representing 16.2% ofGNI. figure on the broader political and cultural scene,
There are stock exchanges in Cairo and Einaudi was bom in Carm (Piedmont) on 24 March
Alexandria. 1874 and died in Rome on 30 October 1961. He
Central Bank of Egypt:
graduated in law from Turin in 1895 and then,
Bank of Alexandria:
while continuing with this studies, embarked on a
Banque du Caire:
career in journalism. The success he achieved in
Banque Misr:
both fields underlined his rare talent and his endless
National Bank of Egypt:
capacity for work. In fact, his academic progress
was so rapid that in 1907 he was appointed as
professor of public finance at the University of
Turin. Meanwhile, he wrote articles for the most
influential Italian daily newspaper of the period, the
Corriere delle Serra, which not only brought him national
See Also recognition but also earned him the reputation of
‘educator’ of the entire country. He became a
► Energy Economics
member of the Senate in 1919, but retired from all
► International Monei
political and public activity with the advent of
► Islamic Economic I
fascism. Towards the end of the First World War he
► Islamic Finance
went into exile in Switzerland. On his return, he
► Oil and the Macroe
was appointed Governor of the Bank of Italy
► Organization of the
(1945), Vice-
President of the Cabinet and Minister in charge of Selected Works
the Budget (1947), and was finally elected President
of the Republic of Italy (1948-1955). At the end of On Luigi Einaudi himself there is a Bibliografia
his seven-year presidential term of office, he was degli scritti edited by Luigi Firpo under the
made a life member of the Senate. auspices of the Bank of Italy, Turin, 1971. It is
The most important aspect of Einaudi’s useful to divide his work into the three main
achievements is the use he made of his academic areas which he outlined: theory, politics and
and journalistic ability, as foundations for his history. Representative works of the three
activity as a statesman and politician. In addition, sections are as follows:
close study of his strictly scientific works reveals 1912. Intorno al concetto di reddito imponibile e di im sistema di
the extent to which he drew on the wealth of imposts sid reddito consnmato. Turin: V. Bona.

knowledge and experience which he had gained also 1919. Osservazioni critiche intorno alia teoria
in other fields. The 3,800 recorded items of dell'ammortamento dell ’imposta e teoria delle variazioni nei

Einaudi’s works cover such a wide range of inter- redditi e nei valori capitali sussequenti all’imposta. Turin:

ests that it is necessary here to concentrate on his Fratelli Bocca.

contributions to the study of public finance and his 1929. Contributo all ricerca della ‘ottima imposta Milan:
ideas on economic policy. Einaudi’s main contri- Bocconi.
butions to the study of public finance were inves- 1938. Miti e paradossi delli giustizia tributaria.
tigations, based on the classical ideas of John Stuart Turin: Luigi Einaudi.
Mill, which gave a solid logical basis to the The following handbooks are available:
principle of the exclusion of savings from taxable 1914. Corso di scienza delle finanze. Turin: Tip. e
income; his research into the theory of Bono.
capitalization of taxation; his critical and con- 1932-66. P r i n c i p i d i s c i e n z a
structive contributions on the effects of certainty d e l l e f i n a l i z e . Turin: La
and stability of fiscal principles; his important Rifoima Sociale.
analysis of the concept of taxable income which he 1932. I I s i s t e m a t r i b u t a r i o
identified with normal income, or, in other words, i t a l i a n o . Turin: La Rifoima Sociale.
with the average income potentiality' of the person With reference to the history of finance and the
subject to taxation. history of ideas see:
Einaudi's position vis-a-vis public intervention 1908. La finanza sabauda all’aprirsi del secolo
in the economy was not hostile in principle, though XVIII e durante la guerra di successione
he undoubtedly took a limited view of state spagnola. Turin: Societa Tip. Editrice
interference in economic life. Since, for Einaudi, Nazionale.
'All liberties were jointly liable', autonomous 1927. La guerra e il sistema tributario italiano.
sources of income were a necessity' to prevent Bari: Laterza.
people from being subjected to a single centralizing 1953. Saggi bibliografici e storici intorno alle
order of the state. He asserted this during the 2 0 dottrine economiche. Rome: Ediz. Storia c
years of fascism, when he continued to teach with Litteratura.
the same independence of mind and without Einaudi's journalistic work has been largely col-
compromising his fidelity to economic liberalism. lected in eight volumes comprising the
Even though Einaudi had been stressing the C r o n a c h e e c o n o m i c h e e
usefiilness of productive public expenditure since p o l i t i c h e d i u n
1919, he showed a singular lack of comprehension t r e n t e n n i o (1893-1925), Turin: Ed.
of the Keynesian contribution, in the belief that it Einaudi, 1959-65, and in L o
would be an inevitable cause of inflation. s c r i t t o i o d e l
P r e s i d e n t s 1 9 4 8 - 1 9 5 5 ,
Turin: Ed. Einaudi, 1956. For many years
Einaudi was Italian correspondent for the
 In P r i m i t i v e M o n e y , i n
Einzig, Paul (1897-1973) i t s E t h n o l o g i c a l , H i s -
t o r i c a l a n d E c o n o m i c
Brendan Brown A s p e c t s , Einzig looks at how different
commodities came to be used as money in primitive
and ancient society. He refutes the hypothesis that
money developed primarily through the progress of
Einzig was bom in Brasov, Transylvania (Austria- division of labour and the resulting complexity of
Hungary). He was both a prolific, widely read trade, which made barter increasingly cumbersome.
author on international monetary topics and a Much more important was the designation of a
renowned journalist. Educated in Hungary and commodity for use in non-commercial payments
France, he received his PhD from the University of (religious sacrifices, blood money, bride prices
Paris. In 1919, Einzig settled in the UK. Soon he etc.).
became the Paris correspondent of the F i n a n -
c i a l N e w s and was appointed its political Selected Works
editor in 1929. When the F i n a n c i a l
N e w s was bought by the F i n a n c i a l 1931. Behind the scenes of international finance.
T i m e s , Einzig became the political editor of London: Macmillan.
the latter newspaper. Also he wrote the daily 1939. T h e b l o o d l e s s
‘Lombard Street Column’ during the mid- and late i n v a s i o n . London: Macmillan.
1930s and many feature articles on currency 1940. E u r o p e i n c h a i n s .
questions. One of his top ‘scoops’ as a journalist London: Penguin.
was the revelation in 1943 of how the Swiss 1949. Money in its ethnological aspects. London:
National Bank was buying looted gold from the Macmillan.
Reichsbank on a huge scale. Already in 1939, 1954. M o n e t a r y p o l i c y . London:
Einzig’s book T h e B l o o d l e s s Penguin.
I n v a s i o n had provided an original account 1960. I n t h e c e n t r e o f
of how Nazi Germany in its exchange rate policies t h i n g s . London: Hutchinson. 1961a.
exploited South-East Europe. T h e o r y o f f o r e i g n
Einzig wrote more than 50 books on financial e x c h a n g e . London: Macmillan.
topics. Perhaps A D y n a m i c
T h e o r y o f F o r w a r d
E x c h a n g e (1961) is the best example of Eisner, Robert (1922-1998)
his powerful combination of economic, practical
and historical knowledge. The book has a section James K. Galbraith
describing the methods of intervention by central
banks in forward exchange markets in the interwar
period - and also by the Austrian and Russian
central banks in the late 19th century. Einzig takes
Abstract
issue with the ‘static theory of forward exchange’ in
Robert Eisner, a leading American macro-
which forward rates are shown as determined by
economist and theorist of the investment func-
given international interest rate differentials. He
tion, was an architect of the Keynesian
stresses that these themselves are influenced by
ascendancy in post-war America. He developed
speculation in the forward market. Einzig showed
the accounting foundations of Keynesian mac-
that except in the case of perfect arbitrage, forward
roeconomics, finally producing a Total Income
markets have to be considered explicitly in an
System of Accounts. His ideas found
analysis of international short-term capital
 application in his later, policy-oriented writings seriously and in developing their implications with
on the budget deficit, the current account, and utmost rigour. This thread tuns through his writing
from his earliest papers on the ‘Invariant Multiplier'.
the Social Security system. His embrace of cap- the permanent income hypothesis, liquidity
ital budgeting underpinned a strong advocacy of preference and the liquidity trap. It reaches its apo-
liberal expenditure on infrastructure, education, gee in his work on a Total Income System of
Accounts (TISA). It suffuses his later, policy-
and research and development. He was through-
oriented writings on the meaning and implications of
out motivated by a commitment to larger social deficits in the budget, current account, and Social
goals, especially full employment, peace, and Security system.
justice.
No shrinking violet, Eisner liked to call his
shots. Thus, H. S.Houthaker 'has not performed [a]
Keywords test correctly’; ‘Bronfenbrenner and Mayer...
American Economic Association; Budget def- confound.. . issues of elasticity' with those of slope';
icits; Capital budgeting; China; One-child ‘Re-estimation with Pifer’s data and application of
policy; Collective bargaining; Depreciation appropriate statistical tests contradict Pifer’s
allowance; Economists Allied for Arms conclusions’ (1998a, pp. 8 , 27, 48). The tone is ever
Reduction; Eisner, R.; Full employment; tactful, the intent always the pursuit of truth, the
Invariant multiplier; Investment function; subtext a certain delight in finding the exact, fatal
Keynesian Revolution; Liquidity preference; weakness of an opposing view. Late in his life, this
Liquidity trap; Natural rate of unemployment author heard Eisner speak to a room of senior
(NAIRU); Office of Price Administration; Peace officials in China on the error and futility of the
economics; Permanent income hypothesis; one-child policy, a delicate issue which he raised in
Replacement costs; Social Security; total the same spirit and with deeply impressive effect.
Income System of Accounts; Unit relative price Underpinning his technical precision lay an
elasticity unflagging commitment to larger social goals,
especially full employment, peace, and justice.
Eisner actively advocated all three throughout his
career, but especially in the later years when he
JEL Classifications
B31 appeared frequently on the opinion pages of the
W a l l S t r e e t J o u r n a l , as a
leading director of Economists Allied for Arms
Robert Eisner, a leading American macroeconomist
Reduction, and in causes devoted to the
and theorist of the investment function, graduated in
advancement of women in the economics
history from College of the City of New York in
profession.
1940, took an MA in sociology from Columbia
For instance, in a 1952 paper in the
University in 1942 and, following service in the
A m e r i c a n E c o n o m i c
army and the Office of Price Administration, a
R e v i e w (1998a, 106-17) Eisner analysed the
Ph.D. in economics under Fritz Machlup at Johns
relationship ofreplacement costs to depreciation
Hopkins University in 1951. He joined the faculty
allowances in a growing economy. In doing so he
of Northwestern University in 1952, rising to hold
called attention to the fact that growth in the latter
the William R. Kenan Professorship of Economics
usually exceeded that in the former, resulting in
from 1974 until his retirement in 1994. He served as
reported profits that were understated for purposes
President of the American Economic Association in
of both taxation and collective bargaining. Point-
1988.
edly, he suggested the work ought to interest both
Eisner was an architect of the Keynesian ascendancy revenue officers and trade unionists.
in post-war America. Much of his work was devoted
to technical developments in that tradition: his
Yet Eisner's views were often unfashionable and
singular distinction lay in taking the accounting politically inconvenient. In important papers in the
foundations of Keynesian macroeconomics 1980s, at a time when Democrats had taken the veil
of fiscal virtue, he undertook with Paul
Pieper to show that (among numerous other diffi- one bridge between the Keynesian Eisner and his
culties with budget accounting) inflation had ren- counterpart, the theorist of investment, public
dered the deficit meaningless, introducing vast finance, and peace economics and stalwart defender
inconsistencies between the nominal budget deficit of Social Security, all of which he was.
and the change in the real public debt. Thus, the Eisner’s investigations of investment involved
Reagan deficits were far smaller than normally pioneering use of corporate records. They permitted
supposed, while those of Carter were surpluses in cross-section analysis of firm decisions, showing
real terms - likely to produce fiscal drag and so to that the concepts of macro models, such as the
bear partial responsibility for the stagnation of those accelerator, operated differently on firms from dif-
years. Correctly accounting for inflation, Eisner ferent industries or with differing recent growth
argued, might have forestalled the new classical histories. In numerous studies, Eisner criticized
critique that led many in those years to abandon neoclassical investment theories. Rejecting the
Keynesian principles. notions of a desired capital stock and unit relative
A closely related cause was the misunderstand- price elasticity, he adhered to a Keynesian relation
ing of ‘national saving’ and the fallacious popular of investment to expected profitability and of
argument that to reduce deficits would lead to expected profits to the rate of growth. An important
increased capital formation. In 1995, Eisner argued theme in this work concerns the appropriate level of
that to take the accounting relation between public aggregation at which to take measurements. Eisner
and private saving found that firms appropriately assess the growth of
their own industry to be the most relevant to profit
as evidence that reducing the federal deficit must
raise national saving should be recognized, on even prospects, not the inherently variable growth of
the slightest reflection, as patently absurd. It is individual firms or the potentially irrelevant growth
startlingly akin to the assumption, more than half a of generalized aggregate demand.
century ago, that saving and investment would be Eisner’s Total Income System of Accounts
increased if we all undertook to save more by con-
suming less. Perhaps! But that is exactly the prop- marked the peak of his campaign to rationalize
osition to be proved, or supported by empirical economic measurement and theory. The importance
evidence, not assumed. (1998a, p. 322) of changing household relations appears vividly in
his initial motivation for this work: ‘What happens
Second only to correct reasoning, evidence to income, output, and productivity when
mattered. In the 1990s Eisner took up arms against clotheswashing moves from the washtub and the
the ‘governing myth’ of economic policy, the nat- professional laundry to the laundromat and to the
ural rate of unemployment introduced by Friedman automatic washer and dryer...?’ (1998b, p. 188).
and Phelps in 1968. From this strangely Particularly noteworthy is capital accumulation by
selfdamaging justification for perpetually high households in a country where transportation is
unemployment, Eisner hoped for a ‘NAIRU provided mainly and increasingly by private car.
escape’. His method was largely econometric, and The challenge of TISA remains to be taken up by
in what may have been his final paper, published in most economists and national income statisticians.
1998 (1998a, pp. 454—87), he argued that a sepa- Finally, midway through the Vietnam War
rate analysis of low-unemployment cases showed Eisner deflated the view that President Johnson
no relationship between full employment and rising might have forestalled inflation by raising taxes; the
inflation. This position was to be vindicated only sure way to that end, he showed, would have
dramatically in the two years following his death. been to avoid the war. This insight led to papers on
Eisner embraced capital budgeting, so that the the ‘staggering cost’ of the Vietnam war, much in
liabilities acquired by the government might be the spirit of total accounts, and on post-cold war
properly offset against corresponding assets. This disarmament. Equally, to the end of his life Robert
position helped underpin a strong advocacy of Eisner defended Social Security from all those who
liberal expenditure on infrastructure, education, and would cut it. Spurious and persistent allegations of
research and development. It also provides financial ‘crisis’ notwithstanding, he
believed that a rich and civilized society can, and matter of style only whether or not formulae
are expressed in terms of elasticities of demand
should, provide decent incomes and care for its old. and supply, or in terms of ordinary derivatives.
To speak of an ‘elasticities approach’ to the bal-
See Also ance of payments is therefore to speak no sense
at all.
► Government Budget Constraint However, behind the nonsensical label there
► Lcbc'::: 7 hides a coherent and distinctive theory of what
. . .. .. ; . ory O determines the response of a country’s balance of
► Social Security in the United States payments to parametric changes in its rate of
► ::v,; exchange, that is, to changes in the terms on
which its currency exchanges for other currencies.
Selected Works The theory goes back to a paper published by
Charles Bickerdike ( ).
1986. How real is the federal deficit? New York: Consider a simplified world containing just
Free Press. two countries (the ‘home’ country and the ‘for-
1994. The misunderstood economy: What counts eign’) and producing and trading just two com-
and how to count it. Cambridge, MA: Harvard modities. Let R be the price of foreign currency in
Business School Press. terms of home currency, let p t be the home price
1997. The great deficit scares: The federal budget, of
trade, and social security. New York: The the /til commodity in terms of home currency
Century Foundation. (so that, in arbitrage equilibrium, p * = p j R is
1998a. The Keynesian revolution, then and now: the foreign price of the commodity in terms of
The selected essays of Robert Eisner, vol. 1. foreign currency), and let B be the home balance
Cheltenham: Edward Elgar. of trade in terms of foreign currency. Then, writ-
1998b. Investment, national income and economic ing z f p i ) and : * ( p f ) as the home and
policy: The selected essays of Robert Eisner,
foreign
vol. 2. Cheltenham: Edward Elgar.
excess demands for the rth commodity,
Bickerdike’s model of the balance of payments
reduces to the system of three equations
Elasticities Approach to the Balance of
Zi(Pi)+fi(pfiR) = 0 (i = 1,2) B
Payments = -^/R)\PWl(Pl)+P2-2iPl)]
CD
Murray C. Kemp
In this system the rate of exchange R is treated as a
parameter and p \ , p 2 and B as variables to
be
determined. Differentiating ( ) with respect to R ,
Keywords
solving for dB and the dp h and converting to
Elasticities approach to the balance of pay-
elasticities, we obtain
ments; Excess demand

vt^+Vi) V*2(1+rh)'\ dfl

. V*i ~ % V*2 - V2 \ J R
JEL Classifications
F32 and

The substance of a theory is independent of the d^^d^

manner in which it is dressed. In particular, it is a Pi V* - Vi R
where 7 7 ,- = ) ( p , ! z / } to Negishi (
(dz/d/?,- ), Kemp ( ), Dombusch
and ??• = ( ) and Kyle ( ).
( d z * / d p * ) ( p * / z * ). In the special
case in which B is initially zero, ( ) takes the
+Vi) v K 1 + ^72)1 ^ Bibliography
dB = -p\ z*2
V 2- V 2 \ R Bickerdike, C.F. 1920. The instability of foreign exchange.
Economic Journal 30: 118-122.
Equation ( ) is often referred to as the Bickerdike- Dombusch, R. 1975. Exchange rates and fiscal policy in a
Robinson-Metzler formula: however, the role of popular model of international trade. American Economic
Robinson ( ) and of Metzler Review 65: 859-871.
Kemp, M.C. 1970. The balance of payments and the terms of
( ) was that of expositor only. trade in relation to financial controls. Review of
Suppose for concreteness that the home country Economic Studies 37: 25-31.
exports the first commodity and imports the second, Kyle, J.F. 1978. Financial assets, non-traded goods and
so that 7 7 1 and 7 7 2 are export-supply elasticities devaluation. Review of Economic Studies 45: 155-163.
Metzler, L.A. 1949. The theory of international trade. In A
and 7 7 2 and 7 7 5 import-demand elasticities. survey of contemporary economics, ed. H.S. Ellis. Phil-
Suppose further that all marginal propensities to adelphia: Blakiston.
buy are positive, so that i p and 7 7 2 are positive, Negishi, T. 1968. Approaches to the analysis of devaluation.
7 7 2 and ?7 jnegative. Then for the balance of International Economic Review 9: 218-227.
Robinson, J. 1947. Essays in the theory of employment. 2nd
payments to improve in response to devaluation it ed. Oxford: Basil Blackwell.
suffices that the sum of the two import demand
elasticities exceed 1 in magnitude, that is, that the
Marshall- Lemer condition be satisfied. Thus Eq. ( )
can be rewritten as Elasticity

V1V2(t + + V2) - 1
+ Vi + vi) dR Peter Newman
d£ = -p*27^
{vi-'ifdt'h-vi)

with all terms of known sign except ( 1 + 7 7 2 +

7 7 2 ). For a positive response of the balance of Abstract
payments to devaluation it suffices also that the Formally invented by Marshall, the concept of
terms of trade improve, or at least that they not elasticity of demand goes beyond the notion,
worsen. For changes in the terms of trade are which can be found in classical economics, that
indicated by changes i n p I / p 2 and, from Eq. ( demand varies less or more than price. The
), crucial property that alone makes elasticity so
important in pure and applied economics is that
d(pi/Pi) _dPi dp2
the elasticity measure is i n v a r i a n t
P\/Pi Pi Pi
t o changes in units of measurement of
V i \ quantities and prices.
= (-$-■ dA*
V/ i - Vi
Keywords
Vi ~ ViJ R
Arc elasticity; Cournot, A. A.; Dimensional
If this expression is non-negative then, from ( ), dB analysis; Duality; Elasticity; Elasticity of
must be positive. demand; Elasticity of substitution; Elasticity of
Bickerdike’s theory is very special in that the supply; Invariance to transformation; Mill, J. S.
excess demand for each commodity depends on the
money price of that commodity only. Implicitly, all
‘cross’ price elasticities are set equal to zero. For
more general theories and, in particular, more JEL Classifications
general versions of ( ), the reader is referred DO
One day in the winter of 1881-2 Alfred Marshall Let/be a real-valued nonzero differentiable function
came down from the sunny rooftop of his hotel in whose domain is some open interval / of the real
Palermo ‘highly delighted’, for he had just invented line. In conformity with Marshall’s Mathematical
elasticity of demand (Keynes pp. 39 n. 3, 45 n. 2). Appendix ( , Note IV, pp. 738—40), the
So delighted was he that within a mere four years e l a s t i c i t y o f f a t t h e
he had introduced the word e l a s t i c i t y p o i n t x , denoted by r / f ( x ) , is
into the technical literature of economics defined here to be the n u m b e r x f (x)//’(x).
(Marshall ), which by his own standards was T h e f u n c t i o n i ] y ( x ),defined by
rushing pell-mell into print. But if the speed of its this formula is called the e l a s t i c i t y o f
introduction was uncharacteristic the manner of it f . To define the elasticity of d e m a n d ' some
was not, tucked away as it was at the end of a authors prefer to follow the convention f ( x ) =
lecture dull even for its time, and giving no hint that — x f ' ( x ) / f ( x ) , which is not used here.
elasticity was new and exciting ( p. 187). Unfortunately there is no standard notation for
The notion that demand varies less or more than elasticity, since the obvious candidates are already
price can of coiuse be found rather often in classical taken, e for e and E for the expectations operator.
economics, especially in John Stuart Mill Cournot’s critical value of p , his criterion for
(Edgeworth , p. 691). But to turn that trite idea into sorting out commodities, is simply that p * for
something useful requires a firm grip on the prior which = -1; he was close indeed. How
idea of quantity demanded a t a p r i c e . ever, unlike Marshall (who is crystal clear on the
So it is not surprising that the only ancient who point) there is no trace in Cournot of the crucial
came close to Marshall’s idea was Cournot himself, property that the elasticity measure is
the inventor of (among much else) the demand i n v a r i a n t to changes in units of
function. measurement of quantities and prices, and it is this
In fact Cournot came so close that it is hard to property alone that makes it so important in pure and
understand, first, why he did not go all the way, and applied economics.
second, why Marshall gave him no credit for A little calculus will prove such invariance, but
showing that way. Such lack of generosity is the is more enlightening to apply the dimensional
more puzzling since we know that between the time analysis of Jevons and Wicksteed. Let the dimension
when (according to Mrs Marshall) he invented ofx be Aand that of/(xj = y be Y , so that/'fv) has
elasticity, and the late spring of 1882 when he first dimension ET1. The dimension of P f ( x ) is then
drafted the chapter on Elasticity for the X ■ Y X 1 • Y 1 and everything cancels. The
P r i n c i p l e s , Marshall reread Cournot elasticity of/at x is a pure number, unaffected by
(Whitaker , vol. 1, p. 85). change in the units of either x ory. (This application
Starting with the demand fimction D is so obvious that the most plausible explanation of
F ( p ) , Cournot pointed out that p F ( p ) is why it was not included in Wicksteed , is that his
total revenue, so that for maximum revenue the entry was actually written before Marshall’s
price p must be such that F ( p ) + P r i n c i p l e s appeared.) Although
p F ' ( p ) =0( , p. 56). Thus invariance to transformation of units is the key
total revenue will increase or decrease with increa property of elasticities, partly as a consequence the
se in price according as A D / A p is larger or measure has a number of other agreeable properties.
smaller than D / p , where A D is the absolute For example, it is easily seen that p f i x ) = d
value of the change in quantity demanded. log f ( x ) / d log x, which paves the way for a
Commercial statistics should therefore be required to whole calculus of elasticities in terms of logarithmic
separate articles of high economic importance into
derivatives (Champemowne ; Allen , pp. 251—4).
two categories, according as their current prices are
above or below the value which makes a maximum One simple application of this calculus is the
of pF(p). We shall see that many economic problems formula r y g ( x ) = > y ( x ) +
have different solutions, according as the article in i ] g ( x ) , where f g is the product of/and g
question belongs to one or other of these two
(with a corresponding formula for the quotient
categories. (Bacon’s translation 1897, p. 54)
function f / g ) , while another is the
characterization of constant elasticity fhnetions as
Douglas’s paper of 1927 was apparently intended to ‘meaningful theorems’ and by non-meaningful
introduce elasticity of supply, which is odd since it theorems in economics. A peculiar aspect of some of
had already appeared 2 0 years before (and rather the elasticity measures introduced then was their
late at that) in the fifth edition of the definition not in terms of the properties of a given
P r i n c i p l e s (see Marshall , vol. 2, p. f u n c t i o n f (as here), but rather as the
521). ratio of proportionate change in one variable to
The extension of elasticity to functions of more proportionate change in another, allegedly causative,
than one variable is easy - one simply uses the variable, without any explicit functional relationship
partial derivatives f rather than the derivative f - intervening. Thus with Hicks’s ‘elasticity of
and is staple fare in textbooks (see for example expectations’ ( , p. 205) there i s no ‘expec
Allen , pp. 310-12). However, many of those tation function’ of which it is an elasticity, as that
textbooks underplay another useful property of term is defined above. Similarly, although the elas-
elasticities of strictly monotonic functions (such as ticity of substitution (<x) invented by Hicks ( )
the usual demand and supply curves) which follows and Robinson ( ) immediately provoked many
from the inverse function theorem. Considering just articles in response (for example, Lemer ), at no
functions of one variable, if we write <3> / time was a ‘substitution function’ introduced whose
'then from that elasticity it was. The lack of a generating function
theorem O' / 1, so from this and the definition of for <x might help to explain why its use often
elasticity, occasions technical difficulty.
It is of some interest to apply duality theory to
the problem of deriving simple formulas for entities
v<b(y) =y®'(y)/®{y) =/MAf'M like <x (cf. Woodland , p. 31). Consider the
= elasticity of substitution obetween two consumer’s
goods x and y , with no restriction being placed on
that is, the elasticity of the inverse function is the preferences apart from the smoothness conditions
inverse of the elasticity. Two obvious applications implicit at this level of analysis. First, take
of this to the elementary theory of the firm are: advantage of homogeneity in both the ordinary and
(i) Since the revenue function is compensated demand functions to write the former
R(q) = pq = q<b(q), function as f p , m ) and the latter as h ( p ,
f ) , where p is the price of x in terms of y , m
marginal revenue (mr) = <S>(q) + qG>'{q) is the consumer’s income in terms of y , and t is
= ®(<7)[1 +?(?®'(?)/®(?)] =®(<7) the m a x i m i z e d level of utility for the
x (1 + %(?)). price- income situation ( p , m ) . Putx*
from which one can derive the more usual but less = f ( p , m ) . Finally, observe that <x is
intuitive formula m r = p [ 1 + (1 wholly determined by the price slope corresponding
/ r j f ( p ) ) \ ; and (ii) since at the firm’s to p together with the indifference curve
corresponding to t , so that we may write cr =
profit maximizing output marginal cost m e =
< j ( p , t ) .
m r , the Lemer ( ) measure
From a modem version of the fundamental
of monopoly power (p -me) / p may be written [$
equation of value theory (Hicks , p. 309),
(?) - m r ] / $ ( q ) = 1 - [0 ( ? ) ( 1 +
i l < l l ( q ) \ / ( t > ( p )
= - >Mq)- fP (P, m) = hp (p, t) - x*fm ip, m) (1 )
Arc elasticity, which is really ordinary elasticity
with the index number problem thrown in, was where f p , h p and /„, are, in sequence, the
introduced quite early by Dalton ( pp. 192—7). But partial derivatives o f f and h with respect to p ,
the heyday of elasticities of all kinds came later, in and of /with respect to m . Multiplying ( ) by p / f
the 1930s, so much so that it is small wonder that in ( p , m ) and writing t y p , i ] / „ , f o r
the immediate post-war period Samuelson ( , pp. the two partial elasticities o f f we obtain
4-5) used elasticity
 Vfpip^m) =php(p,t)/x* Bibliography
- px*mf m(p, m)/(mf(p, m)) Allen, R.G.D. 1938. Mathematical analysis for economists.
= php(p, t)/x* - hjfm(p, in) (2 ) London: Macmillan.
Champemowne, D.G. 1935. A mathematical note on sub-
where k = p x * m , that is, the fraction of m stitution. Economic Journal 15: 246-258.
spent on x . Now since t is the maximized level Cournot, A.A. 1838. Recherches sur les principes
of utihty, given local non-satiation x * = h ( p , mathematiques de la theorie des richesses. Paris:
t ) . Hence, the first term on the right-hand side of Hachette. New edn, ed. G. Lutfalla, Paris: Riviere, 1938.
English trans. by N.T. Bacon, 1897. Reprinted, New
( ) is i ] / , p ( p , t ) , the partial elasticity York: A.M. Kelley, 1960.
of h with respect to p , and ( ) becomes Dalton, H. 1920. Some aspects of the inequality of incomes in
modern communities. London: Routledge.
VfP(P> m) = VhpiP’t) ~ kllfm& m)■ Douglas, PH. 1927. Elasticity of supply as a determinant of
distribution. In Economic essays contributed in honor of
A standard result of Hicks and Allen ( , John Bates Clark, ed. J.H. Hollander. New York:
Macmillan.
see Edgeworth, F.Y. 1894. Elasticity. In Dictionaiy of political
Hicks , p. 20) for the two-good case can be written economy, ed. R.H.L Palgrave, vol. 1. London:
in the present notation as Macmillan.
Hicks, J.R. 1932. The theory of wages. London: Macmillan.
Hicks, J.R. 1939. Value and capital. Oxford: Clarendon
~Vjp(P>m) = krlfli(P’ m) + ( 1 - k)o(p, t) (4) Press.
Hicks, J.R. 1981. Collected essays on economic theory. Vol.
so from ( ) and ( ), 1: Wealth and welfare. Cambridge, MA: Harvard
University Press.
Hicks, J.R., andR.G.D. Allen. 1934. A reconsideration of the
(k-\)a(p,t) = i]hp. (5) theory of value. Economica 1: 52-76, 196-219. Reprinted
Let the cost (expenditure) function for this in Hicks (1981, vol. 1).
Keynes, J.M. 1925. Alfred Marshall, 1842-1924. In Pigou
problem be c ( p , t ) , and denote its partial
(1925).
derivative with respect to p by c p . Then, Lemer, A.P. 1933. The diagrammatical representation of
writing p c p p for the partial elasticity of c p elasticity of substitution. Review of Economic Studies.
with respect to p , since Shephard’s Lemma Reprinted in Lemer (1953).
Lemer, A.P. 1934. The concept of monopoly and the
implies c p = h we have
measurement of monopoly power. Review of
Economic Studies l(June): 157-175. Reprinted in
VhpiP’t) = VcpP(P’t)- (6 )
Lemer (1953).
Lemer, A.P. 1953. Essays in economic analysis. London:
Now k = p x * / m = p h ( p , Macmillan.
m ) / m = p c p ( p , t ) / m . Because Marshall, A. 1885. The graphic method of statistics.
Journal of the Royal Statistical Society. Reprinted in
t is the maximized level of utility m = c ( p ,
Pigou 1925.
t ) , so k = p c p ( p , t ) / c ( p , t ) Marshall, A. 1890. Principles of economics. Vol. 1.
= p c p { p , t ) , where p c p is the London: Macmillan.
partial elasticity of c with respect to p . Marshall, A. 1961. Principles of economics. 9th
Substituting from this and ( ) into ( ), (variorum) edn, with annotations by C.W.
Guillebaud, 2 vols. London: Macmillan.
Pigou, A.C., ed. 1925. Memorials of Alfred Marshall.
<r(p,t) = VcPP(P’t)/(VcP(P’t)-1)- (7) London: Macmillan. Reprinted, New York: A.M.
Kelley, 1966.
Thus the elasticity of substitution in this two- Robinson, J.V. 1933. The economics of imperfect competi-
good case can be expressed entirely in terms of the tion. London: Macmillan.
cost function. Samuelson, P.A. 1947. Foundations of economics analysis.
Cambridge, MA: Harvard University Press.
Whitaker J.K., ed 1975. The early economic writings of
Alfred Marshall, 1867-1890, 2 vols. New York: Free
See Also Press.
Wicksteed, P.H. 1894. Dimensions of economic
► Marshall, Alfred (1842-1924) quantities. In Dictionary of political economy, vol. I,
ed. R.H.I. Palgrave. London: Macmillan.
--------------------------------- T
Elasticity of Intertemporal (l)
Substitution 1=1

where c , is consumption in period t , and 0 <

Christopher Bliss
3 < 1 , and where 3 is the rate at which utility is
discounted. Lifetime utility ( ) is maximized sub-
ject to the lifetime budget constraint:
Abstract
The elasticity of intertemporal substitution (EIS)
measures the willingness on the part of the
consumer to substitute future consumption for
present consumption. It plays a key role in the
theory of consumption and saving, in particular where the y values are incomes in the various
in the life-cycle version of that theory. periods, and r is the real rate of interest. Assuming
positive consumptions in all periods, the maximi-
zation of ( ) requires:
Keywords
Consumption smoothing; Consumption theory; dU\c,\ 1
Elasticity of intertemporal substitution; 3‘ (3)
dc,
Elasticity of substitution; Multiple equilibria;
Overlapping generations models; Risk aversion;
Savings where X is the Lagrange multiplier. From ( ),
taking logs:

JEL Classifications . .".■'I'.'iii dU[ct]

In dct
DO

In 3 (4)

The EIS and Consumption Theory

Differentiating ( ) with respect to r and holding
The elasticity of intertemporal substitution (EIS) is c , constant gives:
an important number in macroeconomic theory. It
measures the willingness on the part of the d2U[cl+1]
consumer to substitute future consumption for dc2,+l dc,+i ^ 1
present consumption. This parameter plays a key d U [ c , + 1 ] d r (1 + r)
role in the theory of consumption and saving, in dc,+1
particular in the life-cycle version of that theory.
For a start we examine the role of the EIS in a basic A useful way of writing ( ) is:
life-cycle model. In that model there is complete
certainty concerning prices, future income, and dU[ct+\]
preferences present and future. The consumer can 1
dc, + 1 = _ 1 dct+1
lend and bonow at will at a single invariant rate of
c,+i dr (1 + r) d2U[ct+1\ dct 1 1
interest, subject only to a lifetime budget constraint.
Preferences are additively separable. The consumer
Or equivalently:
chooses present and future consumption to
maximize:
 1 d c
+ \ _t
is no accident that consumption substitution through
(7) time, with no uncertainty whatsoever, and risk
g(cf+i)
c t+1 d r 1 + r aversion, where uncertainty is necessarily involved,
should involve the same parameter. Absolute risk
where ct is the EIS, defined as: aversion is related to the willingness of a consumer
dU[c] to accept a lottery ticket in preference to a sum of
dc money available for certain, the certain sum being
(7(c) (8)
d2U[c1 lower than the expected value of the lottery. One
C- - - -T2- can think of the extra expected value in the better-
dc~
than-fair lottery as a premium needed to entice the
Equation ( ) indicates that the size of the EIS will be agent to accept the risk. The higher is relative risk
a crucial determinant of how far consumption levels aversion, the larger must be the expected-value
will respond to changes in the interest rate. premium in the lottery. Arrow ( , ch. 3)
The effect of a small change in r analysed provides a detailed discussion, and
above is a standard partial equilibrium result, in references the parallel and independent work of
which enough is held constant to obtain a definite Pratt.
result. The calculation shows how two solution Now consider the life-cycle maximization of ( )
paths compare with regard to c , + b as r is varied subject to ( ). To make the explanation as simple as
slightly, when for each of these paths c t takes the possible let 8 and r both be zero. The consumer
same optimal value. For that special case, ( ) says maximizes:
that c , + i increases with r, which is to say that
T
c , + 1 increases relative to c t . In that particular do)
sense a small increase in r encourages saving. Even t= 1
for the two-period model popular for classroom
exposition, it cannot be shown that a rise in r
encourages saving. However in the two-period subject to the lifetime budget constraint:
model it is true for any separable lifetime utility T T
function, as ( ), that c i declines as r increases, dD
provided that c 2 > y 2 , the usual case. When 1=1 i=i
r increases the substitution effect always favours
lower early consumption. Wheny2 > c 2 , however, With U [ ] a concave function, it is evident that the
the income effect opposes the substitution effect, consumer will consume at the same level in each
and the outcome is uncertain. period:
Equation ( ) shows that the second derivative of
the utility function, how curvy it is if one likes, is
crucial in giving a specific value to the EIS. If: ct 12)
(

17(c) = c2 ^ 1 (9) In the particular sense defined by this special

case, the consumer is averse to consumption var-
then the EIS is constant, independent of c, and
iability over time. It is the same as the risk-averse
equal to a .
consumer disliking variations in wealth when dif-
ferent states of the world are realized. That each
Consumption Smoothing and Risk period of time will certainly arrive, whereas only
Aversion one state of the world will be realized, is irrelevant
in the e x a n t e view of the consumer facing
The EIS as defined in ( ) is the same as the Arrow- uncertainty. A risk-averse agent can be induced to
Pratt measure of relative risk aversion. It accept a gamble if the odds are sufficiently
favourable, that is, if the expected-value premium
is sufficiently large. Similarly, a life-cycle planner Sala-i-Martin ( ), in their influential study of
will opt for a non-constant consumption plan if it economic growth, assume that different countries or
provides a larger total consumption sufficient to regions solve independent Ramsey optimal model
compensate for the unattractive variability. A problems. This leads to the condition:
positive rate of interest plays the same role as an
expected-value premium. It is the sweetener that l d
- S a[AFl{k,\} - 8\ (14)
persuades the consumer to accept variability For c at
this reason it is no surprise to find that the extent to
which the consumer will respond to the sweetener, where F \ is the marginal product of capital, c is
in either case, is governed by precisely how much consumption, k is capital, 8 is the utility discount
the consumer dislikes variability. And the EIS, or rate, A measures total factor productivity as it is
the coefficient of relative risk aversion, as the case affected by policy, culture, corruption, and so on,
may be, measures that dislike of variability. and CJ is the EIS. The lower is k the larger is F \ .
The argument just completed ignores the part If this effect is not offset by poor countries having
played by S , the utility discount rate. The lower total factor productivities, and if all countries
presence of a positive S means that, were r zero, share the same values of 8 and q, then conditional
the consumer would choose a plan with [ 1 - convergence follows from ( ), meaning that
consumption falling through time. Then a positive poor countries grow faster.
r , and especially an r greater than 8 , persuades The poor will be reluctant to save if their value
the consumer to select a consumption plan with of CT is low. And this is a most plausible
consumption falling less rapidly or rising through specification. When all the meals that one eats are
time. How far an optimal plan responds to a given small, it is rationally more difficult to postpone
change in r is governed again by the EIS. eating now for a larger meal later. This point has
been recognized in the literature. For example, King
and Rebelo ( ) allow for a
A Constant or a Variable Coefficient? utility function of the Stone-Geary form, where the
consumer gives priority to a fixed basket of
The EIS has been compared above to the coefficient
essentials until that basket has reaches a critical
of relative risk aversion. In the theory of risk
scale. With those preferences, the poorest con-
aversion the emphasis is on the variability of the
sumers will not save at all, and there is the
coefficient. On this turns the issue of whether the
possibility of a poverty trap. The Stone-Geary
wealthy will be more or less willing to undertake
utility function implies a zero value for the EIS at
risk than the poor. With the EIS the most common
low consumptions, and positive values for higher
assumption is that it is a constant. A popular special
consumptions.
case of ( ) is:

q-1 q—1
U [ C \ , C 2 , ■ ■ ■ An] = C { + 8 c { + ... The EIS in Consumption Studies

+ 8n-1cf (13) Many applied economists used to take the view that
the value of a is close to zero (see Hall ; Mankiw et
This is the love-of-variety utility function of Dixit al. ). This reflects the failure of consumption studies
and Stiglitz ( ), with discounting added. to find a significant effect of the rate of interest on
The EIS measured at any of the consumptions saving. Such estimates are seriously biased if the
above is a. consumer is constrained from borrowing freely (a
The elegance and convenience of forms such as feature ignored in the computations above) or if, as
( ) has made them appealing. Thus Barro and in Deaton ( ),
most consumers save only to replenish
precautionary balances following negative shocks. A Variable EIS in the Diamond Capital
Then the optimizing substitution-based theory does Model
not apply. Blundell et al. ( ) and
Attanasio and Browning ( ) show that repre In their deep study of the Diamond overlapping
sentative consumer models give seriously mis- generations model with capital, De La Croix and
leading results when applied to aggregate Michel ( ) more or less dismiss the impor
consumption data. They use UK household tance of multiple stable equilibria. To summarize, it
expenditure data to model consumption at the is possible to obtain multiple stable steady-state
individual level and obtain a greatly improved fit solutions with simple functional forms, but these
when they allow the rich to have a higher EIS than cases are unsatisfactory at best. If the production
the poor. Does that mean that as economies grow function is Cobb-Douglas and with a simple sep-
richer over time, the average EIS will increase? This
arable utility function, there are no cases of multiple
remains an unanswered question. stable steady states. With a logarithmic utility
function and the constant elasticity of substitution
in production p > 0 , there can be two positive
VEIS Functions steady-states, but it may be that only the comer
degenerate outcome is stable.
Let the utility function be chosen from a class of Rather than using given simple functional forms
which the simplest case is: and looking for a few steady-state solutions, try for
a continuum of solutions as follows. Assume:

' l fe}* <15)

! |c| = exp
dU\c]
dc ff c
where is a positive constant and c is the level of d2U[c} = ( ) (19)
: ---
consumption. This is a VEIS utility function, where dc~
VEIS stands for v a r i a b l e
e l a s t i c i t y o f where a ( c ) is an arbitrary positive increasing
function of c . Then:
i n t e r t e m p o r a l

dU[c d2U[c\
] >0 (16) ~lc^_________L_
dU[c\ a (c)c 20)
(
dc
dc
and:
Integrating ( ) gives:
d2U[c\ 1
Jc1> 0 (17)
dc2 dU[c\
In dc . . d x + In D (21)
)a tyX)X
U [•] is an increasing concave function. Now the
EIS may be computed as: where a is a positive constant, and D is a constant
of integration.
dU[c\ In a steady state solution to the Diamond model
dc we must have:
(18)
d2U[c\ pc
dc2
dU[c dU[c2]
In In dc = In 8 — In R (22)
i]
This increases linearly with consumption at rate />. dc
The poor have a lower EIS and f t - convergence
wi II not necessarily prevail.
rate of return to saving, and 8 is the discount factor. See Also
From ( ) and ( ):
► Consumer Expenditure
' —!—dx=ln 8-In R (23) fl <x(x ) x ► Consumer Expenditure (N

Now in steady state c \ , c2 and R all depend

Bibliography
upon capital per head k . If over some range of
values of k every value gives a steady state, then ( Arrow, KJ. 1971. Essays in the theory of risk bearing.
) will be an identity in k . Let the per capita Amsterdam: North-Holland.
Attanasio, O.P., and M. Browning. 1995. Consumption over
production function be Cobb-Douglas with coef-
the life-cycle and over the business cycle. American
ficient a. Then ( ) takes the form: Economic Review 85: 1118-1137.
Barro, R.J., andX. Sala-i-Martin. 1995. Economic growth.
'k+OCk,01 1
New York: McGraw-Hill.
-1
d x =ln 8 — In (l + aC* ) Blundell, R., M. Browning, and C. Meghir. 1994. Consumer
J(l-a)Jt“-jfc i)
ax x
demand and the life-cycle allocation for household
(24) expenditures. Review of Economic Studies 61: 57-80.
Deaton, A. 1992. Understanding consumption. In Clarendon
When ( ) is an identity in k , over an interval at lectures in economics. Oxford: Clarendon Press.
least, then differentiating both sides of ( ) gives: De La Croix, D., and P. Michel. 2002. A theory of economic
growth: Dynamics and policy in overlapping
111 generations. Cambridge: Cambridge University Press.
Dixit, A.K., and J.E. Stiglitz. 1977. Monopolistic competition
a(k + ocka) k + aka cr((1 — a)k* — k) and optimum product diversity. American Economic
1 Review 67: 297-308.
Hall, R.E. 1988. Intertemporal substitution in consumption.
(1 — oc )kl — k Journal of Political Economy 96: 339-357.
King, R.T., and S.T. Rebelo. 1993. Transitional dynamics and
a(l — a)£a_2
(25) economic growth in the neoclassical model. American
1 + uka~x Economic Review 83: 908-931.
Mankiw, N.G., J.J. Rotenberg, and L. Summers. 1985.
Take a given a value of k , and let <x (<?i) Intertemporal substitution in macroeconomics. Quarterly
values be known for the cq value implied by that k Journal of Economics 100: 225-281.
all the way up to the c 2 defined by the same k .
Then a (c2) values are determined by ( ),
which rolls out a
solution for a such that all values of k on a
connected interval are steady-state equilibrium
levels. The contrast to the case advanced by De La
Croix and Michel is striking.
Elasticity of Substitution
Concluding Remarks
D. R. Helm
The EIS is an important value, just as is its cousin,
the coefficient of relative risk aversion. The use of a
simple functional form has too often frozen the EIS
as a constant. When it is allowed to vary, the (3- Keywords
convergence of growth theory is no longer secure; CES production functions; Cobb-Douglas
cross-section consumption studies perform better; functions; Elasticity; Elasticity of substitution;
and multiple equilibrium in the Diamond capital Hicks, J. R.; Income effects; Indifference
model is seen to be far more probable than previous curves; Production functions; Robinson, J. V.;
studies indicate. Substitution; Substitution effects; Value theory
 JEL Classifications where W \ is the price of the V \ factor.
DO These two definitions of the concept gave rise to
a considerable debate in the early issues of the
The concept of the elasticity of substitution, R e v i e w o f E c o n o m i c
developed by Joan Robinson and John Hicks sep- S t u d i e s , with in particular a notable
arately in the 1930s, represented an important contribution from Kahn ( ) concerned
addition to the marginal theory of the 1870s, in the to identify how these concepts related to each other.
tradition of Marshall, Edgeworth and Pareto. It It turns out that these two original definitions are
brought together two concepts which were already identical when the production function is confined
well established in the literature - the ideas of to two factors of production, where the partial
elasticities (which derive from Mill) and those of derivatives of the production function are the
substitution (which go back to Smith). The marginal productivities of the factor inputs and
relationship defined by the concept is a math- yield the relevant factor prices. In addition, the
ematical one relating to utility and production contributors to the debate attempted to identify the
functions, with considerable economic implications. implications of these somewhat abstract concepts.
It has two applications: to the theory of production, Amongst these were the joint determination by the
and in particular the isoquant relationship between elasticity of substitution and the factor supplies of
factor inputs, and to consumer behaviour and the the relative shares of the factor reward (wages and
indifference curve. Let us look at each in turn. profits), and implications for the definition of
The two inventors of the concept - Joan Rob- imperfect competition with increasing returns to
inson, in her E c o n o m i c s o f scale.
I m p e r f e c t C o m p e t i t i o n ( It is not surprising that it is with the cases where
), and John Hicks in his T h e o r y o f the restrictive neoclassical assumptions for the pro-
W a g e s duction function are not met that most interest
( ) - each developed Marshall’s formula for arises. Two important developments are where pro-
the elasticity of derived demand. Each defined the duction function involves three or more factors and
concept somewhat differently. For Hicks, the def- in extending from Cobb-Douglas to constant elas-
inition was the percentage change in the relative ticity of substitution (CES) production functions.
amount of the factors employed resulting from a But although considerable emphasis has been
given percentage change in the relative marginal placed on the elasticity of substitution in produc-
products or relative prices, that is (following tion, it remains a technical concept concerning
Samuelson ): factor substitutability. It has no direct allocation
consequence. Diminishing elasticity of substitution
a = an = { F i F o / F F \ f ) a 2 \ , does not imply diminishing returns to scale, since
for returns we must have prices. Thus it is restricted
where F ( V i, V 2 ) is a standard neoclassical to describing the technical conditions of production.
production function, and the subscripts are the But, being a technical concept, it can be generalized
partial derivatives. This is sometimes called the to all forms of transformation.
direct elasticity of substitution.For Joan Robinson, Thus, as we noted above, along with a number
on the other hand, concerned with relative shares of other concepts, these tools developed for pro-
and hence distributional issues, the elasticity of duction were taken over to consumer theory.
substitution was defined as ‘the proportionate Because of the implications the concept had for the
change in the ratio of the amounts of the factors development of consumer behaviour, and because
employed divided by the proportionate change in of the insight which the resulting difficulties threw
the ratio of their prices’ ( , p. 256 ): up concerning the concept more generally, this
application is of special interest.
d(VI/V2)/(YI/V2) a It was Hicks (and Allen) who made that step.
d(wi/w2)/(wi/w2) While Joan Robinson’s development of the concept
was closely related to her extension of
Marshall’s theory of the industry, Hicks was depends upon whether preferences can be
familiar with a very different approach to value represented by complete, transitive, utility func-
theory, that of Edgeworth, Pareto and Walras. tions. Much recent evidence from psychologists and
While Joan Robinson had focused on production decision theorists suggests otherwise. Likewise for
substitutions, and hence isoquants, Hicks took the production theory, the concepts of capital and
idea developed in that domain, and translated it labour may be themselves ambiguous.
across to consumer theory, and to the indifference
curves which he had got from Edgeworth. In the
two goods case, price elasticity could be represented See Also
in terms of his fundamental formula, according to
► CES Production Function
which:
► Cobb-Douglas Functions
Price elasticity = k (income elasticity) ► Production Functions
+ (1 - k ) ( e . s.)
Bibliography
where k is the total expenditure that is spent on the
commodity. Thus, with income elasticity, consumer Hicks, J.R. 1932. The theory of wages. London: Macmillan.
theory led into a representation of the effect of a Hicks, J.R. 1939. Value and capital. Oxford: Clarendon
price change in terms of the income and substitution Press.
Hicks, J.R. 1970. Elasticity of substitution again: Substitutes
effects, with elasticity being thus of prime
and complements. Oxford Economic Papers 22: 289-296.
importance in classifying goods by their demand Hicks, J.R., and R.G.D. Allen. 1934. A reconsideration of the
characteristics. theory of value I II. Economica 1 (Pt 1): 52-76. Pt n,
But whereas the elasticity concept in production May, 196-219.
Kahn, R.F. 1933. The elasticity of substitution and the
theory naturally led on to the possibility of
relative share of a factor. Review of Economic Studies 1:
measurement, that step in consumer theory was 72-78.
more contentious. For although this technical con- Robinson, J. 1933. The economics of imperfect competition.
cept represented one important step in the devel- London: Macmillan.
opment of the marginalist approach to the theory of Samuelson, P.A. 1968. Two generalizations of the elasticity
of substitution. In Value, capital and growth, ed. .I N.
value, the theory of demand behaviour requires a Wolfe. Edinburgh: Edinburgh University Press.
behavioural theory of choice. The elasticity of
substitution with respect to the indifference curve is
one technical component. But, as with production
theory, prices, and in this case the budget line, are
also required.
Technical concepts thus aided the formulation of
modem consumer theory as outlined in Hicks and Electricity Markets
Allen’s ‘A Reconsideration of the Theory of Value’
( ) and the opening chapters of James Bushnell and Catherine Wolfram
V a l u e
a n d C a p i t a l ( ), a path from which it
has
scarcely deviated. But, despite the mathematical Keywords
elegance of this construction, it may be argued that Cost-based regulation; Electricity industry;
it disguised many of the important underlying Electricity markets; Experimental economics;
questions. The increased power of the indifference Game theory; Incentive regulation; Investment;
curve analysis begged the question of whether Liberalization; Market power; Natural
consumer preferences could in reality be monopoly; Oligopoly simulation analysis; Pri-
represented in this abstract way. Ultimately, vatization; Real-Time pricing; State-Owned
whether consumer behaviour is well described by utilities
concepts like the elasticity of substitution,
 JEL Classifications Most wholesale electricity is traded through
L66 long-term (a week or longer) forward contracts.
Many markets also feature day-ahead auction-
based exchanges. Because supply and demand must
In many parts of the world buyers and sellers now be continually balanced to preserve transmission
trade electrical energy in liberalized markets. These stability, transmission system operators run real-
markets have partially replaced cost-based time balancing markets. Prices in these high-
regulation and government ownership. frequency markets can be highly volatile since
Since the 1980s, governments in many countries electricity is non-storable and real-time demand
have privatized and restructured their electricity fluctuates dramatically. To meet unforeseen
industries. Liberalized electricity markets now contingencies, transmission system operators also
operate in much of Europe, North and South contract for and occasionally use standby or reserve
America, New Zealand and Australia. These generation services. Many markets reflect price
changes were primarily motivated by the perception differences across geographical locations when
that the previous regimes of either state ownership parts of the transmission grid are congested
or cost-of-service regulation yielded inefficient (Schweppe et al. ; Chao and Peck ). Game theorists
operations and poor investment decisions. and experimental economists are involved in the
Liberalization of the electricity industry also ongoing process of designing electricity markets
reflected the progression of a deregulation (Wilson ), while empirical researchers have used
movement that had already transformed infra- detailed auction data to estimate how well
structure industries, including water, communica- predictions from theoretical models describe firm
tions and transportation, in many countries. behaviour (Wolak ; Hortascu and Puller ).
Although electricity shares many characteristics At the retail level, the vision of liberalization
with other deregulated industries, the differences was to provide customers a choice among com-
have proven to be more important than the simi- peting retailers who would operate as either
larities. Electricity has been one of the most chal- resellers or integrated providers with access to
lenging industries to liberalize and in most places customers through a regulated common-carriage
new layers of regulations have replaced the old. distribution network. In most restructured US
Historically, electricity was viewed as a natural markets, retail competition for residential customers
monopoly. Typically, a single utility company is very weak (Joskow ). Retail competition is more
generated, transmitted and distributed all electricity advanced in the United Kingdom, although
in its service territory. In much of the world, the evidence suggests that customers have been slow to
monopoly was a state-owned utility. Within the take advantage of the ability to switch to a lower-
United States, private investor-owned companies priced retailer (Waddams ). Several authors have
supplied the majority of customers, although fed- noted the economic benefits of allowing retail
erally and municipally owned companies played an prices to vary to reflect real-time changes in the
important minority role. These companies operated wholesale prices, although this sort of real-time
under multiple layers of local, state and federal retail pricing has been slow to take hold in practice
regulation. (Borenstein and Holland ; Joskow and Tirole ).
Restructured electricity markets share a com- Oligopoly simulation analysis indicates the
mon basic organization. The three segments - potential for serious market power problems
generation, transmission, and distribution - have because suppliers face extremely inelastic demand
been unbundled. Wholesale generation, no longer and entry requires long lead times (Green and
viewed as a natural monopoly, is priced through a Newbery ). Empirical work has indicated that
market process. Transmission and distribution market power has indeed been present, although to
remain regulated, although in many cases some varying degrees in different
form of incentive regulation has replaced cost-of-
service regulation or state ownership.
markets. Wolfram ( ) found that prices in Chao, H.P., and S. Peck. 1992. A market mechanism for
England and Wales were lower than static oligopoly electric power transmission. Journal of Regulatory’
Economics 10: 25-60.
models would suggest. By contrast, extreme levels Fabrizio, K., N. Rose, and C. Wolfram. 2004. Does com-
of market power in California contributed to record petition reduce costs? Assessing the impact of regulatory
high prices in 2000-1 (Borenstein et al. ). restructuring on US electric generation efficiency. CSEM
The explanations for these differences working paper WP-135. Berkeley: University of
California Energy Institute.
have focused on variations in the threat of future Green, R., and D. Newbery. 1992. Competition in the British
regulation and in the extent of long-term fixed price electricity spot market. Journal of Political Economy
contracts (Bushnell et al. ). 100: 929-953.
Although the main motivation for market lib- Hortascu, A., and S. Puller. 2004. Understanding strategic
bidding in restructured electricity markets: A case study
eralization was to improve economic efficiency, of ERCOT. Working paper. Chicago: University of
there have been few attempts to measure efficiency Chicago. Online. Available at
changes. Newbery and Pollitt ( ) and . Accessed
Fabrizio et al. ( ) find modest positive effects 20 July 2005.
Joskow, P. 2005. The difficult transition to competitive
of market liberalization on, respectively, industry electricity markets in the US. In Electricity’
efficiency in the United Kingdom and plant-level restructuring: Choices and challenges, ed. J. Griffen and
efficiency in the United States. S. Puller. Chicago: University of Chicago Press.
As electricity industry restructuring moves for- Joskow, P., and J. Tirole. 2004. Retail electricity competition.
CMI working paper 44. Cambridge, MA: MIT.
ward, the major unresolved question is the degree to
Newbery, D., and M. Pollitt 1997. The restructuring and
which public policy will influence investment privatization of Britain’s CEGB - was it worth it?
decisions. Electric generating plants are long- lived, Journal of Industrial Economics 45: 269-303.
so while operating efficiency gains appear to be Schweppe, F., M. Caramanis, R. Tabors, and R. Bohn. 1988.
Spot pricing ofelectricity. Norwell: Kluwer Academic
real, the potential gains from improved investment
Publishers.
stand to be larger. Also, policies to limit the Waddams, C. 2004. Spoilt for choice? The costs and benefits
environmental impact of electricity generation of opening UK residential energy markets. Work ing
could affect the types of technologies in which we paper 04-1. Norwich: Centre for Competition and
Regulation, University of East Anglia.
invest.
Wilson, R. 2002. Architecture of power markets.
Econometrica 70: 1299-1340.
Wolak, F. 2000. An empirical analysis of the impact of
hedge contracts on bidding behavior in a competitive
See Also electricity market. International Economic Journal 14:
1-39.
► :<> Wolfram, C. 1999. Measuring duopoly power in the
► Energy Economics British electricity spot market. American Economic
Review 89: 805-826.

► Privatization Impacts in Transition Economies

Bibliography
Electronic Commerce
Borenstein, S., and S. Holland. 2005. On the efficiency of
competitive electricity markets with time-invariant retail
prices. RAND Journal of Economics 36: 469-493. Avi Goldfarb
Borenstein, S., J. Bushnell, and F. Wolak. 2002. Measuring
market inefficiencies in California’s deregulated
wholesale electricity market. American Economic Review
92: 1376-1405.
Bushnell, J., E. Mansur, and C. Saravia. 2005. Vertical Abstract
arrangements, market structure, and competition: An Electronic commerce is the exchange, distribu-
analysis of restructured US electricity markets. CSEM
tion, or marketing of goods or services over the
working paper WP-126. Berkeley: University of Cali-
fornia Energy Institute. Internet. This article first reviews electronic
commerce adoption across US industries.
 While the Internet is used in most industries, it businesses that sell products directly to their cus-
has had a profound impact only on a small tomers and businesses that function as intermedi-
number. Businesses that rely heavily on elec- aries. This definition also includes businesses that
tronic commerce can be divided into four operate only online, the online business of those
groups: retail, media, business-to-business and that operate online and offline, and businesses that
other intermediaries. Each of these is discussed. use the Internet but not as their primary business
The article concludes with a discussion of some function.
features of electronic commerce that are of
special interest to economists: lower economic
frictions, lower communication costs, lower Adoption of Electronic Commerce by
marginal costs and rich data. Industry

While most attention has focused on those few

Keywords businesses where the Internet is a fundamental part
Advertising; Bundling; Communication costs; of their strategy, electronic commerce is just one
Computer industry; Economic frictions; Elec- aspect of business processes for most businesses.
tronic commerce; Internet, economics of the; As of 2000, nearly 90 per cent of large US estab-
Media; Menu costs; Price dispersion; Retail; lishments used the Internet (Forman et al. ). Nearly
Search costs; Switching costs all industries and cities had adoption rates well over
70 per cent. For the vast majority of these
establishments, the Internet was used to send and
JEL Classifications receive email, to help automate some basic pro-
L81;L86
cesses like inventory management, and/or for web
browsing. This basic level of use was particularly
In this article, electronic commerce is defined as the
important to establishments in rural areas (Forman
exchange, distribution, or marketing of goods or
et al. ). Overall, the impact on most industries, from
services over the Internet.
nursing homes to construction to furniture
There is, unfortunately, no standard definition
manufacturing to petrol stations, has been limited.
used in the academic literature or the popular press.
The Internet is used in day-to-day business activi-
A broader definition would include all business
ties, but it is a small piece in a much larger puzzle.
facilitated by telephones, fax machines, televisions,
Even in retail, the US Census reported that Internet
and other technologies that are ‘electronic’. This
sales (totalling $26.3 billion) were just 2.7 per cent
broad definition, however, becomes so large that it
of total US retail sales in the second quarter of2006
encompasses a substantial fraction of all economic
(U.S. Census Bureau ).
activity since the 1950s. A narrower definition
Still, a small portion of businesses have used the
would focus only on items sold over the World
Internet to enhance business processes at a deep
Wide Web, the browser- enabled portion of the
level. While little research has examined why some
Internet. This definition omits much of the
industries adopted quickly and others did not, it is
important business-to-business segment of
the businesses that adopted quickly that get the
electronic commerce and the numerous advertising-
majority of the attention. The Internet has had a
supported websites.
profound effect on publishing, securities trading,
The definition used here encompasses a variety
some wholesaling, and some retailing (for example,
of ways in which businesses have used the Internet.
books and computers). In particular, businesses that
The Internet is a worldwide network of computers
rely heavily on electronic commerce can be divided
that connect to each other using the communication
into four (not necessarily mutually exclusive)
protocols defined by TCP/IP. Electronic commerce
groups: retail, media,
includes businesses that have used the Internet to
business-to-business (B2B), and other
reach other businesses and to reach consumers
intermediaries.
directly. It includes
Retail of the media market and the digital nature of the
Electronic commerce represents the introduction of product mean that competition between media
a new sales channel. While the size of the online websites is different in nature from competition
channel is still small relative to the entire retail between online retailers.
sector, electronic commerce has had a large effect
on some retail markets. According to the U.S. Intermediaries
Census, Internet sales made up over ten per cent According to Alexa.com, six of the top seven most
of 2004 retail sales in two broad categories if popular websites in October 2006 had roles as
online-only stores are included: electronics and intermediaries: Yahoo, MSN, Google,
appliance stores (that is, NAICS 443) and sporting MySpace, YouTube, and eBay. While these inter-
goods, hobby, book, and music stores (that is, mediaries may share features of media websites
NAICS 451) (U.S. Census Bureau ). Much of the (Google) or retailers (eBay), their primary business
literature on electronic commerce has focused on is to facilitate online interactions. Without physical
these categories, as well as motor vehicles and storefronts or displays, intermediaries help
travel. individuals (and firms) find each other online.
A new channel has the potential to create chan- Intermediaries allow people with heterogeneous
nel conflict. There is considerable evidence that tastes to find better matches in terms of media,
consumers compare prices and options across products, and people (Scott Morton ).
channels (Prince ; Ellison and Ellison ). Forman et
Business to Business
al. ( ) show that use of the
Business-to-business (B2B) electronic commerce is
online channel depends on local offline retail
a relatively under-researched area, perhaps because
options. Also, Hendershott and Jie Zhang ( )
of the difficulties in obtaining data. Still, B2B
argue that manufacturers may face resistance from
transactions are many times the size of business-to-
their retailers to setting up a direct online channel.
consumer transactions. Lucking- Reiley and
They show that the benefits of selling directly to
Spulber ( ) summarize many of
consumers (rather than though a retailer) depend on
the key questions and opportunities in B2B elec-
the relative online-offline search costs. The benefits
tronic commerce including B2B exchanges, auto-
of the online channel are largest for goods that are
matic ordering, and outsourcing. Some aspects of
not widely available in retail stores (that is, high
the Internet, such as asynchronous communication,
offline search costs) and for goods that do not need
may be particularly important for international B2B
to be touched to assess quality (that is, low online
interactions. Many B2B applications can also be
search costs).
done on electronic data interchange (EDI) rather
Media Websites than the Internet.
In addition to a new retail channel, the Internet has
provided a new media outlet. This outlet has
Key Features of Electronic Commerce for
developed a market structure similar to the maga-
General Economic Research
zine industry (Goldfarb ). Media websites provide
information to visitors and earn money (mostly) In addition to its widespread usage across industries
through advertising. In particular, entry is easy but and its profound impact on a small set of them,
distribution is difficult to achieve; concentration is electronic commerce has a number of features that
largely determined by market size and distribution make it a particularly interesting area of study for
costs; large media conglomerates coexist with small economists.
niche players; and there is a high mortality rate.
Online media appear to be particularly important to Fewer Economic Frictions
overcome local isolation (Sinai and Waldfogel ). The Internet reduces a number of economic fric-
The two-sided nature tions that are often cited as key contributors to
observed imperfections in markets. To the con- Lower Communication Costs
sumer, search and switching costs are reduced The Internet reduces communication costs consid-
substantially. To the firm, menu and distribution erably. It provides an additional means of commu-
costs may fall. nication that creates new potential to interact with
For consumers, the Internet makes it relatively customers, suppliers and with other branches of the
easy to search through several retail options. Instead same firm. Internet communication differs from
of having to walk from store to store, consumers telephone communication in two primary ways.
can simply click from one company to another First, the marginal cost of communication is effec-
without leaving their desks. Furthermore, a number tively zero, even over long distances. While
of intermediaries exist that reduce search costs even establishing a connection is costly, each additional
further. These ‘shopbots’ allows consumers to e-mail, web page viewed, and instant messaging
compare prices and features from several websites interaction has no monetary cost to the communi-
during a single keyword search. In addition to lower cator. Second, Internet communication is often
search costs, switching costs are also lower online asynchronous. Unlike telephone communications,
than offline. It is not difficult to switch from one the people communicating do not necessarily have
competitor to another. Much of the earhest research to be available at the same time. This has many
examining electronic commerce focused on why important applications. For example, it facilitates
price dispersion persisted in this environment. communication across time zones. Together, these
Broadly speaking, this literature concluded that, all features of Internet communication mean that geog-
else equal, search and switching costs are lower raphy may be less important online. Given access,
online; however, firms created search and switching people can communicate with any other person who
costs to overcome this challenge (Ellison and has access, irrespective of location. Still, despite the
Ellison ). Consequently, there is still substantial substantial fall in long-distance communications
price dispersion online. Still, low search costs do costs, most online communication is local because
not mean zero search costs. Visibility matters to the social networks are local (Wellman ).
long-term prospects of any business-to-consumer
company. Many early Internet companies struggled Lower Marginal Costs
because they misinterpreted low search costs as Many goods sold over the Internet are digital in
zero search costs, mistakenly assuming customers nature (for example, newspaper content, music,
would arrive once they set up the website. information). The marginal cost of replication for
Firms also benefit from fewer frictions online. digital goods is near zero. Depending on the par-
In particular, the menu costs of changing prices and ticular good, fixed costs may be high (software) or
updating product offerings are much lower online low (blogs). Shapiro and Varian ( ) discuss in
than offline. In addition to the reduction in menu detail the economics of goods with high fixed and
costs, some firms benefit from lower distribution low marginal costs. If fixed costs are high enough,
costs: for digital goods (namely, music, news and this cost structure allows monopolists with broad
images) online distribution costs are near zero. Low flexibility in pricing, versioning and bundling pol-
menu costs combined with the digital nature of icies. It also leads to substantial economies of scale
many online products allow for mass customization and incentives to sell a broad scope of products. In
of products (Murthi and Sarkar ) and creative markets with more than one player, this cost
bundling, licensing, versioning and pricing structure can lead to fierce competition and little
strategies. Shapiro and Varian ( ) and Bakos profit. If fixed costs are low and entry is easy then
and Brynjolfsson prices should approach zero.
( ) provide examples of a number of situations One misunderstood aspect of electronic com-
in which online firms are better able to match merce is that many Internet business models have
customers needs and therefore are better able to not benefited from low marginal costs, and
price discriminate. therefore have no cost advantage over offline
competition. Low marginal costs apply only to
digital goods
and services. In the late 1990s, many companies Bakos, Y., and E. Brynjolfsson. 1999. Bundling information
failed because their business models shipped heavy goods: Price, profits, and efficiency. Management
Science 45: 1613-1630.
items to consumers. For example, taking orders for Ellison, G., and S.F. Ellison. 2004. Search, obfuscation, and
pet food and shipping it to customers involves very price elasticities on the Internet. Working paper, no.
high marginal costs per item sold. 10570. Cambridge, MA: NBER.
Ellison, G., and S.F. Ellison. 2005. Lessons about markets
Rich Data from the Internet. Journal of Economic Perspectives
19(2): 139-158.
By definition, all online activity is digital. This Ellison, G., and S.F. Ellison. 2006. Internet retail demand:
means that it is relatively easy to record and store Taxes, geography, and online-offline competition.
information on the behaviour of consumers and Working paper no. 12242. Cambridge, MA: NBER.
firms online. In contrast, it is extremely expensive Forman, C., Ghose, A., and Goldfarb, A. 2006. Geography
and electronic commerce: measuring convenience,
to track all a shopper’s activity in a typical offline selection, and price. Working paper no. 06-15. New
store. Online, however, every item browsed and the York: NET Institute.
time spent looking is easily recorded. Tins presents Forman, C., Goldfarb, A., and Greenstein, S. 2002. Digital
an opportunity for both firms and researchers. dispersion: An industrial and geographic census of
commercial Internet use. Working paper no. 9287.
Firms can use this data to better understand their Cambridge, MA: NBER.
customers, which leads to more effective customi- Forman, C., A. Goldfarb, and S. Greenstein. 2005. How did
zation. Researchers can use this data to answer location affect adoption of the commercial Internet?
many questions that previously could not be Global village vs. urban leadership. Journal of Urban
Economics 58: 389-420.
answered due to data constraints. Online data has Goldfarb, A. 2004. Concentration in advertising-supported
greatly enhanced of our understanding of a number online markets: An empirical approach. Economics of
of economic concepts including auctions (for Innovation and New Technology 13: 581-594.
example, Bajari and Hortacsu ), the economics of Hendershott, T., eds. 2007. Handbook of economics and
information systems. Amsterdam: North-Holland.
information (for example, Jin and Kato ), and social Hendershott, T., and Jie Zhang. 2006. A model of direct and
interactions (for example, Mayzlin and Chevalier ). intermediated sales. Journal of Economics & Man-
In summary, this article has identified some agement Strategy 15: 279-316.
important features of electronic commerce and the Jin, G.Z. and Kato, A. 2005. Price, quality, and reputation:
Evidence from an online field experiment. RAND Journal
some of the main areas of related economic
of Economics 37:983-1004. (forthcoming).
research. Useful surveys of electronic commerce Lucking-Reiley, D., and D.F. Spulber. 2001. Business-to-
and related subjects include Scott Morton ( ), business electronic commerce. Journal of Economic
Hendershott ( ), and Ellison and Ellison ( ). Perspectives 15(1): 55-68.
Mayzlin, D., and J.A. Chevalier. 2006. The effect of word- of-
mouth on sales: Online book reviews. Journal of
See Also Marketing Research 43: 345-354.
Murthi, B.P.S., and S. Sarkar. 2003. The role of the man-
► Computer Industry agement sciences in research on personalization. Man-
► -iformation ' .. ..gy : :: : agement Science 49: 1344-1362.
Prince, J. 2006. The beginning of online/retail competition
and its origins: An application to personal computers. In
► Internet, Economics of the
the International Journal of Industrial Qrganiza- tion25
► :: ce 139-156 (forthcoming).
Scott Morton, F. 2006. Consumer benefit from use of the
Internet. In Innovation policy and the economy, ed. A.B..
Bibliography Jaffe, L. Lemer, and S. Stem, vol. 6. Cambridge, MA:
MIT Press.
Bajari, P., and A. Hortacsu. 2003. The winner’s curse, reserve Shapiro, C., and H.R. Varian. 1999. Information rules: A
prices, and endogenous entry: Empirical insights from strategic guide to the network economy. Boston: Harvard
eBay auctions. RAND Journal of Economics 34: 329-355. Business School Press.
Sinai, T., and J. Waldfogel. 2004. Geography and the Internet:
Is the Internet a substitute or a complement for cities?
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U.S. Census Bureau. 2006a. E-Stats, 25 May. Online. and social organization of a state. It includes the
Available at: bureaucrats and civil servants who rule the macro-
. Accessed 13 Jan 2007.
U.S. Census Bureau. 2006b. Quarterly retail e-commerce
environment; the political elite that governs and
sales, 2nd quarter 2006. operates the executive, legislative and judicial
structures; and the business elite. Non-ruling elites
U.S. Census Bureau News. Online. Available at: Accessed 13
include the members of the media, academia and
Jan 2007. the intelligentsia.
Wellman, B. 2001. Computer networks as social networks. Even in a democratic regime in which the power
Science 29: 2031-2034. is meant to reside in the d e m o s (‘the people’),
power is really concentrated in the hands of a few.
All political organizations, even democracies, tend
Elites and Economic Outcomes towards domination by an oligarchy, which Mills (
) called the p o w e r
Elise S. Brezis and Peter Temin e l i t e . This
is the i r o n l a w o f o l i g a r c h y
as stated by Michels ( ). This stratification of
society based on the
accumulation of decisionmaking power therefore
Abstract
differs from the familiar stratification based on
Elites are a necessary part of economic activity.
income and economic means, or on ownership of
It therefore matters how elites are recruited and
the factors of production as emphasized by Marx.
how they act History is full of examples of elites
The effects of elite actions on the economy
that have acted well and also badly. Modem
operate through several channels: economic growth
research has examined the training of elites,
and development; social mobility; inequality; and
recruitment schemes and incentives for elites to
the political system, which in turn affects the
discover how they can be used to promote,
economy. The characteristics that affect these
rather than impede, economic growth. The
economic realms are ( a ) the extent of the
literature has also emphasized the eifect of elite
intertwining and inter-connections of elites; and
interconnection and elite recraitment on social
( b ) the stability and recruitment of the elite.
mobility; it has shown that the standardization of
elite education over the years may lead to
uniformity and the creation of a transnational
Elites' Interconnections
oligarchy.
Keywords The ruling elite can display unity and collusion,
Circulation of elites; Class; Corruption; Cultural
acting as a monolithic group, or it can be
capital; Economic growth; Education; Elites and fragmented and characterized by dissociation and
economic outcomes; Globalization; Human diversification of power, a ‘polyarchy’ that permits
capital; Inequality; Iron law of oligarchy; competition among its members.
Meritocracy; Power elite; Social capital; Social The elite in non-democratic polities displays
mobility; Symbolic capital; Technical change unity, has unlimited political and economic power,
and typically acts on behalf of its own interests. But
democracy should a priori impose some control on
the power of the ruling elite. Indeed, Schumpeter (
JEL Classifications ) claimed that the dem
N8;D3;Z13 ocratic process permits ‘free competition among
would-be leaders for the vote of the electorate’ and
A ruling elite (from the Latin e l i g e r e , ‘to that the masses can choose between various elites.
elect’) is a small, dominant group that enjoys the In contrast, classical elite theorists such as Mosca (
power of decision in the various sectors of the ); Pareto ( ), Michels and Mills
economic emphasized that there can be collusion even in
democracies. Numerous elites may not be mutually dilutes the power of the elite by broadening polit-
competitive and may not control and balance each ical participation and reducing inequality.
other; instead, they may be intertwined as a
unanimous, cohesive power elite. Economic Growth
A strong interconnection among elites has the
consequence that all sectors of the economy are
Economic Consequences of the Extent ruled by a group that thinks in a monolithic way.
of Interconnection Two lines of thoughts have related a monolithic
group to economic growth. The first one underlines
Inequality that a monolithic group leads to the stagnation of
The elite’s plurality and competition ensures its ideas and attitudes, which in turn may prevent the
responsiveness to the demands of the public, while adoption of major technological breakthroughs
a consensual elite might use its power for its own (Bourdieu ). The lack of com
interests. Etzioni-Halevy ( ) claims that a petition in a monolithic powerful group also gen-
unified elite does not use its power to reduce erates corruption, with harmful consequences for
inequality and promote the development of a more growth.
egalitarian society, due to common recruitment and The second line of thought argues that wealthy
common interests. It is the plurality and differenti- elites with enough political power to block changes
ation of the members of the elite that enables them will not accept adopting institutions that would
to countervail each others’ power and to increase enhance growth, since they might hurt them.
their responsiveness to the will of public. In conse- Acemoglu et al. ( ) developed this line
quence, elite homogeneity might actually increase of thought in relation to colonial impacts, showing
the gap between the elite and the masses. that, wherever colonial governments were com-
When the political elite controls wealth and the posed of few elite members, economic progress was
main factors of production, then elite and class reduced.
stratifications coincide, and consequently power Following the same line of reasoning,
and wealth are in the hands of the same happy few. Acemoglu and Robinson ( ) and Gradstein
Engerman and Sokoloff ( ) showed that ( ) stressed that elite plurality, in which the
members of the elite who have power and wealth political and economic elites are separate, explains
establish institutions that serve their own interests the adoption of political franchise and industriali-
and exclude the masses from benefits. In conse- zation in western Europe; while 19th-century east-
quence, inequality persists through institutional ern Europe, where elite unity was strong, did not
development in the elite’s own favour. Justman and adopt growth-enhancing institutions, since its elites
Gradstein ( ) added that elite unity leads held on to their wealth and power.
to greater inequality through regressive redistribu- Paradoxically, in countries in which the elite
tion policy. A power elite that controls wealth may was united and consensual, with common aims, the
refrain from investment in human capital of the transition to capitalist production in the 1990s took
majority because education would increase the lat- place without violence, as in Poland and the Czech
ter’s political voice and weaken the elite’s hold on Republic. In contrast, wherever the elite was
power (Easterly ); yet in some cases, the elite divided and fragmented, there were conflicts,
deliberately decides to forfeit power by investing in especially on the ethno-nationalist level, as in
human capital as a consequence of a cost-benefit Yugoslavia and Romania (Pakulski ).
analysis (Boruguignon and Verdier ).
The extent of elite unity can be endogenously
determined (Sokoloff and Engerman ), and elite Recruitment and Training of Elites
unity can also be affected by revolutions, wars and
economic growth. Justman and Gradstein ( )
argue that economic growth
the a r i s t o c r a c y (Greek for ‘rule by the Economic Consequences of
best’), a term that became pejorative and was later the Recruitment of Elites
changed to m e r i t o c r a c y (coined by
Young ). Pareto argued that a stable economic Social Mobility in the Economy
system needs a c i r c u l a t i o n o f Prior to recruitment through meritocracy, social
e l i t e s , so that the most capable and talented mobility, and in particular the potential for non-elite
are in the governing class. He stressed that the members to enter the elite, was low. Temin ( , )
quality of the nding class can be maintained only if showed that today, as in the
social mobility is allowed, so that the non-elite has 1900s, and despite meritocracy, the American
the possibility of entering the elite: ‘History is a economic elite is composed almost entirely of white
cemetery of aristocracies’ (Pareto ). His theory may Protestant males who have been educated for the
be viewed as a sort of social Darwinism in which most part in Ivy League colleges. Although in 1900
mobility is needed, just as evolution relied upon the political elite was quite similar to the business
competition and selection. elite, today the former is more diversified; the
For millennia, recruitment of the Western elite political elite has changed in its recruitment, while
was based on social inheritance and was carried out the economic elite has not. In other words,
via heredity, nepotism and violence. Hereditary minorities have not penetrated the economic elite in
monarchy was considered the most legitimate the United States (see also Friedman and Tedlow ,
means of recruitment for rulers, and the upper elite which summarizes studies on US elite mobility, and
was made up of wealthy large landowners, an Foreman-Peck and Smith on British elites).
e t a t d e f a i t considered normal in Recruitment to a university through meritocratic
agrarian societies. Nevertheless, there were some entrance exams, does not, indeed, lead to enrolment
channels of entrance into the elite, such as military from all classes of society according to distribution
prowess and exploits or involvement in government or ability, nor does it necessarily lead to the
finance (Brezis and Crouzet ). admission of the most talented. Recruitment by
In democracies, the political elite came to be entrance exam still encompasses a bias in favour of
recruited mainly by election. Yet for a long time, elite candidates because this type of exam requires a
the franchise was not for all. Big land- owners and pattern of aptitude and thinking that favours
members of the upper middle class were the candidates from an elite background. All elite
overwhelming majority in parliaments and cabinets, positions may be open to all applicants with the
even though some prominent business people right qualifications, but they are more accessible to
entered the political elite. Only in the late 19th those with specific social, cultural and symbolic
century did members of the lower middle class and capital (Arrow et al. ). Thus the power elite
working class enter the political elite. maintains its status and power by a s t r a t e g y
From the 19th century onwards, the circulation o f d i s t i n c t i o n , or a cultural bias
of the business elite took two differing yet con- that is necessary for accessing it (Bourdieu ). A
current paths. The first was that economic growth small difference in culture and education leads to
led to spurts of new firms and the decline of others, narrow recruitment, and in turn to class-based
allowing a new business elite to emerge stratification in the recruitment of the elite, despite
(Schumpeter ). The second path was the rise of the meritocratic selection for universities (Brezis and
professions, with competitive and meritocratic Crouzet ).
exams that led to circulation of elites (Perkin ). The relationship between mobility and the
After the Second World War, the elite was mainly political system, as emphasized by Pareto, has been
recruited through education into elite universities to analysed by sociologists. For instance, Lengyel (
which admission started to be conferred following ) showed that circulation in the
success at meritocratic exams. elite occurs at times of political upheavals and
revolutions: the existing elite is eliminated and
replaced by a new one. The first-generation mem- numerous effects on the world economy. In the
bers of the elite following a political change have opposite direction, globalization will also affect the
neither specific training and education nor specific elite, as we are now facing a globalization of
origin; they are the trailblazers, the entrepreneurs education of the elite.
who seized power on the strength of their compe- In its first wave, globalization of education will
tence. In the next generation, the elite becomes probably create a new collection of elites and elicit
narrowly recruited from the best educated, and some changes, yet the unity and uniformity of the
members are selected mostly by training and edu- elite will be even greater, not only at the national
cation. The elite returns to an occupational spe- level but also at the global level. National elites will
cialization, similar to the meritocratic profession be replaced by a worldwide elite, along with
criterion of earlier industrialization (Perkin ). uniformity in culture and education. We will face an
international technocratic elite with its own norms,
Economic Growth ethos, and identity, as well as its private clubs like
A crucial element of economic growth is that the the Davos World Economic Forum - a transnational
recruited elite be of the highest quality. Countries in oligarchy.
which elites are recruited in a non-meritocratic way
face the problem of the quality of their elites.
However, the prevalence of meritocratic recruitment
does not necessarily lead to the selection of the best
ruling elites. Brezis and Crouzet ( ) See Also
argue that, when a country faces only mild tech-
nological and structural changes, the narrow ► Economic Growth, Empirical Regularities in
recruitment, due to meritocracy, optimally fulfils its ► I/obA::/
purpose, since the cultural bias of the elites is an
advantage in the given type of technology. ► onomics and
However, at times of major changes in technology,
elites recruited this way are not the best for
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School of Economics and Political Science. Calsoyas, C.D.
discriminatory tolls inverse to distance, in contrast 1950. The mathematical theory of monopoly in 1839: Charles
to tolls proportional to distance, could be devised Ellet, Jr. Journal of Political Economy 58: 162-170.
whereby all interested parties (management,
shippers, the state) could be made better off. In a
series of papers (1842-4) Ellet extended his
Ely, Richard Theodore (1854-1943)
theoretical analysis of inputs and input selection
(1839) to one of the earliest attempts to develop, A. W. Coats
empirically specify and test a theoretical cost
function. Utilizing a ‘law’ of costs which included
his selected determinants of annual total railway
costs, Ellet estimated the empirical dimensions from
data collected from the mid-1830s. He then Keywords
reaffirmed the power of his initial equation with American Economic Association; Commons,
new and supplementary data. J.R.; Ely, R.T.; German Historical School;
In all, the calibre and completeness of Ellet’s Institutionalism; Knies, K.G.A.
theoretical and empirical inventions would not
 JEL Classifications New York City. Eventually hit by the depression,
B31 Ely was forced to depend on the support of friends
and former students as he completed his autobi-
ography and failed to complete a massive history of
Ely was born in Ripley, New York, on 13 April American economic thought initiated 50 years
1854 and died at Old Lyme, Connecticut, on 4 earlier.
October 1943. An ardent Christian Socialist and outspoken
Ely’s long and vigorous career epitomizes the critic of laissez-faire individualism and ‘old school’
general proposition that an economist can exert a English classical economics, Ely delighted social
major constructive influence on his subject and reformers and outraged conservatives by his
profession even though his original contribution to writings on such controversial current topics as
economic theory is negligible. A highly effective socialism and the American labour movement.
teacher and maker of careers for his former Prone to emotional overstatement and careless in
students; prolific author of popular articles, schol- exposition, his public pronouncements and
arly volumes, and publications series; organizer and reputation frequently embarrassed the aspiring
fund-raiser for major research projects; founder of young professional economists with whom he
various academic institutes and associations; leader founded the American Economic Association, in
or participant in numerous reform societies; and 1885, and for a time discouraged some moderate
centre of innumerable controversies, Ely was the and conservative economists from joining.
most widely known, even notorious, economist in Although Ely’s original draft prospectus had been
the USA around the turn ofthe 2 0 th century. rejected, and the association’s original constitution
After a brief spell as a country schoolteacher was toned down, and then dropped, the organization
and a preliminary year at Dartmouth College, Ely hovered uneasily between missionary evangelism
graduated from Columbia College in 1876 and was and scholarly objectivity until he was obliged to
awarded a three-year fellowship to study phi- relinquish his secretaryship in 1892.
losophy in Germany. He soon switched to political Two years later, at Wisconsin, Ely's fellow
economy, came under the influence of Karl Knies professionals rallied around him when he was
at Heidelberg, where he obtained a Ph.D., siunma denounced for preaching socialism and encouraging
cum laude, in 1878, and later attended Adolph strikes, and, although he was completely exonerated
Wagner’s lectures in Berlin. Returning to the USA in a ‘trial' that attracted national attention, Ely
he was unemployed for more than a year before his gradually became more conservative. Ironically, in
appointment, initially on a half-time basis, at Johns the 1920s his instimte was attacked, no doubt
Hopkins, where he taught from 1881 to 1892. He unfairly, as a tool of the public utilities, and was
then moved to Wisconsin, founding an outstanding referred to disparagingly in a report on professional
school of Economics, Political Science and History ethics by a committee of the American Association
including such luminaries as F.J. Turner, E.A. Ross, of University Professors, in 1930.
and J.R. Commons. A unique collaboration During his long lifetime Ely wrote extensively
developed between the social scientists and the on an extraordinarily wide variety of topics, often in
state legislators, especially under the La Follette a popular and journalistic fashion. Nevertheless, he
governorship, which pioneered major social and repeatedly opened up new research topics that were
economic reform legislation. In 1925 Ely took his developed by his colleagues and former students -
Institute for Research in Land Economics and for example, in labour history, state taxation, land
Public Utilities, founded in 1920, from Madison to economics, and natural resources - and his various
Northwestern University, and remained there until textbooks, especially the multiedition
1932, when he launched a new, but impoverished O u t l i n e s o f E c o n o m i c s
Institute for Economic Research in which sold 350,000 copies, were both widely used
and highly regarded.
 At Wisconsin he helped to launch the American edn with Ralph Hess, New York: Macmillan
Association for Labor Legislation, of which he Co., 1938.
became President, and raised private resources to 1894. Socialism: An examination of its nature, its
finance John R. Commons’s massive strength, its weakness. With suggestions for
D o c u m e n t a r y H i s t o i y o f social reform. London: S. Sonnenschein Co.;
A m e r i c a n S o c i e t y (11 vols, 1910- Newyork and Boston: T.Y. Crowell Co.
11). He served as President of the American 1900. M o n o p o l i e s a n d
Economic Association in 1900-1901. t r u s t s . New York: Macmillan Co.
Ely was a stimulating teacher whose ideas Reprinted, 1912.
formed a direct link between the doctrines of the 1903. S t u d i e s i n t h e
German Historical School and American institu- e v o l u t i o n o f i n d u s t r i a l
tionalism, a link most clearly evident in his s o c i e t y . New York/London:
neglected two-volume study of P r o p e r t y Macmillan Co. Reprinted, 1918.
a n d C o n t r a c t i n t h e i r 1914. Property and contract in their relations to
R e l a t i o n s t o t h e the distribution of wealth. 2 vols. New York:
D i s t r i b u t i o n o f W e a l t h Macmillan Co. Reprinted, 1922.
(1914). Many of his students went on to 1924. (With E.W. Morehouse.) E l e m e n t s
distinguished careers in academic and/or public life. o f l a n d e c o n o m i c s . New
He was undoubtedly an outstanding academic York: Macmillan Co.
entrepreneur, and his contribution to the American Reprinted, 1932.
Economic Association is recognized in its annual 1928. (With G.S. Wehrwein.) L a n d
e c o n o m i c s . Ann Arbor: Edwards
Bros. Revised edn, Madison: University of
Wisconsin Press, 1964.
Selected Works
1938. Ground under our feet: An autobiography.
1883. F r e n c h a n d G e r m a n New York: Macmillan Co.
s o c i a l i s m i n m o d e r n
t i m e s . New York: Harper & Brothers. Bibliography
Reprinted, 1911.
1884a. T h e p a s t a n d t h e
p r e s e n t o f p o l i t i c a l
e c o n o m y . Baltimore: N. Murray for Johns Emergence
Hopkins. 1884b. R e c e n t A m e r i c a n
s o c i a l i s m . Baltimore: N. Murray for Yannis M. Ioannides
Johns Hopkins. Reprinted, 1885. 1886. T h e
l a b o u r m o v e m e n t i n
A m e r i c a . New York: T.Y. Crowell Co.
New edn, revised and enlarged, New York:
Abstract
Macmillan Co, 1905. 1888a. T a x a t i o n i n
With its philosophical pedigree and its use
A m e r i c a n s t a t e s a n d
especially among life scientists and science
c i t i e s .
writers since the early 1990s, the term ‘emer-
New York: T.Y. Crowell Co.
gence’ in economics is more evocative than
1888b. Social aspects of Christianity. Boston: W.L.
precise, reflects influence from physics and
Greene and Co.
biology, and is now associated with phenomena
1889a. A n i n t r o d u c t i o n t o
where economic structures evolve into
p o l i t i c a l e c o n o m y . New
qualitatively different forms. These exhibit
York: Chautauqua Press. New and revised edn,
properties that are emergent in that they apply
New York: Eaton and Mains; Cincinnati:
at an aggregate level but lack individual
Jennings and Pye, 1901.
 analogues and therefore are not describable at applications with predominantly economic phe-
the individual level. This article emphasizes nomena where emergence of macroscopic prop-
applications that possess firm economic foun- erties may be elucidated by means of economic
dations, from the evolution of patterns in inter- arguments. These range from neighbourhood tip-
national trade to the establishment of a common ping and evolution of patterns in international trade
currency. to emergence of urban structure and the
establishment of norms and institutions and of a
Keywords common currency, among many others.
Aggregation; Autarky; Class; Cobb-Douglas More generally, emergent properties or behav-
functions; Complementarities; Congestion; iours have been studied in a variety of circum-
Division of labour; Economic geography; stances in nature, such as emergence of
Elasticity of substitution; Emergence; Fiat differentiated behaviour in colonies of animals, of
money; Financial market globalization; First herding behaviour in organizations and markets, of
fundamental theorem of welfare economics; specialization of individuals into occupations and of
Foreign aid; Herding; Innovation; International cities and of regions and countries in specific
currencies; International currency; International products, of groups of biological cells in
finance; International trade; Invisible hand; multicellular biological organisms and even of
Mill, J. S.; Multiple equilibria; Neighbours and groups of processors in computer simulations
neighbourhoods; Poverty traps; Power laws; involving cellular automata (see Holland ). The
Residential segregation; Specialization; World Wide Web is an example of a decentralized
Spontaneous order; Stochastic stability theory; engineering system that is continuously being
Tipping points; Trade costs; Urban modified by human initiatives in the form of actions
agglomeration; Urbanization by individuals and firms. The web has not been
deliberately designed and no central organization
administers how different sites are linked to others.
Some of the properties of the graph topology of the
JEL Classifications
D85 web may be termed as e m e r g e n t , such as
that the number of links pointing to each page
Having acquired widespread use among fife sci- follows approximately a power law, with a few
entists and science writers since the early 1990s, the pages being pointed to by many others and most
term ‘emergence’ in economics is more evocative others seldom, and the fact that any pair of pages
than precise, reflects influence from physics and can be connected to each other through a relatively
biology, and has come to be associated with short chain of links in the average.
phenomena involving evolution of economic The presence of‘emergence’ within the vocab-
structures into qualitatively different forms. These ulary of economists does suggest some interplay
phenomena exhibit properties that are emergent in with multidisciplinary research by scientists who
the sense that they are novel and apply at an have been associated with the Santa Fe Institute (
aggregate more ‘complex’ level but lack individual ). To quote from
analogues and therefore are not describable at, or Kauffman ( , p. 24), an alternative definition
reducible to, the individual level. A good case in of emergence is that ‘[t]he whole is greater than the
point is the statement that consciousness is an sum of its parts’. And ‘life itself is an emergent
emergent property of the brain. The notion of phenomenon... arising as the molecular diversity of
emergence originates in the philosophy of science, a prebiotic chemical system increases beyond a
with John Stuart Mill being an important precursor threshold of complexity. If tme, then life is not
(see Stanford Encyclopedia of Philosophy ). located in the property of any single molecule - in
This article reviews, albeit selectively, the recent the details - but is a collective property of systems
usage of the term by emphasizing of interacting molecules.’ The entirety of complex
molecules together is able to reproduce and evolve, agents as edges when each agent’s connections with
a ‘stunning property’. other follows a given distribution p k and the
Blume and Durlauf ( ) argue that emer number of agents is large. According to Newman et
gence plays an important role even within the body al. ( ), depending upon whether the quantity
of neoclassical economics proper. For example, the E l k 1 ] 2 E [ k \ is greater than or equal to 0 ,
extent to which macroeconomics is a distinct or
discipline from microeconomics would be falls below 0 , there emerges, as / tends to infinity, a
explained by emergent properties as alluded to by p r o p o r t i o n of all individuals being
the statement ‘aggregation is not summation’ (see interconnected, or, alternatively, the economy
Kirman ). Consider, within microeconomics and consists of different groups of finite sizes. In other
general equilibrium theory, the metaphor of the words, the social structure undergoes a p h a s e
invisible hand of the market (which goes back to t r a n s i t i o n when this quantity exceeds 0 :
Adam Smith), whereby individuals’ pursuit oftheir a giant interconnected component emerges. Intui-
own selfish aims leads to social outcomes that obey tively, starting from a connected component of the
important social properties. Under certain condi- graph, consider adding a new edge that connects
tions, after markets have brought about an equilib- with a previously isolated node of degree k .
rium, it is impossible to make anyone better off Doing so will change the number of nodes on the
without making someone worse off. Thus, the first boundary of the connected component by — 1 + ( k
fundamental theorem of welfare economics is an 1) k 2. The likelihood that a node is on the
emergent property of social outcomes. However, boundary of the connected component is pro-
the more modem work on emergence in economics portional to k . The expected change in the number
has emphasized emergence of patterns. Similarly, of nodes on the boundary when an additional node is
Hayek’s concept of spontaneous order may be connected is given by Y . , k , ( k , —
considered an instance of emergence. 2)/]CA. If this quantity is negative, then the number
There are numerous other contexts where of nodes on the boundary decreases and therefore
emergence has been alleged to occur. This article the connected component will stop growing. If it is
explores a number of examples of emergence that positive, on the other hand, then the number of
are limited to social and economic settings. They boundary nodes will grow and the connected
underscore the scope of the concept of emergence in component will grow, limited only by the size of the
such settings. As discussed earlier, there are many network.
other contexts in socioeconomic settings and In the simple case of the Erdos and Renyi
beyond, ranging from computation to the life random graph, where the number of connections is
sciences. proportional to the number of individuals, the phase
transition occurs when the factor of proportionality
is equal to 1 / 2 and the corresponding average
Emergent Social Interconnections number of connections per person is equal to 1.
Below this value, there are too few edges and the
Suppose that a society consists of I individuals,
components of the random graph are small; above
where / is large, where any two individuals may be
that value, a proportion of the entire graph belongs
linked in a way that allows for communication,
to a single, g i a n t component. In this case,
social relations, or social interactions. Let p k
emergence of a qualitatively different social
denote the probability that each individual is
structure depends on the value of a single parameter
connected with exactly k other individuals. A
(Kirman ; Ioannides ;
literature going back to Erdos and Renyi ( ) and
Durlauf ). Individual behaviour that leads to a law
continuing at the time of writing up
for the number of individuals’ connections does not
to Newman et al. ( ) has studied the topolog
necessarily imply the same macroscopic outcome in
ical properties of the (random) graph formed by the
all circumstances. Similarly, social outcomes are not
agents as nodes and connections between
described by means of mere summation of
individual actions; aggregation is
not summation (Kirman ). Kauffman ( , process continues until there are no whites left; ft)
p. 57) invokes this in the context of autocatalytic 0 . If, on the other hand, c o < F(<u), additional
reactions and goes as far as seeing this ‘as a toy whites have an incentive to enter, and this process
version of phase transition that I believe led to the continues until c o = 1. Thus, the process has
origin of life’. three equilibria, (0 , 0 *, 0 ), of which the two
extreme ones, either only blacks or no blacks in the
neighbourhood, are stable, and the mixed one, with
Patterns of Residential Segregation ft)* whites in the neighbourhood, where ft)* =
F(ft)*), unstable. The mixed equilibrium defines the
Now we turn to a description of neighbourhood t i p p i n g p o i n t . Individuals’
tipping, which is originally due to Thomas C. preferences differ widely, but only extreme
Schelling ( ) and has been adapted here outcomes e m e r g e at the social equilibrium.
from recent works. Suppose that individual i is Schelling ( ) under
white and would live in a neighbourhood provided scores how outcomes that persist may not be what
that the percentage of whites among her neigh- individuals had intended.
bours, o j e [0, 1], is at leastw, , c o > w,. She Could such a stark outcome be due to the fact
moves out otherwise. Individuals differ in terms of that the respective populations of individuals are not
preference characteristic w u which is assumed to being replenished? It turns out that, if one goes
be distributed in a typical neighbourhood according deeper and allows for turnover and stochastic
to F(<w), when the analysis starts. For any shocks, persistence of stable states may be rigor-
neighbourhood with a share of white residents equal ously characterized by means of the tools of sto-
to u, the percentage of white individuals who would chastic stability theory (Blume and Durlauf ; Young
find living there acceptable are those with w < ). Multiplicity of equilibria allows, of course, for
c o . Their share is given by the value of the accidents of history to become reinforced over time.
cumulative distribution function at c o , F
F ( c o ) .
In Fig. , let the horizontal axis ei denote it and Emergence of Urbanization
w j t the vertical axis e2 the cumulative
distribution F, and (0, 0 ) the 45-degree line. As The concentrated economic activity that we asso-
long as < x > > / ' ( < ’ ) ) , whites have ciate with the emergence of cities punctuates the
an incentive to exit the neighbourhood, causing a
reduction of c o , and this
Emergence,
Fig. 1 Neighbourhood
tipping, poverty traps
physical and economic landscape throughout the interplay between the value of agglomeration and
world. How did it emerge? While small-scale the cost of congestion. If the former dominates,
agriculture and home production could be reason- spatially uniform steady states are unstable. Fujita et
ably accurately referred to as spatially uniform al. ( ), Chaps. 6 and 17) develop a
distribution of economic activity, the world pop- model with ingredients from economic geography
ulation is increasingly concentrated in cities. Also, that incorporates trading costs and also allows for
urbanization has been closely associated with eco- uniform distributions of economic activity to exhibit
nomic development. different stability properties. Again, conditions
Let us consider a simple setting where utility U under which agglomerations prevail possess
depends on individual productivity, itself an intuitive economic appeal.
increasing function / ( n t ) , of the total number
of others in the same location, n h and on the share
of a fixed resource, R . Even when utility is Emergence of Poverty Traps
assumed to be increasing and concave in both
arguments, it is initially increasing, as a function of In a standard neoclassical growth model that
n h may reach a peak at /?*, and then may start extends over discrete time, with a demographic
decreasing. In other words, a larger population structure consisting of two overlapping generations
initially means more innovation and mutually and individuals living for two periods, working only
beneficial interaction until congestion offsets them. in the first and retiring in the second, individual
Consider then two alternative locations, / 1 ,2 , savings would be proportional to the wage rate
that do not under Cobb-Douglas preferences. Let the aggregate
interact spatially, and a total of N individuals who production function expressing output Y t as a
wish to locate so as to maximize utility. At a ftmction of capital, labour and total factor
locational equilibrium, individuals must be productivity, K „ L „ A , respectively, be of
indifferent as to where they locate. If N < the constant elasticity of substitution form,
2 n * , the symmetric equilibrium, whereni =
n 2 = \ N , is unstable and agglomeration - Y , = A (W' 4 + (1 -
that is, either site occupied by the entire population
- is stable. Therefore, the trade-off between the If the elasticity of substitution is sufficiently
value of agglomeration and the cost of congestion small - that is, complementarity between capital and
moves the economy away from the symmetric labour is high - and total factor productivity
outcome (Anas ). sufficiently large, the time map of the economy -
Consider next a setting where interactions do that is, the amount of capital per person next period
explicitly depend on distance to others, as with (axis e 2 ) as a ftmction of the amount of capital
accessibility to others being valued and congestion per person in the present period (axis ej) - may be
disliked. If individuals are allowed to relocate, with loosely graphed, as in Fig. . Therefore, depending
probabilities that depend on expected utilities in upon the economy’s starting point, it may end up at
each site relative to all other sites, then a dynamic a steady state either with high or with low capital
model may be formulated that describes locational per person at a steady state. The mid-range
outcomes for an entire population. The economy (‘symmetric’) steady state is unstable. Therefore,
may attain steady states that are either uniform conditions of productive complementarities, (even
(populations are equal across all sites) or uneven small) initial differences in capital per person, and
(with some sites having large and others small possibly historical accidents as well across countries
populations). Such a stylized reduced-form model in terms of characteristics and endowments when
of spatial patterns of human settlements (see growth starts, mitigate in favour of an explanation
Papageorgiou and Smith ) yields spatially uniform for
outcomes that are either stable or unstable.
Agglomeration is determined by the
inequalities in incomes per person across different globalization on the cross-country pattern of
countries. The same mechanism worldwide pro- development in the world economy. In the absence
duces sharply different outcomes (see Azariadis and of the international financial market, the world
Stachurski , for an in-depth treatment). economy converges to the symmetric steady state,
Similar arguments may be developed in order to and the cross-country difference disappears in the
understand persistence in the inequality of the dis- long ran. Financial market globalization causes the
tribution of wealth within an economy. Matsuyama instability of the symmetric steady state and
( ) presents a model of emergent class struc generates stable asymmetric steady states, in which
ture, in which a society inhabited by inherently the world economy is polarized into the rich and the
identical households may, depending upon param- poor. The world output is smaller, the rich are richer
eter values, be endogenously split into the rich and the poor are poorer in these asymmetric steady
bourgeoisie and the poor proletariat. For some states than in the (unstable) symmetric steady state.
parameter values, the model has no steady state The model thus demonstrates the possibility that
where all households remain equally wealthy. The financial market globalization may cause, or at least
model predicts emergent class structure or the rise magnify, inequality among nations, and that the
of class societies. Even if every household starts international financial market is a mechanism
with the same amount of wealth, the society will through which some countries become rich at the
experience ‘symmetry breaking’ and will be polar- expense of others. Furthermore, the poor countries
ized into two classes in steady state, where the rich cannot jointly escape from the poverty trap by
maintain a high level of wealth partly due to the merely cutting their links to the rich. Nor would
presence of the poor, who have no choice but to foreign aid from the rich to the poor eliminate
work for the rich at a wage rate strictly lower than inequality; as in a game of musical chairs, some
the ‘fair’ value of labour. countries must be excluded from being rich.
It is worth noting that similar modelling tools Especially at times of political and economic
may be used to express Adam Smith’s famous upheavals, many different national currencies may
dictum that ‘the division of labour is limited by the circulate simultaneously within and across
extent of the market’ and thus endogenize countries. From a modelling viewpoint, such cir-
specialization (Weitzman ). The division of labour cumstances fit neatly multiplicity of equilibria.
emerges as individuals in an economy acquire Emergence of a particular currency as an interna-
specialized roles. tional currency, which in turn depends on the
degree of economic and financial integration, may
be more of a decentralized phenomenon then the
Emergent Structures in International emergence and establishment of a national currency
Economics: Autarky, Specialization, (Matsuyama et al. ). To start with, a national
and International Currencies currency is typically fiat money, whose use is
decreed although not necessarily ensured. World
Krugman ( ) and Matsuyama ( ) discuss monetary history suggests that a bewildering variety
how a world economy where all countries are of commodities have served as medium of
initially identical and live in autarky (a ‘symmetric’ exchange, unit of account and store of value, and
outcome) leads to a world that is separated into rich may have coexisted at times of financial
and poor regions, once countries engage in uncertainties. It has been known at least since
international trade. International trade c a u s e s Menger ( ) that fiat
specialization and agglomeration of different eco- money comes to dominate other options, thus
nomic activities in different regions of the world to leading to establishment of monetary equilibria,
emerge, with some countries being rich and others because individuals accept fiat money in trade when
poor. In several similarly motivated papers, it is convenient and they trust that others will do the
Matsuyama (in particular, Matsuyama , ) shows the same. Such an outcome may be fragile,
effects of financial market
when trust in the currency is weakened, especially Blume, L.E., and S.N. Durlauf. 2003. Equilibrium concepts
in time of war and other upheavals. Howitt and for social interaction models. International Game Theory
Review 5: 193-209.
Clower ( ) employ ‘rales’ concerning trans Durlauf, S.N. 1997. Statistical mechanics approaches to
actor behaviour (instead of relying on a priori socioeconomic behavior. In The economy as an evolving
principles of equilibrium and rationality) to show complex system II, ed. W.B. Arthur, S.N. Durlauf, and D.
Lane. Redwood City, CA: Addison-Wesley.
computationally commodity ‘money’ as a possible
Erdos, P, and A. Renyi. 1960. On the evolution of random
emergent property of interactions between gain- graphs. Publications of the Mathematical Institute of the
seeking transactors who are unaware of any system- Hungarian Academy of Sciences 5: 17-61.
wide consequences of their own actions. Similar is Fujita, M., PR. Krugman, and A.J. Venables. 1999. The spatial
economy. Cambridge, MA: MIT Press.
the emergence of standards in new industries Holland, J.H. 1998. Emergence: From chaos to order. Reading,
described by many writers. MA: Addison-Wesley.
Howitt, P, and R. Clower. 2000. The emergence of economic
organization. Journal of Economic Behavior and Organization
Concluding Remarks 41: 55-84.
Ioannides, Y.M. 1990. Trading uncertainty and market form.
International Economic Review 31: 619-638.
The scientific literature, along with popular science
Kauffman, S. A. 1995. At home in the universe: The search for
literature, on emergence has sought to explain the the laws of self organization and complexity. Oxford:
emergence of persistent patterns as outcomes of Oxford University Press.
dynamic interactions between individuals, groups of Kirman, A.P. 1983. Communication in markets: A suggested
approach. Economic Letters 12: 1-5.
individuals and other entities. Such emergence is
Kirman, A.P. 1992. Whom or what does the representative
typically intrinsic to specific nonlinear dynamic individual represent? Journal of Economic Perspectives
processes and represents international currency. Not 6(2): 117-13 6.
all possible outcomes may be sustained at Krugman, P.R. 1995. Complexity and emergent structure in
equilibrium, and economic and political structures the international economy. In New directions in trade
theory, ed. A.V. Deardorff, J. Levinsohn, and R.M. Stem.
emerge as a result of self-organization. Future Ann Arbor: University of Michigan Press.
research needs to go beyond evolutionary thinking Matsuyama, K. 1995. Comment on P. Krugman, ‘Complexity
and also deal with emergence in the context of and Emergent Structure in the International Economy’. In
purposeful action by forward-looking agents, as New directions in trade theory, ed. A.- V. Deardorff, J.
Levinsohn, and R.M. Stem. Ann Arbor: University of
opposed to social outcomes of decentralized inter- Michigan Press.
actions of many agents. Matsuyama, K. 2004. Financial market globalization, sym-
metry breaking and endogenous and endogenous
inequality of nations. Econometrica 72: 853-884.
See Also Matsuyama, K. 2006. The 2005 Lawrence R. Klein lecture:
Emergent class structure. International Economic Review
47: 327-360.
► . 7 Traps
Matsuyama, K., N. Kiyotaki, and A. Matsui. 1993. Toward a
► Spontaneous Order
theory of international currency. Review of Economic
Studies 60: 283-307.
Menger, C. 1892. On the origins of money. Economic Journal
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Young, H.P. 1998. Individual strategy and social structure: An 2 0 th century - the emergence of a growing class of
evolutionary theory of institutions. Princeton: Princeton (formerly) poor countries that took off, and
University Press. managed to close half of their income gap with the
OECD countries within a generation or two.
Remarkably, from 1960 to 1989 seven high-
performing Asian economies (HPAEs) experienced
unprecedented growth rates of the real GDP per
Emerging Markets capita in the range of four to seven per cent. This
phenomenon has been the focus of a notable
Joshua Aizenman research report by the World Bank ( ), whose title
T h e E a s t A s i a n M i r a c l e
suggests a possible, though controversial, inter-
pretation. The big story of recent years has been that
Abstract
the two most populous countries, China and India,
The club of high-performing emerging markets joined the HPAE club. With few exceptions (such
is fairly concentrated in East Asia. Their TFP as Chile and Botswana), the club of high-
growth may not be extraordinary, though their performing emerging markets is fairly concentrated
growth rate is unprecedented. Factors argued to in East Asia. The HPAEs’ remarkable growth rates
promote growth include trade, investment, during recent decades imply a sizable drop in global
external financing, and good governance. The poverty rates, also entailing greater concentration of
importance of external financing is overrated - the incidence of extreme poverty, mostly in Africa
higher growth induces higher saving rate, (see Fischer ). Yet the emerging markets
allowing investment to be self-financed. phenomenon goes well beyond Asia, encompassing
Institutional changes as the key for take-off a growing share of developing countries that are
remains debatable - India and China took off closing, though at a lower rate than the HPAEs,
without any prior major institutional overhaul. their income gap with the OECD countries.
Allowing newcomers to challenge incumbents These developments were in sharp contrast to
and the capacity to adjust policies to shocks may the pessimistic predictions made in the 1950-60s by
be the keys for sustainable growth. several influential economic growth models (for a
review, see Easterly ). The HPAE experience
dispelled most of these fears. The superior
Keywords
performance of the HPAEs illustrated that the fast
Agency problems; Asian miracle; Emerging growth option is viable, raising pertinent questions,
markets; External financing; Financial liberal- and stirring a lively debate. While the World Bank (
ization; Financial risk; Growth and governance; ) dubbed the experience of
Growth and institutions; Growth and the HPAEs a ‘miracle’, Young ( ) questioned
international trade; High-performing Asian this ‘miraculous’ interpretation, arguing that it is in
economies; Moral hazard; Savings; Shocks; line with Solow’s growth model. Specifically, he
Solow, R.; Take-off; Total factor productivity reasoned that most of the growth has been the
outcome of very high rates of investment in tangible
and human capital, and a sizable increase in labour
JEL Classifications market participation. Controlling for these factors,
016
Young found that the HPAEs’ total factor
productivity growth is in line with the historical
‘Emerging markets’ are countries or markets that
are not well established economically and finan- experience of other countries. The debate about
cially, but are making progress in that direction.
the role of accumulation in accounting for the Some of the obstacles preventing countries from
HPAE experience is not over, yet the large drop of taking off arise from political economy factors.
the growth rate of Japan in the 1990s, and the East Specifically, as growth is frequently associated with
Asian financial crisis of 1997, somehow deflated the emergence of new sectors and new elites,
the ‘East Asian miracle’ hypothesis, suggesting the incumbent policymakers opt to block development
onset of Solow’s growth convergence. Even if in an attempt to preserve their rents and their grip
Young’s thesis is correct, the speed and relative on power. This phenomenon was vividly illustrated
smoothness of the convergence of the HPAEs to the at the micro level by De Soto ( ), and was
OECD’s development level are without precedent. shown to be a major impediment
It raises questions about the obstacles preventing to growth (see Parente and Prescott ). As the burden
other countries from accomplishing this task, and of the low growth would mostly affect future
about the ways to facilitate the take-off process in generations, the low growth equilibrium may persist
other regions. with limited opposition. Proponents of this view
The HPAE take-offs have been associated with point out that free commerce, both internal
fast growth of exports climbing, over time, the (between provinces or states in a union) and
technology ladder of trade. This led to a lively international, provides a powerful constraint on an
debate about the importance of exports as the incumbent’s ability to block development.
engine of growth: is the dominant causal association The importance of external financing and
from exports to growth or vice versa? Earlier financial integration in the development process
studies inferred that trade liberalization enhances remains a hotly debated topic. Advocates of finan-
growth (Ben-David ; Edwards ), a point disputed by cial liberalization in the early 1990s argued that
Rodriguez and Rodrik ( ). Several authors external financing would alleviate the scarcity of
revisited this saving in developing countries, inducing higher
issue, applying better controls, inferring strong investments and thus higher growth rates. In
growth effects of trade openness. Frankel and contrast, Rodrik ( ) and Stiglitz ( )
Romer ( ) applied measures of the geo questioned the gains from financial liberalization.
graphic component of countries’ trade to obtain Indeed, the 1990s experience with financial liber-
instrumental variables estimates of the effect of alization suggests that the gains from external
trade on income. They inferred that ordinary least financing are overrated - the bottleneck inhibiting
square (OLS) estimates understate the effects of economic growth is less the scarcity of saving and
trade, and that trade has a significant large positive more the scarcity of good governance. This can be
effect on income. The contrast between the illustrated by tracing the patterns of self-financing
economic performance of the Soviet Union and that ratios, measuring the share of tangible capital
of China in the second part of the 2 0 th century financed by past national saving (see Aizenman et
suggests another advantage of export orientation: it al. ). Higher self-financing rates of the nation’s
imposes a powerful market test on domestic output. stock of capital are associated with a significant
Since exports must meet the quality and pricing i n c r e a s e in growth rates. Remarkably, the
tests of the global market, export-led growth limits wave of financial reforms in the 1990s led to deeper
potential distortions induced by ‘growth promoting’ diversification, where greater inflows from the
domestic policies. Specifically, it prevents Soviet OECD financed comparable outflows from
Union-type superficial economic growth induced by developing countries, with little effect on the
forced investment, growth that may result in inferior availability of resources to finance tangible
products that would be wiped out in the absence of investment.
protection. Export-oriented growth also forces These findings are consistent with several
countries to move faster towards the technological interpretations. The first deals with risk: agents in
frontier in order to survive competitive global various countries may react to exposure to financial
pressures. risk differently. The desire to diversify these risks
may lead to two-way capital flows,
with little change in net positions (see Dooley ). The not satisfactorily explain the role of institutions in
ultimate obstacles limiting external financing may the growth process. The remarkable take-offs of
be related to acute moral hazard and agency China and India in recent decades, episodes directly
problems - sovereign states, decision makers and affecting about a third of the global population,
corporate insiders pursue their own interests at the cannot obviously be explained by reference to
expense of outside investors (see Gertler and institutional changes. This suggests that there is no
Rogoff ; Stulz ). An alternative interpretation simple correspondence or causality between growth
follows Caroll and Weil ( ), who found that and institutions. A tentative answer is provided by
statistical causality runs Rodrik ( ), who identifies a nonlinear interaction
from higher growth rates to higher saving rates. between shocks, polarization of a society and the
They conjectured that the growth-saving causality quality of institutions. This argument suggests the
may be explained by habit formation, where con- key importance of the capacity of societies to adjust
sumers’ utility depends on both present and past policies to shocks. A deeper understanding of the
consumption. ‘Habit formation’, however, may be interaction between history, geography, polarization
observationally equivalent to adaptive learning in and institutions remains a challenge awaiting future
the presence of uncertainty in countries where research.
private savings are taxed in arbitrary and The exciting developments associated with the
unpredictable ways, credibility must be acquired as emergence of a growing class of (formerly) poor
an outcome of a time-consuming learning process. countries that took off implies that the rewards for
In these circumstances, a higher growth rate adopting the proper growth incentives are high. A
provides a positive signal about the competence and remaining challenge is how to facilitate the
the intentions of the administration, increasing widening of the emerging market club, and how to
saving and investment over time. Consequently, minimize the prospects of new conflicts associated
agents in countries characterized by greater political with the emergence of new economic powers like
instability and polarization would be more cautious China and India.
in increasing their saving and investment rates
following a reform. Hence, accomplishing take-offs
in Latin America may be much harder than in Asia,
explaining Latin America’s relatively low growth
rate. (Various studies pointed out that policy See Also
uncertainty and political instability reduce private
investment and growth; see Ramey and Ramey ;
Aizenman and Marion ).
I close this review with an outline of open
issues. The positive association between the
equality of institutions and growth is well
documented, yet the precise role of institutions in
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Young, A. 1995. The tyranny of numbers: Confronting the Introduction
statistical realities of the East Asian growth experience.
Quarterlv Journal of Economics 110: 641-680. Empirical likelihood (EL) is a method for estima-
tion and inference without making distributional
assumptions. The main feature of EL is the use of a
discrete distribution to approximate the unknown
distribution function nonparametrically, where the
approximating discrete distribution is
typically supported by empirical observations.
£ ( 6 ) = max^ (/?!,... , p n ) subject to ^ p t
Owen ( ) and subsequent papers considered i= 1
applications of this approach to moment condition
models. Their important discovery is that EL, which = 1, J 2 p i g ( z i , d ) = 0 . (2)
i=\
can be interpreted as a nonparametric maximum
likelihood estimation (NPMLE) method, possesses A straightforward application of the Lagrange
many desirable asymptotic properties that are multiplier method shows that i ( 6 ) is represented
analogous to those of parametric likelihood by
procedures. To describe more details of empirical
likelihood, consider i.i.d. data {z,-}" j, where each z,
is distributed according to an unknown probability
£(8) = min - ^ log(l + y'g(zt, 8))
distribution F 0 . Suppose the expectation of an yew
P'7-valued function g ( z , 8 o), which is known
up to the finitedimensional parameter 8 ( , in 0 c P — nlogn (3)
/l
. is restricted to be zero:
(see, for example, Kitamura ). The numerical
evaluation of the function £ ( ■ ) is easy, because
(3) is a low-dimensional convex maximization
E [ g { z , 0o)] g ( z , 0 o)dEo(z) = 0 . (1 ) problem, for which a simple Newton algorithm
works. Second, obtain the empirical likelihood
estimator 0EL as the maximizer of ( ). The max-
Let A denote the simplex , p „ ) : imization of f ( 8 ) with respect to 8 is
Y H = \ typically carried our using a nonlinear optimization
P i = \ , 0 < P i , i = 1,..., n } . Each algorithm.
vector ( p i , ... , p n ) e A ‘parametrizes’ the Basic properties of the empirical likelihood
unknown distributionF 0 byF „ ( z ) = Y l i procedure are now well-understood. The EL esti-
P i 1 {P < }> - P ( 1{-} signifies the usual indicator mator 6 e l is n1/2-consistent and asymptotically
z r

function). This is the approximating discrete normal. Let D and S denote E [ V e g ( z ,

distribution mentioned above. The nonparametric 0O)] and E [ g ( z , 8 0 ) g ( z , 8 0 n then
loglikelihood function to be maximized is its asymptotic distribution is given by N(0,(ZySD) _ '
). Also, suppose R is a known Revalued function
0)pi of 6 , and the econometrician poses a hypothesis
i=1 i=\
that 8 0 is restricted as R ( 8 0 ) = 0, where
= 0,(p1,...,p„)eA,6e®. the s restrictions are independent. This can be
tested by forming a nonparametric analogue of the
Let ^0EL,PELI> • • • >RELn) denote the value of parametric likelihood ratio statistic. Let r = —
( 6 , p i , . . . , p „ ) € 0 x A that 2(supy . R < y ) = o£ ( 8 ) — supe 6 ®£),
maximizes This is called the (maximum) empirical then this obeys the chi-square distribution with s
likelihood estimator. The NPMLE for 8 and F are degrees of freedom asymptotically under the null.
0EL and = ELIPEUHP < 4 One might expect that the The factor r is called the empirical likelihood ratio
high dimensionality of the parameter space 0 x A (ELR) statistic. ELR also applies to testing over-
makes the above maximization problem intractable identifying restrictions: see section “
for any practical application. Fortunately, that is not ”. These properties and
the case, if one uses the following nested procedure. other basics of EL and related methods have been
First, fix 8 at a value in 0 and consider the studied extensively in the literature (see Qin and
loglikelihood with the parameters Lawless ; Imbens ; Kitamura ; Kitamura and Stutzer
( p \ , . . . , p „) ‘profiled out’: ; Smith ; Imbens et al. ; Newey and Smith ).
 An alternative way to motivate EL is to use a The Fenchel duality theorem implies that v ( 6 ) =
minimum divergence estimation framework. Let v* ( 9 ) . Since the true value 9 0 minimizes
/and g denote the density functions or the proba- v ( 6 ) over 0 , it follows that
bility functions of distribution functions F and G .
Define a ‘divergence measure’ between F and Gto 8 0 = argmin0 S©v*(0 ). (5)
be
Note that the integral in the definition of v* is
the expected value of p * ( X +
'm y ' g ( z , 9 ) ) with respect the true
D{F,G) F g(z) g(z) dz, (4)
distribution F 0 , which is unknown in practice. A
feasible procedure is obtained by replacing the
for a convex function p . It is easy to see that D ( expectation with the sample average, that is
, G ) is minimized at G . Let

n
g(z, 8)dF = 0,.FisaCDF v(8) = max i=i
IGR^GR’ ( 6)

Then T = Ug e ® F ( 8 ) is the set of all Corresponding to ( ), an appropriate minimum

probability distributions that are compatible with distance estimator takes the form
the moment restriction ( ). Now consider the
problem of minimizing the divergence 8 = argmin06(p>v*(0).
D { F , F 0) with respect to F e F . In other
words, a distribution that is ‘closest’ to the true This minimum divergence framework yields
distribution F 0 in the class of distributions T is empirical likelihood as a special case with i p -
sought. Pick a value 8 e 0 and define (x) = — log(x) (or equivalently, p * (x) = — 1
log(-y)). Other choices for p are, of course,
possible. For example, p ( x ) = x log(x)
v(8)
inf D ( F . Fo) g ( z , 9 ) f dz yields
= 0, the ‘exponential tilt’ estimator (Kitamura and
subject to
Stutzer ), while p ( z ) j ( x 2 1 ) corresponds
/dz = 1 . to the
continuous updating GMM estimator (CUE) (Hansen
(P)
et al. ). A convenient parametric family of convex
functions known as the Cressie-Read family (Read
The value v ( 8 ) is regarded as the minimum
and Cressie ) subsumes these three important cases.
divergence between F ( l and the set of
If p belongs to the Cressie-Read family, one can
distributions that satisfy the moment restriction
show that the minimum divergence estimator can be
with respect to g ( z , 8 ) . The nonnegativity
written as
of/is maintained if p is modified so that p ( z )
= oo forz < 0 (see Borwein and Lewis ). The
primal problem ( ) has a dual problem

v*(0 ) = max X- F*{^ + y'g( z ^)W Q (z)

argmin max (7)
A G R, y G I e
e e ©y R<?

(DP)

where p is the convex conjugate (or the Legendre where //v) = p ( y + 1). This is essentially
transformation) of p , that is p * ( y ) = equivalent to the generalized empirical likelihood
sup.r[xy—cp(x)]. ( ) is a finite-dimensional (GEL) estimator by Smith ( ). Smith ( )
unconstrained convex maximization problem. provides a detailed account for GEL.
EL and the Large Deviation Principle A n = 1 {|0„ — 6 q > c j depends on 6 0 and F 0 ,

Like the conventional asymptotic method, the large therefore the worst case scenario is given by the pair
deviation principle (LDP) offers first order (allowed in the model ( )) that maximizes Pr
approximations for various estimators and tests. { A n } . Suppose an estimator 0 „ minimizes
Unlike the conventional theory, which produces this worst-case probability, thereby achieving mini-
local linear approximations, the LDP provides maxity. The limit inferior of the minimax proba-
global nonlinear approximations, ft is the latter bility provides an asymptotic minimax criterion.
feature that enables the LDP to yield results not Kitamura and Otsu ( ) show that an estimator
obtained by the conventional linear approximations. that attains the lower bound of the asymptotic
For example, the LDP shows that EL enjoys many minimax criterion can be obtained from the EL
optimality properties that are not shared by, for objective function £ ( 9 ) in ( ) as follows:
example, the conventional GMM estimator.
To introduce the concept of the LDP in the 9id = aigmmQn(9),Qn(9) = sup 1(0*).
0 6© 0*6®:||0*-0||>e
context of moment condition models, suppose the
econometrician observes i.i.d. data (zb . . . , z„), Calculating 0 [ d in practice is straightforward.
where z, satisfies the restriction ( ). Let A n be an If the dimension of 9 is high, it is also possible to
event as a result of estimation or testing: for exam- focus on a low-dimensional sub-vector of 9 and
ple, if one uses an estimator 9 „ to estimate 9 0 ,
obtain a large deviation minimax estimator for it,
one may consider A „ = 1 {116 „ — 6 ( ) \
treating the rest as nuisance parameters.
> c} for a constant c . Then Pr{.4„! is the
Kitamura ( ) shows that empirical likeli
probability of the estimator missing the tme value
hood dominates other methods in terms of the LDP
by a margin larger than c . Or, in testing a null
when applied to overidentifying restrictions testing.
hypothesis Ho, A n can represent the event that H0
Researchers routinely test overidentifying
is accepted. If the null is incorrect, P r \ A „ j is
restrictions of the form
the probability oftype II errors. In either way, lim,, x
Pr \ A „ j = 0 if the estimator or the test is
consistent. The LDP also deals with asymptotic
g(z, 6)dF = 0 for some 9 e © and
properties, but it is concerned with the limit of the
form lim,, x I logPr {/1„}. (If the limit does not for some distribution function F,
exist, one needs to consider lim inf or lim sup, (O)
depending on the purpose of analysis.) Let d < 0
denote the above limit so that P r { A n } « e with dim(0) = k and g € R9, q > k . The log
n d
, which characterizes how fast Pr !A n } empirical likelihood under the restriction ( ) is supe 6
decays. The goal is to obtain a procedure that ® £ ( 0 ) ; without the restriction, it is — n log
maximizes the speed of decay d . n . The ELR test statistic for ( ) is the difference of
Kitamura and Otsu ( ) study the estimation the two multiplied by 2. It is asymptotically
of models of the form ( ) using the LDP. One distributed according to the y 1 distribution with q
complication in the application of the LDP to an k degrees of freedom under ( ) (Qin and Lawless ).
estimation problem in general is that an estimator Using the notation in the previous section, rewrite
that maximizes the limiting decay rate d with A „ the above null in an equivalent form: (0) , : F q €
1 {||0„ 9 ( \ > cj uniformly in unknown T . It turns out that ELR for (O)' has a property of
parameters does not exist in general, unless the being uniformly most powerful in an LDP criterion.
model belongs to the exponential family. A possible To state this optimality property of ELR formally,
way around this issue is to pursue minimax let F denote the set of all probability distribution
optimality, rather uniform optimality. See Puhalskii
functions. Practically all reasonable tests for ( ) (or
and Spokoiny ( ) for a general
(O)') can be represented by a partition Q (Qi; Q 2 ) of
discussion on such a minimax framework. Note that
F,
the probability of the event
such that if the empirical distribution function F „ Higher-Order Asymptotics
falls into Qi (Q2) one rejects (accepts) ( ). It is a
straightforward exercise to show that the ELR test An alternative way to see why EL works well is to
rejects the null if the Kullback-Leibler divergence analyse it using higher-order asymptotics. Newey
K ( F m G ) betweenF „ and G, minimized and Smith ( ) investigate higher-order prop
overG C ' F , is too large. Therefore ELR is erties of the GEL family of estimators. To illustrate
represented by the following partition of F : A = their findings, it is instructive to look at the first-
(Ap A2), Ai = {A : inf^gFK ( F , G ) < order condition that the EL estimator satisfies, that
r j ) , A2 = A2 = Aj for a positive number //. is V g l (^KIJ = 0. A straightforward
Following Owen ( ), calculation shows that this condition, using the
for an event A „ that involves observations z b..zn notation D ( 6 ) =
that are randomly sampled from F , let Pr{ A „ ; J 2 " = i P E u ^ e g { F , 9 ) a n d S ( 9
F } denote the probability of the event. By ) = £"=1 P E L i g i F , 9 ) g { z h
applying a mathematical result called Sanov’s 9 ) ' , can be written as
theorem, it can be shown that
= 0 ; (8 )
sup limsup - logPr(/*„ e A2; A*} < //.
F* G T n—* 00 %
see Theorem 2.3 ofNewey and Smith ( ). The
Kit am lira ( ) also shows that if the follow factor D^EL) S ' (^EL) can be interpreted as
ing inequality holds for a test Q (Qi; Q2) that a feasible version of the optimal weight for the
satisfies some regularity conditions (see Kitamura , sample moment g ( 6 ) = \ Y j " = \
for the regularity conditions): g ( z i ’ & ) ■ Equation ( ) is similar to the
first-order condition for GMM, though there are
important differences. Notice that the Jacobian term
sup limsup - logPr{A„ c Q2; F * } < 77,
F * e F n —>00 f t D and the variance term S are estimated by D
($EL) and S in ( ). It can be shown that these are
then it must be that
semi- parametrically efficient estimators of D and
S under the moment restriction ( ). This means that
limsup - logPr{A„ C | Qi; F * * } they are asymptotically uncorrelated with g
K—> 0 0 f t
( 6 0 ) , removing the important source of the
> limsup -logPr{A„ E Ap F * *} second- order bias of GMM. Moreover, the EL
00 ft
estimator does not involve a preliminary estimator,
for every F * The first two of the above three thereby eliminating another source of the second-
inequalities mean that the ELR test A and the order bias in GMM. Newey and Smith ( ) formalize
arbitrary regular test Q are comparable in terms of this intuition and obtain an important conclusion
its LDP property of type I error probabilities. But that the second-order bias of the EL estimator is
the third inequality implies that the ELR test is no equal to that of the infeasible method-of-moments
less powerful than the arbitrary test if the LDP of estimator that optimally weightsgby the unknown
type II error probabilities are used to measure the factor G S . In contrast, the first-order condition
asymptotic powers of the tests. Note that the third of GMM takes a similar form, but the terms that
inequality holds for every A * that is, it holds correspond to D and S are inefficiently estimated,
uniformly over alternatives. Since the test (Qj, fl2) is causing bias. Newey and Smith ( ) note that the
arbitrary, this shows that ELR is uniformly most first-order conditions of GEL estimators have a
powerful in an LDP sense. Such a property is form where D is efficiently estimated but S is not,
sometimes referred to as the Generalized Neyman- leaving a source of bias that is not present for EL.
Pearson (GNP) optimality. Higher-order properties of ELR tests have been
studied in the literature as well. One of the signif-
icant findings in the early literature of empirical
likelihood is the Bartlett correctability of the that it spans the ‘optimal instrument’ asymptoti-
empirical likelihood ratio test, discovered by cally, their procedure also achieves the semi-
DiCiccio et al. ( ). Consider the ELR test parametric efficiency bound.
statistic for Ho:0 = 9 0 in the model ( ) with q = A topic that is closely related to the above is
k . DiCiccio et al. ( ) show that the accu nonparametric specification testing. Suppose, for
racy of the y 1 asymptotic approximation for the example, one is interested in testing the
distribution of the ELR statistic can be improved specification of a parametric regression model
from the rate n 1 to the much faster rate n 2 by E \ y \ x ] = m ( x , 9 o ) , where m
multiplying it by a factor called the Bartlett is parametrized by a vector 9 0 e ©. The null
coefficient. hypothesis of correct specification can be written in
terms of a conditional moment restriction for the
function g(z, 9 ) = y m ( x , 9 ) ; z =
Some Variations of EL ( x , >>)':

EL is applicable to many problems other than ( ), £[g(z, 0)|x] = Oforsome0e © (C)

but they sometimes require extending and modi-
Tripathi and Kitamura ( ) shows that a
fying the standard EL method described so far. For
conditional version of the ELR test applies to the
example, suppose economic theory implies that the
above problem. They propose a simple procedure:
conditional mean ofg(z,0 o) given a vector of
reject ( ) if the maximized value of the conditional
covariates .r is zero:
empirical likelihood function, which is essentially
E[g(z,60)\x}=0 (9) the one used in Kitamura et al. ( ), is too small.
They also calculate the
This restriction is stronger than ( ). Though one asymptotic power of their test. Their analysis shows
can choose an arbitrary function a (.r) of .r as an that the EL-based testing procedure has an
instrument, this can be problematic since ( a ) asymptotic optimality property in terms of an
choosing an instrument that delivers strong iden- average power criterion.
tification may be a difficult task, and ( b ) an Another example in which EL needs an appro-
arbitrary instrument does not achieve efficiency in priate modification is a time series model. Suppose
general. Kitamura et al. ( ) use the kernel the researcher observes a strictly stationary and
regression technique to incorporate the information weakly dependent time series {zb ... , z,}, and each
in the conditional moment restriction into empirical z t satisfies the moment condition E [ g ( z t ,
likelihood. Their estimator achieves the 0O)] 0,0 ( i C_ ©• Applying EL to this
semiparametric efficiency bound of the model ( ) model ignoring dependence is inappropriate; it
under weak regularity conditions. While there exist leads to efficiency loss, and the chi-square asymp-
estimators that achieve efficiency in the model, the totics of the ELR test break down.
EL-based estimator has an advantage that finding a There are at least three alternative ways to deal
preliminary estimator that is consistent is not with the problem caused by dependence. The first
necessary. A simulation study in Kitamura et al. ( approach is to parametrize the dynamics using a
) indicates that the reduced form time series model such as a vector
conditional EL estimator and tests based on it work autoregression (VAR) model (Kitamura ). While
remarkably well in finite samples. Donald et al. ( straightforward, this approach involves the risk of
) propose an alternative estimator mis-specifying the dynamics, and reduces the
for ( ). Their idea is to use a sequence functions of x appeal of EL as nonparametric likelihood. The
as a vector of instruments, then apply EL to the second approach is the blocking method proposed
resulting unconditional moment restriction model. by Kitamura and Stutzer ( ) and Kitamura ( ).
By letting the dimension of the instrument vector The idea is to form
grow with the sample size in such a way data blocks by taking consecutive observations, and
apply EL to them. This is termed blockwise
empirical likelihood (BEL). BEL preserves the deviations. Manuscript, Department of Economics,
dependence information in the data, in a fully Yale University.
Kitamura, Y., and M. Stutzer. 1997. An information
nonparametric manner. The third approach is a theoretic alternative to generalized method of
hybrid of the first and the second approaches moments estimation. Econometrica 65: 861-874.
(Kitamura ). That is, one apphes a low order Kitamura, Y., G. Tripathi, and H. Ahn. 2004.
parametric filter to lessen the degree of dependence Empirical likelihood based inference in conditional
moment restriction models. Econometrica 72:
in the data, then apply BEL to the filtered data. 1667-1714.
While this does not change the desirable asymptotic Newey, W.K., and R.J. Smith. 2004. Higher order
property of BEL, it appears to have advantages in properties of GMM and generalized empirical
finite samples when apphed to a time series that is likelihood estimators. Econometrica 72: 219-255.
Owen, A. 1988. Empirical likelihood ratio confidence
highly persistent. intervals for a single functional. Biometrika 75:
237-249.
Owen, A. 2001. Empirical likelihood. New York:
Chapman and Hall/CRC.
See Also Puhalskii, A., and V. Spokoiny. 1998. On large-
deviation efficiency in statistical inference.
► icncnj ■: Method ::: Moments 3ssanation Bernoulli 4: 203-272.
Qin, J., and J. Lawless. 1994. Empirical likelihood and
► ni. nan Estimation general estimating equations. Annals of Statistics
► feet© Autoregress:.ons 22: 300-325.
Read, T.R.C., and N.A.C. Cressie. 1988. Goodness-of-
fit statistics for discrete multivariate data. Berlin:
Bibliography Springer.
Smith, R.J. 1997. Alternative semi-parametric
Borwein, J.M., and A.S. Lewis. 1991. Duality relation- likelihood approaches to generalized method of
ships for entropy-type minimization problems. moments estimation. Economic Journal 107: 503-
SIAM 519.
Journal of Control and Optimization 29: 325-338.
DiCiccio, T., P. Hall, and J. Romano. 1991. Empirical
likelihood is Bartlettcorrectable. Annals of
Statistics 19: 1053-1061.
Donald, S.G., G.W. Imbens, and W.K. Newey. 2003. Employment, Theories of
Empirical likelihood estimation and consistent tests
with conditional moment restrictions. Journal of M. Bronfenbrenner
Econometrics 117: 55-93.
Hansen, L.P., J. Heaton, and A. Yaron. 1996. Finite-
sample properties of some alternative GMM
estimators. Journal of Business and Economic
Statistics 14: 262-280.
Theories of employment are actually concerned
Imbens, G.W. 1997. One-step estimators for over-
identified generalized method of moments models. with involuntary unemployment. They deal with the
Review of Economic Studies 64: 359-383. definition, nature, and causes of such unem-
Imbens, G.W., R.H. Spady, and P. Johnson. 1998. ployment, and also with economic polices to reduce
Information theoretic approaches to inference in
moment condition models. Econometrica 66: 333-
or alleviate it. They consider such questions as:
357.
Kitamura, Y. 1997. Empirical likelihood methods with How serious is the problem of involuntary unem-
weakly dependent processes. Annals of Statistics ployment, both in the short and in the longer
25: 2084-2102. run?
Kitamura, Y. 2001. Asymptotic optimality of empirical
Is such unemployment a feature of economic
likelihood for testing moment restrictions.
Econometrica 69: 1661-1672. equilibrium, or is it an exclusively disequilib-
Kitamura, Y. 2006. Empirical likelihood methods in rium phenomenon?
econometrics: theory and practice. In Advances in Is there a ‘natural’ or ‘normal’ or ‘non-inflation-
economics and econometrics: Theory and
accelerating’ unemployment rate?
applications, ninth world congress, ed. R. Blundell,
W.K. Newey, and T. Persson. Cambridge:
Cambridge University Press.
Is there a trade-off between unemployment and may the export of unemployment by export
inflation rates? If so, what are the terms of trade- subsidies and protection against imports.
off, and are they stable?
Under what circumstances, if any, can assurance of Variants of the first of these positions -
long-term high employment be combined with sometimes called neoclassical, but actually much
assurance of price-level stability (or non- older than the ‘neoclassical revolution’ of the 1870s
accelerating inflation)? - dominated economic orthodoxy in Western
countries prior to the 1930s. Variants of the second
position, articulated by John Maynard Keynes’s
Opposed Positions General Theory of Employment Interest and Money
( , esp.
Two basic and opposed positions of economists ch. 19) are called Keynesian, although none of the
on employment theory may be summarized as basic ideas was precisely new in 1936. (Marx, for
follows: example, had gone far beyond Keynes in regarding
a ‘reserve army of the unemployed’ as highly
(1) Applying standard supply-and-demand analysis functional in capitalism, its function being to hold
to labour markets makes unemployment a wage rates at an established subsistence level.) But
disequilibrium phenomenon, resulting from the much as persistent depression unemployment
prevalence and persistence of real and money threatened neoclassicism, persistent and
wage rates higher than the demand for labour accelerating inflation has later threatened Keynes-
will support. Its solution is the lowering of real ianism. Revolts against Keynesian neoorthodoxy
wage rates to market-clearing levels, rather have taken two opposite tacks; towards
than any arbitrary removal of certain classes of reformulated neoclassicism on one side, and
workers from the labour supply. Public support towards ‘incomes policies’ of employment guar-
for the unemployed may perhaps subsidize antees (with regulated prices and usually also
search for desirable jobs, but it should not wages) at the opposite end of the spectrum. The
subsidize withdrawal from the labour force. current (mid-1980s) situation is variously described
Intentional stimulation of labour demand, as by as fluid, as chaotic, and as ‘in shambles’. It cannot
monetary expansion or fiscal deficits, is apt to be called ‘cut and dried’!
kindle or accelerate inflation, and/or to raise Conflict between neoclassicals and Keynesians
interest rates and discourage investment. is exacerbated by denunciation in each group ofthe
Limitation of labour- saving technical progress other’s policy proposals as dangerously harmful. To
will slow economic growth at the expense of the confirmed neoclassicist, artificial demand
future generations. stimulus, repeated and anticipated, soon raises
(2) Unemployment results from equilibrium society’s (unofficial) ‘discomfort index’ by raising
between aggregate supply and demand for the the inflation rate more than it lowers the measured
national output at a level too low to require the unemployment rate. To file confirmed Keynesian,
productive services of the full labour supply. the immediate effect of any real or money wage cut
The appropriate remedy is expansion of is to deepen recession by shifting purchasing power
demand by fiscal and monetary measures - from ‘spenders’ (the working class) to ‘savers’
increased public spending, lower taxes, (capitalists and corporate treasuries).
accelerated monetary growth, lower interest
rates. Removal of particular groups from the
labour market - youth, the elderly, secondary Neoclassical Employment Theory
workers in families with employed
breadwinners -and moratoria on labour- saving Mature neoclassical employment theory, as
innovations may be legitimate devices to represented by A.C. Pigou’s 77l e o r y o f
reduce unemployment in the short ran, as U n e m p l o y m e n t ( ), draws its
analysis from Alfred
Marshall’s Principles of Econom ics ( ). There appearing in mid-Depression, this volume is
had been little formal employment theory in Mar- remembered chiefly as the fuse that lit Keynes’s
shall himself, the most nearly relevant materials G e n e r a l T h e o r y , but deserves a
being the treatment of derived demand (Book V, eh. better fate. Much of it can be interpreted as standing
vi) with reference to the building trades, rather than Pigou’s earlier argument on its head, so as to
the ‘wages’ chapters of Book VI. Book V includes provide us an exposition of conditions under which
Marshall’s famous ‘four laws’ governing the extent employment can be r e s t o r e d most rapidly
to which a rise in the demand and price of an output in a depression, and with m i n i m u m cuts in
(houses ) causes a rise in the demand and wage of real wages. These conditions are embodied in
an input (building workers). In today’s economic devices to r a i s e the elasticity of demand for
terminology and Marshall’s order, these laws state labour. These several devices involve shifts in
that the rise in demand for the input will increase aggregate demand, private and (especially) public
more, the lower the elasticity of substitution from what Pigou calls ‘centres’ where (T) a is low
between that input and other inputs, the lower the to others where it is high, (2 ) from centres where
elasticity of demand for the output, the less the r j is low to others where it is high, (3) from
importance of that input in the production process centres where k is low to others where it is high -
for the output, and the less the elasticities of supply surely the most important quantitatively - and
of substitute inputs. This seems far removed from finally (4) from centres where e is low to others
employment theory, but Pigou, in successive where it is high.
editions of his E c o n o m i c s o f On the more aggregative plane, Pigou seems
W e l f a r e ( , 1st edition entitled W e a l t h wavering and inconsistent in the light of fifty years’
a n d additional development of macroeconomic theory.
W e l f a r e , 1912) restated Marshall’s laws as Over the long term, he argues in the second chapter
conditions under which workers might obtain higher of Part V, increases in aggregate demand serve only
wages, presumably after union organization, with to raise prices and wages without increasing
minimum losses of employment. A full employment. In the short run, however, they can be
mathematical statement, combining all four laws in helpful if not carried too far. This apparently
a single formula for the elasticity of the derived implies that Say’s Law is valid as a long-run prop-
demand for a labour input, dates from J.R. Hicks’s osition, but inoperative in the short run.
T h e o r y o f W a g e s ( ). Denoting by Pigou’s approach may seem naive in transfer-
E , r ) , a , e ring microeconomic analysis to the macroeconomic
the respective elasticities of labour demand, output plane, and in its failure to examine Say’s Law more
demand, substitution between labour and ‘capital’, intensively than it does. But it is far from the
and supply of ‘capital’, the Hicks equation is: labour-and union-bashing that neoclassical
economic argumentation is often supposed to
E _ + e) + kafj - e) represent.
<?( >] + e) + k(rj - e)

with k representing the relative importance of Keynesian Employment Theory

labour in production as measured by the propor-
tionate share of wage payments in total cost. (The Despite its title, Lord Keynes’s G e n e r a l
equation ignores shifts of consumer demand T h e o r y is a treatise on the macroeconomic
between more and less labour-intensive commod- theory of income determination. Its employment
ities.) From Hicks’s equation, Marshall’s laws theory is confined largely to attacks on the
follow immediately, with the possible exception of Marshall-Pigou tradition, under the assumption (too
the third one on ‘the importance of being obvious to require either stress or detailed
unimportant’. development) that aggregate real income and the
We come now to Pigou’s T h e o r y o f unemployment rate are inversely related under any
U n e m p l o y m e n t . Based on the given state of technology.
Marshallian structure and
 Strengthening and specifying of the Keynesian employment’, on the other hand, Lemer meant 1 0 0
relation between income on the one hand, and per cent of the labour force, minus only the
employment and unemployment on the other, came frictional lacunae consequent upon job changing.
only after advances in econometrics and in Lemer set low rather than high full employment as
computer technology. A standard specification has the preferred target of employment policy, and
been contributed by Arthur Okun. ‘Okun’s Law’ or outlined a detailed (but probably impractical)
the ‘Okun curve’, as it is variously known, may be scheme of wage controls for attaining and
written in disguised differential- equation form. For maintaining it. (Most professed Keynesians, more
example, let us denote by U the percentage ambitious than Lemer, would strive for high full
change in the measured unemployment rate over a employment.)
given period and by Y the percentage change in a The ‘expository Keynesianism’ of the textbooks
real-income measure like deflated GNP or GDP stresses primarily the s h a p e s and
over the same period. p a r a m e t e r s of such relations as the
consumption, marginal efficiency, and liquidity
functions which determine the level of income in
-0 = a(? -YoJ or U + a(f - f0) = 0
the Keynesian scheme. At a more advanced level,
the emphasis appears to be changing, to stress
Here a is a statistical parameter, while To is the rather the v o l a t i l i t y of these functions as
income growth rate estimated to be required if the expectations fluctuate. Leijonhufvud ( ) calls the
unemployment rate is not to rise. Neither real nor newer view ‘the economics of Keynes’ as distin-
nominal wage rate movements are taken into guished from the ‘Keynesian economics’ of the
explicit account. (The estimates of To are based on textbooks. The change in emphasis may also result
regressions of high-employment points only, and from the defence of Keynesian macroeconomics,
the slope of this regression is called the country’s with its employment-theory appendage, against its
potential growth rate. The area between such a critics, whose argument can be paraphrased: ‘The
regression and the country’s actual growth path is aggregate demand for the national output depends
sometimes called an ‘Okun gap’.) inversely on the general price level, as the demand
The ( a , Y o ) values may of course vary for a single commodity depends upon its price. If
widely, both across countries and over time. For the human wants are insatiable at a zero price level, it
US 1949-60, Okun’s estimate of a was about 0.3, follows that there exists a positive price (and
and his estimate of Y 0 about 3.75 per cent. The likewise wage) level at which full-employment
usefulness of the widely used Okun analysis is output can be absorbed.’ (The critics could not,
questionable, however, in the presence of supply however, prove that the market-clearing set of fiill-
shocks, wage ‘explosions’, and similar disturbances. employment wage rates was at or above
(A productivity jump, for example, might be ‘subsistence’, however defined.)
expected to lower a and raise Y o . The The Keynesian rebuttal, due largely to Glower (
combination of these shifts increases the income ), introduced the distinction between actual
growth rate required to reduce an existing unem- and ‘notional’ demands for output and especially
ployment rate or to keep that rate from rising. ) for labour. In a recession, the demand function for
Shifting from the empirical to the analytical output is weaker than the ‘notional’ fiill-
side, a fruitful development of Keynesian unem- employment demand function would be. At the
ployment theory was the distinction between high same time, the actual demand for labour is less than
and low full employment, introduced by A.P. the notional one which would prevail were potential
Lemer’s E c o n o m i c s o f employers reasonably sure of selling fiill-
E m p l o y m e n t ( , employment output at profitable prices. The
ch. 13). By Tow full employment’ Lemer meant impasse or vicious circle could be broken when the
essentially what was later called NAIRU in the demand for output (see Fig. ) could rise from
United Kingdom, namely the non-inflation-
accelerating rate of unemployment. By ‘high full
Employment, Theories of.
Fig. 1 Investment and
saving in a 2-period
model

A D to A D ' by public policies which improved Equilibrium is then not unique. Depending upon
the state of confidence - without reference to the the state of notional as well as actual demand, there
multiplier mechanism of the Keynesian textbooks. are an infinite number of possible equilibria at as
The equilibrium position could move from point many levels of income and employment. We cannot
E , possibly all the way to point E ' at the full- be sure a p r i o r i that wage deflation will
employment income level F , with money wages produce increases in employment.
remaining the same and with no need to press
aggregate supply A S vertically downward to A S
as by a wage cut. Conclusion
Now suppose, in the same recession, there was
to be a complete ‘hands-off’ policy. As unemploy- The British Broadcasting Company featured in
ment continued with nothing done about it beyond December 1944 a series of postwar-planning pro-
calls for wage reductions, notional aggregate grammes entitled J o b s f o r A l l . These
demand would fall, perhaps as far as A D " if the were inspired not only by Lord Keynes’s
policy were to lead to budget-balancing and mon- G e n e r a l T h e o r y but by the
etary contraction. Even if hard times and wage extensions and applications proposed by Michal
concessions from labour eventually forced aggre- Kalecki in the Oxford Institute of Statistics’
gate supply to the A S ' position, the result would E c o n o m i c s o f F u l l
be hyper-deflation rather than recovery. (The E m p l o y m e n t (Burchardt et al. ).
Hoover debacle of 1931-2 in the United States and (Kalecki, who would later assume temporary
the contemporaneous Briining one in Germany are leadership of British Keynesianism after Keynes’s
cases in point.) By the time aggregate supply had own death in 1946, had proposed ‘incomes policies’
reached A S ' , the equilibrium point E " would and income redistribution as preferable to either
prevail, with output (and therefore employment) deficit finance or stimulation of private investment
below those at E , even though deflationary cost- as a route to full employment.) A junior member of
cutting would have restored high employment had that Oxford team, and a speaker in the BBC
aggregate demand remained at A D . J o b s f o r A l l series, was G. D. N.
Worswick. In July 1984,
the same G.D.N. Worswick, now Professor at Leijonhufvud, A. 1968. On Keynesian economics and the
Oxford and President of the Royal Economic economics of Keynes. New York/Oxford: Oxford
University Press.
Society, delivered his presidential address on ‘Jobs Lemer, A.P. 1951. Economics of employment. New
for All?’, later published in the E c o n o m i c York: McGraw-Hill.
J o u r n a l (Worswick ). It was the same sub- Marshall, A. 1890. Principles of economics. London:
ject, but note the question mark. Macmillan.
Okun, A. 1970. The political economy of prosperity.
The substance of Worswick’s address was that, Washington, DC/New York: Brookings
unfortunately, that question mark belonged in his Institution/Norton.
new title, and could not be expunged even after Patinkin, D. 1956. Money, interest, and prices. Evanston:
forty additional years of planning, theorizing, and Row, Peterson.
Pigou, A.C. 1920. The economics of welfare. London:
experimentation. We quote from his final paragraph
Macmillan.
(p. 14): Pigou, A.C. 1933. The theory of unemployment. London:
When it comes to action, [The Economics of Full Macmillan.
Employment] was already too optimistic. We Worswick, G.D.N. 1985. Jobs for all? Economic Journal
assumed that trade unions would readily accept 93: 1-14.
some limitations on free collective bargaining
as a small price to pay for ending
unemployment. There was too little recognition
that it is my restraint which is necessary to
secure your employment. Is it possible to Empty Boxes
devise schemes which are not only of
advantage for the national economy, or for N. F. R. Crafts
workers as a whole, but can also be seen to be
to the advantage ... of members of trade unions
who are already in employment? This is a task
for the new generation of economists to
undertake. Until a lasting solution is found, the ‘Empty Economic Boxes’ is the title of a famous
question mark after my title must remain.
article in the E c o n o m i c J o u r n a l
of 1922 and a phrase which has subsequently
entered the language of economics as a shorthand
See Also
for ‘abstract theory without practical relevance’.
The paper was written by J.H. Clapham, the leading
► aggregate Demanc and Supply Analysis
British economic historian of the interwar years and
► Effective Demand
first Professor of Economic History at Cambridge
► Full Employment
University.
► avoluntary Unemployment
As an economic historian, Clapham showed a
► leynes, John Maynard (188 '.
‘special predilection for hard and tangible facts’
► leynes’s
(Postan 1946, p. 57). His classic text, A n
► Output and Employment
E c o n o m i c E l i s t o r y o f
► 'hillips Curve
M o d e r n B r i t a i n (3 vols.: ;
; ) is notable for its pioneering insis
Bibliography tence on presenting facts as far as possible in
Burchardt, F.A., et al. 1944. The economics of full detailed quantitative form. Clapham is especially
employment. Oxford: Basil Blackwell. remembered for his statement on the methodology
Clower, R. 1965. The Keynesian counter-revolution, a of economic history subsequently eagerly embraced
theoretical appraisal. In The theory of interest rates, by ‘new economic historians’: Every economic
ed. F. Hahn and F. Brechling. London: Macmillan.
Hicks, J.R. 1932. The theory of wages. London:
historian should, however, have acquired what
Macmillan. might be called the statistical sense, the habit of
Keynes, J.M. 1936. The general theory of employment, asking in relation to any institution, policy, group or
interest and money. London: Macmillan. movement the questions: how large? how long?
how often? how representative? ( , p. 328).
 Clapham was not (nor was any of his contem- time, industrial economics textbooks still offer very
poraries), however, a new economic historian, in substantial reservations about the precision of
that his work was not characterized by the use of available estimates (Hay and Morris eh. 2 ).
formal economic analysis or econometrics. His In economic history also, there has been pro-
approach to economic history echoes his 1922 gress in applying Pigou’s ideas as revised by the
article in finding little of practical relevance in the subsequent theoretical literature. By far the most
economic theory of his day. In effect, Clapham interesting study is that of David ( , eh. 2),
revealed a preference for a shift in the balance of which found econometric evidence of external
economists’ research programmes away from pure, economies from irreversible learning effects in the
abstract theory towards collection of better American cotton textile industry before 1825 and
E
economic data. a l s o that thereafter there was no justification
The 1922 article was directed particularly for infant-industry protection.
towards Pigou’s ( ) proposals for taxation of David’s paper is an excellent example of the
decreasing returns and subsidy of increasing returns ‘new economic history’, with its stress on use of
industries. Clapham argued that ‘the Laws of theory and hypothesis testing. In fact, new eco-
Returns have never been attached to specific nomic history has generally used models based on
industries; that the boxes are, in fact, empty’ ( , p. mainstream neoclassical economics and, in general,
312). In effect, Clapham criti this has undoubtedly proved fruitful - much more so
cized the lack of evidence on long-run cost curves than a sceptic like Clapham would have imagined.
for both firm and industry and on learning effects. For example, discussions of the slave economy in
He also expressed scepticism about the prospects the United States and entrepreneurial behaviour in
for empirical work in this area. Pigou’s reply ( ) late Victorian Britain have been substantially
expressed the belief that evidence would enriched.
be forthcoming and that, in any case, economic Nevertheless, there is cause for concern about
thinking was useful as a method of analysis in the one-way relationship which has developed in
policy questions. the past quarter-century between economics and
Ironically, Pigou’s work gave rise to a consid- economic history. There is a danger not so much of
erable body of theoretical rather than empirical inevitably empty boxes as of forcing historical
literature, which left relatively little of his initial examples into particular boxes; that is, of operating
proposals intact. Notable articles by Knight ( ), with priors that are too tight. In particular, as
Robertson ( ), Viner ( ) and Ellis McClelland ( , p. 125) has emphasized, new
and Fellner ( ) made clear, for example, the economic historians should be wary of automati-
distinctions between external diseconomies and cally believing that the marginal equivalences of the
transfer payments to fixed factors and between neoclassical model are tolerably achieved in all
externalities from irreversible learning effects and situations.
minimum efficient scale on a given long-run Perhaps, also, economists have more to learn
average cost curve. from economic history than they seem presently to
Already by the end of the interwar period believe. Obviously, the past offers a much wider
Pigou’s hopes for empirical research were starting array of facts and institutions than the present,
to be fulfilled by pioneering investigations into evidence which at present is undemtilized. In
production functions, cost curves and learning addition, the study of history necessarily involves
effects, which are reviewed in Walters ( ), seeking to understand particular events, and expo-
Johnston ( ) and Alchian ( ). It should sure to the difficulties of this can give an interesting
be said that econometric work has by now achieved perspective on modem economic analysis.
far more than Clapham believed possible, and the Economic historians like David would argue that
results are seriously considered in the context of the past is characterized by pervasive learning
antitrust policy (e.g. Cmnd. 7198, ), if not in effects and technical interrelatedness so as to
taxation policy. At the same
produce path-dependent sequences of economic Clapham, J.H. 1938. An economic history of modern Brit-
changes. If in fact the increasing-returns box is as ain. Vol. 3: Machines and national rivalries. Cam-
bridge: Cambridge University Press.
full as initial investigations in technological history Command Paper no. 7198. 1978. A review of monopolies
suggest it could be, then critics of orthodox theory and mergers policy. London: HMSO.
like Kaldor ( ) will find their positions David, PA. 1975. Technical choice, innovation and eco-
strengthened. nomic growth. Cambridge: Cambridge University
Press.
Moreover, in such a world the past matters in Ellis, H.S., and W. Fellner. 1943. External economies
ways that neoclassical theory ignores, and the and diseconomies. American Economic Review 33(3):
balance of research in economic history should be 493-511.
different; for example, less emphasis in research on Hay, D.A., and D.J. Morris. 1979. Industrial economics:
Theory and evidence. Oxford: Oxford University
the rationality of individual entrepreneurs in Press.
Victorian Britain and more on the impact of an Hendry, D.F. 1980. Econometrics: Alchemy or
‘early start’ on subsequent economic performance. science? Economica 47(188): 387-406.
A modern-day Clapham would still say that we Johnston, J. 1960. Statistical cost analysis. New York:
McGraw-Hill.
do not know enough about ‘increasing returns’, but
Kaldor, N. 1972. The irrelevance of equilibrium
rather than turning his back on the concept, he economics. Economic Journal 82: 1237-1255.
would surely insist on the importance of economic Knight, F.H. 1924. Some fallacies in the interpretation
history in establishing how full this box is and of social cost. Quarterly Journal of Economics 38:
582-606.
would now recognize that to some extent the
Leontief, W. 1971. Theoretical assumptions and non-
importance of economic history depends on the observed facts. American Economic Review 61(1): 1-
answer. He would also find common cause with 7.
applied economists and econometricians like McClelland, P.D. 1975. Causal explanation and model
building in history, economics and the new economic
Leontief ( ) and Hendry
history. Ithaca: Cornell University Press.
( ) in wishing that more resources were Pigou, A.C. 1920. The economics of welfare. London:
devoted to gathering information on economies past Macmillan.
and present. Pigou, A.C. 1922. Empty economic boxes: A reply.
Economic Journal 32: 458-465.
Robertson, D.H. 1924. Those empty boxes. Economic
Journal 34: 16-30.
See Also Viner, J. 1931. Cost curves and supply curves.
Zeitschrift fur Nationalokonomie 3: 23-46.
► Clapham, John Harold (1873-1946) Walters, A.A. 1963. Production functions and cost
► ' a. V-. functions: An econometric survey. Econometrica
► Increasing Returns to Scale

Bibliography
Encompassing
Alchian, A. 1963. Reliability ofprogress curves in
airframe production. Econometrica 31(4): 679-693. Grayham E. Mizon
Clapham, J.H. 1922. Of empty economic boxes.
Economic Journal 32: 305-314.
Clapham, J.H. 1926. An economic history of modern Brit-
ain. Vol. 1: The early railway age. Cambridge: Cam-
bridge University Press. Abstract
Clapham, J.H. 1931. Economic history as a discipline. The concept of encompassing is defined and the
In Encyclopaedia of the social sciences, vol. 5, ed. E.R.A.
Seligman and A. Johnson. London: Macmillan. role that it and congruence have in econometric
Clapham, J.H. 1932. An economic history of modern Brit- modelling is discussed. Empirically, more than
ain. Vol 2: Free trade and steel. Cambridge: Cambridge one model can appear to be congruent, but that
University Press. which encompasses its rivals is dominant and
will encompass all models nested within it and
accurately predict the
 mis-specifications of non-congruent models. be denoted by the joint density D x ( x t |X, ,,/)
These results are consistent with a general-to- for x, conditional on its history X,_i with
specific modelling strategy being successful in parameters t p . Knowledge of the DGP endows
practice. Alternative forms and applications of one with omniscience and in particular the ability to
encompassing tests are discussed. derive the properties of all models involving the
same variables such as/Jt(x/|X/ i,x), but, alas, for
Keywords practical purposes it is unattainable. In empirical
Congmence; Encompassing; Gaussian linear modelling, therefore, congruence means that, given
regression models; Indirect inference; Models; the available information, the model is
Non-nested hypotheses; Simulation; Testing indistinguishable from the DGP for the chosen
variables, that is, no evidence has been evinced that
the model is not the DGP. Testing the latter requires
JEL Classification that extensive, not limited, searching is done for
Cl evidence of non-congruence. This leads to the
adoption of statistical tests of model mis-
specification (for example, wrong functional form,
heteroskedastic or serially correlated residuals) as
Introduction and Motivation indirect but practical tests of congruence (Hendry ;
Mizon ). Since in practice a congruent model will
Imaginative and productive disciplines like eco- not be the DGP, it will not necessarily be able to
nomics generate many new theories, partly to explain the properties of other models, and in
extend the range of phenomena that they embrace particular those that constitute the current best
but also to improve on existing theories. New knowledge and practice. Thus, a valuable part of the
theories require rigorous evaluation to establish evaluation of a model is an assessment of whether it
their worth if they are to be relevant, reliable, and represents an advance on existing knowledge. ‘The
robust. In addition to checking their logical con- encompassing principle is concerned with the
sistency and relevance it is important to assess their ability of a model to account for the behaviour of
coherence with observation. The latter usually others, or less ambitiously, to explain the behaviour
involves the development of a model that embodies of relevant characteristics of other models’ (Mizon ,
the essential characteristics of the theory and has p. 136). A well- known illustration in physics,
observable implications. discussed by Okasha ( ), for example, is
The analysis presented here concentrates on the provided by New
evaluation of empirical models. Numerous criteria ton’s laws of motion and gravitation that
have been proposed for assessing the coherence of encompassed Kepler’s laws of motion and gravi-
an empirical model with observation. Measures of tation as well as Galileo’s law of free-fall, and as a
goodness of fit and selection criteria based on result the same laws explained the motion of bodies
likelihood functions (usually degrees of freedom in both the terrestrial and the celestial domains. This
adjusted) are common (Schwarz ), and are often added credence to Newton’s laws, as it does for all
used both to assess coherence with observation and models that encompass their rivals. It was widely
to select the preferred model. Probably the most believed for a long time that Newton’s theory
comprehensive and demanding criterion for data revealed the workings of nature and had the ability
coherence is that of congruence (Hendry ; to explain everything in principle. However,
Bontemps and Mizon ), which requires a model to Newton’s laws have been superseded or
be a valid reduction of whatever process actually encompassed by Einstein’s relativity theory and
generates the observed data - the data generation quantum mechanics. This illustrates the fact that
process (DGP). When x, contains the full set of modelling, like discovery, is not a once-for-all
variables involved in an investigation, let the DGP event, but a continuous process of development.
Progress in science, however, is achieved in many
ways, with confidence and persistence playing a predictions perform badly. Congruence is the ana-
role in some instances as a consequence of rejection logue of setting up controlled experimental con-
not being accepted as final or corroboration of ditions. The need to distinguish between alternative
models that are subsequently superseded not being theories that each appear to be coherent with
taken as definitive. outcomes, experimental or non-experimental, leads
to the search for dominant theories. For disciplines
that are largely non-experimental, having a
Background principle such as encompassing is essential for
discriminating between alternative models.
The idea underlying the encompassing principle has Typically, alternative empirical models use
a long pedigree; for example, the comparison of different information sets and possibly different
competing theories has been long recognized as a functional forms, and are thus separate or non-
basic ingredient of a scientific research strategy nested. This non-nested feature enables more than
(Nagel ). The implementation via a statistical one model to be congruent with respect to sample
contrast equally has a long history; Cox ( , information - each can be congruent with respect to
) are the most significant early examples. its own information set - and so it is important to
These papers introduced statistical tests for separate assess their relative merits. Using the encompassing
families of hypotheses, and discussed several principle, Ericsson and Hendry ( ) analyse this
examples to illustrate their practical relevance. The issue and
tests were later developed in the literature on non- show that the corroboration of more than one model
nested hypothesis testing (Pesaran ; Davidson and can imply the inadequacy of each, and Mizon ( )
MacKinnon ), and provides an illustration by compar
encompassing (Mizon ). The latter paper contains a ing a Keynesian and a monetarist model of infla-
general presentation of the concept of encompassing tion. Hence, congruence and encompassing are
and discussion of numerous applications, and inextricably linked; in particular, encompassing
Mizon and Richard ( ) provides a comparisons of non-congruent models can be
theoretical framework for encompassing, on which misleading. For example, general models will not
other theoretical papers have built extensions. always encompass simplifications of themselves
Davidson et al. ( ) is one of the first even though that might seem to be an obvious
attempts to develop a framework for a scientific characteristic of a general model, but a congruent
comparison of alternative economic theories and general model will always encompass simpler
econometric models implementing them. Different models (Hendry ; Gourieroux and Monfort ;
econometric models for the series of UK con- Bontemps and Mizon ).
sumption, which rely on different economic
hypotheses about consumption behaviour, were
embedded in a general model and shown to imply Principle
different testable restrictions on its coefficients.
Distinguished natural scientists have expressed Underlying all empirical econometric analyses is an
surprise that social scientists are able to leam information set (collection of variables or their
anything from empirical observation when they sigma field), and a corresponding probability space.
rarely have experimental evidence. However, the This information set has to be sufficiently general
encompassing principle provides precisely the to include all the variables thought to be relevant to
analogue of the physical experiment. Experiments the empirical implementation of theoretical models
enable physicists and chemists to sift through in the form of statistical models. It is also important
alternative theories by evaluating the veracity of that this information set include the variables
their implications or predictions in controlled con- needed for all competing models that are to be
ditions, and thus to eliminate those theories whose compared. When these variables are \ t the
 Mi^y = Zib + m, Ul
M i — y = Z i g + U2 (1 )
uM2, c ~ y = Zib + Z2c + c e ^ ' N ( 0 , s
2
c l n )
DGP for the observed sample n x k iis( i the joint density
Krolzig ( ) describe and illustrate the perfor
x 1 , and atZ,the particular
when y isZ)nv(x,|X,_i,/) is = parameter 1 .2 )value < p
mance of a computer program that implements a
= < p 0 . Let a parametric statistical model of general-to specific modelling strategy.
the joint distribution be M f = {/v(x,|X,_i,x)xeS The comparison of Gaussian linear regression
c R k } . Let x be the maximum likelihood models provides a simple and convenient frame-
estimator of £; so that x work to illustrate the main ideas. Consider the two
P P
— a n d x —> x ( f n ) = x q which is models M i and M2 defined in:
the pseudo-
Mf DGP W R

trae value of x .
Note that the parameters of a model are not
arbitrary in that M f and its parameterization £; are
chosen to correspond to phenomena of interest such
as elasticities and partial responses within the cho-
containing n observations on the independent and
sen probability space. For the two alternative
two sets of explanatory variables respectively with
models Mi = {/'j(xf|Xf_i,<?!),<?! <E © \ C R P l }
no variables in common. The explanatory variables
and M 2 = { f 1 { x l \ X t - i , q 1 ) , q 1
£ & i C R p2} the concept of parametric are distributed independently of the error vectors u,
encompassing, in accordance with the approach in v, and e. When Mi, M 2 and M c are each
Mizon ( ), Mizon hypotheses about the distribution of y|z, the models
and Richard ( ), and Hendry and Richard M i and M2 are non-nested in that neither is a
( ), can be defined as follows. M i encom special case of the other, whereas both Mi and M 2
passes M 2 (denoted M^M^if and only if q 2 0 are nested within M c . A test of the hypothesis
= h2 i (<?io) when 9 i 0 is the pseudo-true value that Mi encompasses M2 (M, £ M 2 ) is possible
of the maximum likelihood estimator q t of q { i using the contrast i p y = y — yj = (Z2 Z2)
= 1 ,2 , and h2 i(^io) is the binding function given by *Z2Qiy with Q] = ^I„ — Zi(Z'jZi) *Zj j between the
q 2 maximum likelihood estimator of y , 8 =
-^h2 i(<7 10) (Mizon and Richard ; Hendry (Z',Z2)- *Z(y, and an estimate fj (Z(Z 2) 1 Z2 (ZjZi) 1
and Richard ; Gourieroux and Monfort ). Note that Zjy of the pseudo-tme value of g under Mi given
this definition of encompassing applies when M\ by gj = p l i m n ^ 0 < ] U l ( g ) . The sam-
and M2 are non-nested as well as nested. However, ple complete parametric encompassing test statistic
Hendry and Richard ( ) is given by
showed that when M , and M 2 are non-nested (Mi V c = «AT(Z;Z2) (Z2 Q,Z2 ) - 1 (Z;Z
t S > M i ) is equivalent to Mi being a valid 2 ) $ y / k 2 ^ c
when ^=y'(l„-Z(Z'Z)-1 Z')y/(n-A- 1 - k 2 )
reduction of the minimum completing model M, =
is the unbiased estimator of a 2 c with Z = (Zi, Z2).
Mi U M2 ( s o that Mi,Mi C Mc ) when M 2 1 is the
model which represents all aspects of M 2 that are Under the complete parametric encompassing
not contained in M ,. When this condition is satis- hypothesis H c : i f / = y — =0 the statistic
fied, M i is said to parsimoniously encompass Mi t ] c is
( M 1 rf;MC) . Parsimonious encompassing is the distributed as F { k 2 , n — k \ —
property that a model is a valid reduction of a more k 2 ) : Mizon and Richard ( ) showed that
general model. When a general-to-simple modelling this is precisely the same
strategy is adopted, the general unrestricted model statistic as that for testing the hypothesis c = 0 in
(GUM) will have been chosen to embed the ( ), that is, the test statistic for ( M \ S M i ) is
different econometric models implementing rival exactly the same as that for M \ < $ p M Q in this
economic theories for the phenomenon of interest. case. Variance encompassing is based on the
Hence searching for the model that parsimoniously contrast i j / 2 = f f 2 — a 2 2 l between er2
a

encompasses the congruent GUM is an efficient and an estimator of er^j = a \ + (a \ / n ) b \

the pseudo-true value c \ under M i when Q2 = as the basis for parameter estimation. A consistent
estimator of the parameters involved in the
^I„ — Z2 (Z2 Z2 ) ' Z2 j. Mizon and Richard
encompassing contrast can be obtained when a
( ) showed that the resulting variance
correction based on the simulated pseudo-true
encompassing test statistic is asymptotically
values of the testing statistics is applied. This
equivalent to each of the one degree of freedom
approach has the potential to extend the application
non-nested test statistics developed by Cox ( ,
of the encompassing principle enormously. The
), Pesaran ( ), and Davidson and
relationship between encompassing and conditional
MacKinnon ( ), among others. The fact that
moment or m-tests (Newey ) is discussed in White (
variance dominance is a necessary but not a suffi-
) and Lu and Mizon
cient condition for variance encompassing high-
( ). The possibility that the encompassing
lights a serious limitation of choosing models on the
principle be used as a generator of test statistics is
basis of goodness-of-fit selection criteria rather than
discussed in Mizon and Richard ( ).
comparing the alternative models using
Govaerts et al. ( ) consider the application of
encompassing test statistics.
encompassing in dynamic models, and Hendry and
Mizon ( ) apply it to the comparison of
Further Developments alternative dynamic simultaneous equations models
containing integrated and cointegrated variables. A
This analysis illustrates the fact that the choice of Bayesian approach to encompassing is presented in
statistic for the encompassing contrast is very Florens et al. ( ) and, as a result
important, and may depend very much on the of using statistical procedures rather than pseudo-
purpose of the analysis or the nature of the models true values as in Mizon and Richard ( ),
being investigated. For example, when the GUM is argues that encompassing can be interpreted as a
not easily available or the calculation of pseudo- property of model specificity analogous to that of
true values for other encompassing test statistics is sufficiency for statistics. The encompassing rela-
difficult, comparison of the forecasting abilities tionship between nonparametric models is consid-
provides an alternative basis for an encompassing ered in Bontemps et al. ( ). Finally, Hendry
test. Although selecting models on the basis of et al. ( ) contains a comprehensive statement
forecast performance can be very misleading for and analysis of encompassing as well as many
some purposes in a non-stationary environment with applications of the principle.
regime shifts (Hendry and Mizon ), the concept of
forecast encompassing is a valuable method of
See Also
model comparison. Forecast encompassing statistics
were presented by Chong and Hendry ( ),
► Artificial ;
and Ericsson ( )
► orecasti
and Lu and Mizon ( ) extend this analysis in
► dodel Selection
several directions, including multi-step ahead
► Models
forecasts from nonlinear dynamic models with
► ’esting
estimated coefficients. Similarly, when the analytic
calculation of pseudo-true values is intractable
simulation methods may be used to estimate the Bibliography
pseudo-true values and hence compute the non-
Bontemps, C., and G. Mizon. 2003. Congruence and
nested test statistics (Hendry and Richard ; Pesaran encompassing. In Econometrics and the philosophy of
and Pesaran ). Gourieroux et al. ( ) developed a economics, ed. B. Stigum. Princeton: Princeton University
comprehensive frame Press.
Bontemps, C., J. Florens, and J. Richard. 2006. Encompassing
work for such simulation known as indirect infer-
in regression models: parametric and non-parametric
ence, which allows choice of auxiliary functions procedures. In Progressive modelling:
 Non-nested testing and encompassing, ed. M. Marcellino and Hendry, D.F., Marcellino, M. and Mizon, G.E., eds. 2008.
G. Mizon. Oxford: Oxford University Press. Oxford bulletin of economics and statistics, Special Issue
Chong, Y., and D. Hendry. 1990. Econometric evaluation of on Encompassing, 70, issue si, 711-939.
linear macro-economic models. In Modelling economic Lu, M., and G. Mizon. 1991. Forecast encompassing and
series, ed. C. Granger. Oxford: Clarendon. model evaluation. In Economic structural change, analysis
Cox, D. 1961. Tests of separate families of hypotheses. and forecasting, ed. P. Hackl and A. Westlund. Berlin:
Proceedings of the Fourth Berkeley Symposium on Springer.
Mathematical Statistics and Probability 1, 105-23. Berkeley: Lu, M., and G. Mizon. 1996. The encompassing principle and
University of California Press. hypothesis testing. Econometric Theory 12: 845-858.
Cox, D. 1962. Further results on tests of separate families of Mizon, G. 1984. The encompassing approach in econo-
hypotheses. Journal of the Roval Statistical Society B 24: 406- metrics. In Econometrics and quantitative economics, ed. D.
424. Hendry and K. Wallis. Oxford: Blackwell.
Davidson, R., and J. MacKinnon. 1981. Several tests for Mizon, G. 1989. The role of econometric modelling in
model specification in the presence of alternative economic analysis. Revista Espanola de Economia 6: 167-
hypotheses. Econometrica 49: 781-793. 191.
Davidson, J., D. Hendry, F. Srba, and J. Yeo. 1978. Econo- Mizon, G. 1995. Progressive modelling of macroeconomic
metric modelling of the aggregate time-series relationship time series: The LSE methodology. In Macroeconometrics:
between consumers’ expenditure and income in the Developments, tensions and
United Kingdom. Economic Journal 88: 661-692. prospects, ed. K. Hoover. Dordrecht: Kluwer Academic
Ericsson, N. 1993. Comment on ‘On the limitations of Press.
comparing mean squared forecast errors’, by M. P. Mizon, G., and J.-F. Richard. 1986. The encompassing
Clements and D. F. Hendry. Journal of Forecasting 12: 644- principle and its application to non-nested hypothesis
651. tests. Econometrica 54: 657-678.
Ericsson, N., and D. Hendry. 1999. Encompassing and Nagel, E. 1961. The structure of science. New York: Harcourt
rational expectations: How sequential corroboration can Brace.
imply refutation. Empirical Economics 24: 1-21. Newey, W. 1985. Maximum likelihood specification testing
Florens, J.-P., D. Hendry, and J.-F. Richard. 1996. and conditional moment tests. Econometrica 53: 1047-
Encompassing and specificity. Econometric Theory 12: 620- 1070.
656.^ Okasha, S. 2002. Philosophy of science: A very short introduction.
Gourieroux, C., and A. Monfort. 1995. Testing, Oxford: Oxford University Press.
encompassing, and simulating dynamic econometric Pesaran, M. 1974. On the general problem of model selection.
models. Econometric Theory 11: 195-228. Review of Economic Studies 41: 153-171.
Gourieroux, C., A. Monfort, andE. Renault. 1993. Indirect Pesaran, M., and B. Pesaran. 1993. A simulation approach to
inference. Journal of Applied Econometrics 8: 85-118. the problem of computing Cox’s statistic for testing non-
Govaerts, B., D. Hendry, and J.-F. Richard. 1994. nested models. Journal of Econometrics 57: 377-392.
Encompassing in stationary linear dynamic models. Schwarz, G. 1978. Estimating the dimension of a model.
Journal of Econometrics 63: 245-270. Annals of Statistics 6: 461-464.
Hendry, D. 1995. Dynamic econometrics. Oxford: Oxford White, H. 1994. Estimation, inference and specification analysis.
University Press. Cambridge: Cambridge University Press.
Hendry, D., and H.-M. Krolzig. 2003. New developments in
automatic general-tospedfic modelling. In Econometrics
and the philosophy of economics, ed. B. Stigum. Princeton:
Princeton University Press.
Hendry, D., and G. Mizon. 1993. Evaluating dynamic
econometric models by encompassing the VAR. In
Models, methods and applications of econometrics, ed. P.
Phillips. Oxford: Basil Blackwell.
Hendry, D., and G. Mizon. 2005. Forecasting in the presence Endogeneity and Exogeneity
of structural breaks and policy regime shifts. In
Identification and inference for econometric models: Festschrift
in Honor of Tom Rothenberg, ed. D. Andrews and J. Stock.
John Geweke
Cambridge, UK: Cambridge University Press.
Hendry, D., and J.-F. Richard 1989. Recent developments in
the theory of encompassing. In Contributions to operations
research and economics. The XXth anniversary of CORE, ed. B.
Comet and H. Tulkens. Cambridge, MA: MIT Press. Abstract
Endogeneity and exogeneity are properties of
variables in economic or econometric models.
The specification of these properties in
 restrictions on y may d e t e r m i n e y, at least
variables is an essential component of the pro-
for x C R : C R , but the existence of a
cess of model specification. This article con-
u n i q u e solution has no bearing on the
siders their application in the specification of, in
turn, deterministic and stochastic models. endogeneity and exogeneity of the variables.
The formal distinction between endogeneity and
Keywords exogeneity in econometric models was emphasized
Cowles Commission; Endogeneity and exo- by the Cowles Commission in its pathbreaking work
geneity; Model specification; Simultaneous on the estimation of simultaneous economic
equations models; Statistical inference relationships. The class of models it considered is
contained in the specification

JEL Classifications B(T)y(t) + r ( L ) x ( t ) =u(f);

C3 A(L)u(t) = e(f); cov[e(f), y(f

Endogeneity and exogeneity are properties of vari- — s)] = 0,.v > 0; cov[e(t),x(t
ables in economic or econometric models. The — s)] = 0,all.v;
specification of these properties for respective vari- e(t) ~IIDN(o,^).
ables is an essential component of die entire process
of model specification. The words have an ambig- The vectors x(f) and y(t) are observed, whereas u(t)
uous meaning, for they have been applied in closely and e(t) are underlying disturbances not observed
related but conceptually distinct ways, particularly but affecting y(t). The lag operator L is defined by
in the specification of stochastic models. We con- L x ( t) = x(t 1); the roots of |B(C)| and |A(C)| are
sider in turn the case of deterministic and stochastic assumed to have modulus greater than 1 , a stability
models, concentrating mainly on die latter. condition guaranteeing the non-explosive behaviour
A deterministic economic model typically of y given any stable path for x. The Cowles
specifies restrictions to be satisfied by a vector of Commission definition of exogeneity in this model
variables y. These restrictions often incorporate a (Koopmans and Hood , pp. 117-20) as set forth in
second vector of variables x, and the restrictions Christ ( , p. 156)
themselves may hold only if x itself satisfies certain is as follows:
An exogenous variable in a stochastic model is a
restrictions. The model asserts
variable whose value in each period is statistically
independent of the values of all the random distur-
\ / x e R , G(x, y) = 0. bances in the model in all periods.

The variables x are exogenous and the variables y All other variables are endogenous. In the proto-
are endogenous. The defining distinction between x typical model set forth above x is exogenous and y
and y is that y may be (and generally is) restricted is endogenous.
by x, but not conversely. This distinction is an The Cowles Commission distinction between
essential part of the specification of the functioningendogeneity and exogeneity applied to a specific
of the model, as may be seen from the trivial model, class of models, with linear relationships and nor-
mally distributed disturbances. The exogenous
VxeR1, x + y = 0. variables x in the prototypical model have two
important but quite distinct properties. First, the
The condition x + y 0 is symmetric in .r and y; the model may be solved to yield an expression for y(t)
further stipulation that x is exogenous and y is in terms of current and past values of x and e,
endogenous specifies that in the model .r restricts y
and not conversely, a property that cannot be y(0 = B(L)-1r(L)x(0 +B(L)-1A(L)s(t).
derived from x + y 0. In many instances the
Given suitably restricted x(t) (for example, all x {x(f), t < T + J}eR(T + J)
uniformly boimded, or being realizations of a
stationary stochastic process with finite variance) it there are no further restrictions on { y ( j ) , i
is natural to complete the model by specifying that < T}, for any ./ > 0. If the model in fact does
it is valid for all x meeting the restrictions, and this restrict {y(0, t < T } , then y is model
is often done. The variables x are therefore endogenous. As examples consider
exogenous here as x is exogenous in a deterministic Model 1:
economic model. A second, distinct property of
these variables is that in estimation x U ) (— oo < y(t) = ay(t — 1) + bx(t) + u(t),
t < oo) may be regarded as fixed, thus extending to x{t) = cx{t — 1) + o(t);
the environment of simultaneous equation models
methods of statistical inference initially designed Model 2:
for experimental settings. It was generally
y(t) = ay(t — 1) + bx(t) + u(t),
recognized that exogeneity in the prototypical
x{t) = cx{t — 1) + dy{t) + o(f);
model was a sufficient but not a necessary
condition to justify treating variables as fixed for
Model 3:
purposes of inference. If u(t) in the model is serially
independent (that is, A(Z) I) then lagged values of y y(t) = ay{t -!)
may also be treated as fixed for purposes of the +h{x(t) + E[x(t) | x(t — s), s > 0]} + u(t),
model; this leads to the definition of ‘predetermined x(t) = cx(t — 1) + v(t).
variables’ (Christ p. 227) following Koopmans and
Hood ( pp. 117-21): In each case w(t) and v(t) are mutually and seri-
ally independent, and normally distributed. The
A variable is predetermined at time t if all its current parameters are assumed to satisfy the usual stability
and past values are independent of the vector of
restrictions guaranteeing that x and y have normal
current disturbances in the model, and these distur-
bances are serially independent. distributions with finite variances. In all three
models y is model endogenous, and x is model
These two properties were not explicitly distin- exogenous in Models 1 and 3 but not 2. For estima-
guished in the prototypical model (Koopmans ; tion the situation is different. In Model 1, treating x
Koopmans and Hood ) and tended to remain (t), x ( l — 1 ) and y ( t — 1 ) as fixed
merged in the literature over the next quarter- simplifies inference at no cost; y i t — 1 ) is a
century (for example, Christ ; Theil ; Geweke ). By classic predetermined variable in the sense of
the late 1970s there had developed a tension Koopmans and Hood ( )
between the two, due to the increasing and Christ ( ). Similarly in Model 2, x ( l -
sophistication of estimation procedures in nonlinear 1)
models, treatment of rational expectations, and the and y ( l — 1 ) may be regarded as fixed for
explicit consideration of the respective dynamic purposes of inference despite the fact that x and v
properties of endogenous and exogenous variables are both model endogenous. When Model 3 is
(Sims , ; Geweke reexpressed
). Engle et al. ( ), drawing on this litera
ture and discussions at the 1979 Warwick Summer y(t) = ay(t — 1 ) + bx(t) + bcx(t — 1 ) + u(t),
Workshop, formalized the distinction of the two x(t) = cx(t — 1 ) + v(t),
properties we have discussed. Drawing on their
definitions 2.3 and 2.5 and the discussions in Sims ( it is clear that x ( t ) cannot be treated as fixed if
) and Geweke ( ), x is m o d e l the parameters are to be estimated efficiently since
e x o g there are cross-equation restrictions involving the
e n o u s if given (x(f), t < T } £ R(7) the parameter c. Model exogeneity of a variable is thus
model may restrict t < T } , but given neither a necessary nor a sufficient condition for
treating that variable as fixed for purposes of
 The condition that a set of variables can be See Also
regarded as fixed for inference can be formalized,
following Engleet al. ( ) along the lines given
in Geweke ( ). Let
X = [x(l),...,x(n)] and Y = [y(l),...,y(«)]

be matrices of n observations on the variables x and

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for statistical purposes? In Statistical inference in dynamic
using only L \ (Y| X, X \ ) , that is, x may be
economic models, ed. T.C. Koopmans. New York: Wiley.
regarded as fixed for purposes of inference. Koopmans, T.C., and W.C. Hood. 1953. The estimation of
The concepts of model exogeneity and weak simultaneous economic relationships. In Studies in
exogeneity play important but distinct roles in the econometric method, ed. W.C. Hood and T.C. Koopmans.
New York: Wiley.
construction, estimation, and evaluation of econo-
Sims, C.A. 1972. Money, income, and causality. American
metric models. The dichotomy between variables Economic Review 62: 540-552.
that are model exogenous and model endogenous is Sims, C.A. 1977. Exogeneity and causal ordering in mac-
a global property of a model, drawing in effect a roeconomic models. In New methods in business cycle
research, ed. C.A. Sims. Minneapolis: Federal Reserve
logical distinction between the inputs of the model
Bank of Minneapolis.
|.Y(7), / < 7'j G R ( T ) and the set of variables Theil, H. 1971. Principles of econometrics. New York: Wiley.
restricted by the model {y(t), t < T ) . Since
model exogeneity stipulates that {x(t), t < T
+ J ) places no more restrictions on {y(t), t <
T ) than does { \ ( t ) , t < T } , the
global property of model exogeneity is in principle
Endogenous and Exogenous Money
testable, either in the presence or absence of other
restrictions imposed by the model. When conducted Meghnad Desai
in the absence of most other restrictions this test is
often termed a ‘causality test’, and its use as a test
of specification was introduced by Sims ( ).
The distinction
between weakly exogenous and weakly endogenous The issue of endogeneity or exogeneity of money is
variables permits a simplification of the likelihood one that runs through the history of monetary
function that depends on the subset of the model’s theory, with prominent authors appearing to hold
parameters that are of interest to the investigator. It views on either side. Narrowly put, those who plug
is a logical property of the model: the same results for the exogeneity view take one or all among the
would be obtained using L (X| Y| / - ] . / - cluster of variables - price level, interest rate or real
2 ) , as using Z(Y| X, X f ) . The stipulation of
output - as being determined by movements in the
weak exogeneity is therefore not, by itself, testable. stock of money. Those who
hold the endogeneity view consider that the stock of can be defined. This macroeconomic model will
money in circulation is determined by one or all of consist of four variables P , Y , R and M
the variables mentioned above. This narrow whose exogenous/endogenous status is at debate.
definition begs several questions. The variables We subdivide them into the three non-monetary
price level (P ), interest rate ( R ) , real output variables P , Y , R labelled Aand money M .
(Y ) and money stock ( M ) are all at the There are of course other truly exogneous variables
macroeconomic level, i.e. in the context of a one- - tastes, technology, international variables - which
good economy. Some part of the continuing debate we label Z. Now we observe that the variables X
can be traced to the view held by various and M are correlated, i.e. jointly distributed condi-
participants in the controversy about whether such a tional upon the set of variables Z. The question of
high level of aggregation is appropriate, e.g. is there endogeneity or exogeneity of money is as to
a rate of interest? Another part of the debate refers whether the correlation between X and M can be
to the choice of money stock variable. Is it written in terms of Abeing a function of M and Z, or
commodity money (gold), fiat (paper) money, bank M being a function of A and Z. In econometric
deposits or a larger measure of liquidity that is to terms, can we partition the joint distribution of X
stand for t h e money stock? The problem can be and M into a c o n d i t i o n a l distribution of
dealt with even at a one-good level either in the X on M , Z and a marginal distribution of M on
context of a closed economy or an open economy Z (the exogenous money case) or a conditional
and either in an equilibrium or a disequilibrium distribution of M on X and Z and a marginal
context, static or dynamic, short ran or long run. distribution of X on Z. Thus when we say money is
The basic issue is about the direction of causality- exogenous it is exogenous with respect to X
money to other variables or other variables to variables but it could still be determined by Z
money. But as our understanding of the underlying variables; symmetrically for the X variables being
statistical theory concerning causality and exogenous. If M is influenced by the past values of
exogeneity has advanced in recent years, it must X as well as by Z though not by the current values
also be added that participants in the controversy of A, then Mis said to be weakly exogenous. Thus
conflate the exogeneity of a variable (especially of M may be controlled by monetary authorities but
money) with its c o n t r o l l a b i l i t y by they may be reacting to past behaviour of
policy. Strictly speaking one can have exogeneity Avariables. Then Mis determined by a reaction
without any presumption that the variable can be function and is only weakly exogenous. The same
manipulated by policy, for example rainfall. Also definition of weak exogeneity extends to the Z
once posed in a dynamic context, we should variables. Thus even international variables, such as
distinguish between weak exogeneity, which allows capital inflow, may be determined by past values of
for feedback from the endogenous to the exogenous A variables in which case they are weakly
variables over time, and strong exogeneity, which exogenous (for further detail, see Desai ). The best
does not allow such a feedback (Hendry et al. ). way to consider the issue of exogeneity of money is
Endogeneity or exogeneity are notions that only to specify the type of money economy envisaged -
make sense in the context of a model. Frequently in commodity money, paper money, credit money and
the past, there has been a failure to specify such a look at the variables likely to influence the supply
model, which has then allowed the controversy to of money and its relation with other variables.
continue.

Commodity Money
Some Definitions
Historically the argument about exogeneity is
To simplify matters, at the risk of putting off constructed around the Quantity Theory of Money,
readers, let us begin by specifying a small model which stated that the amount of money in
within whose context endogeneity and exogeneity circulation at any time determined the volume
of trade and if the amount went on increasing it are willing to ‘accommodate’ a greater volume of
would lead sooner or later to an increase in price. In trade, this can only be because they find it profitable
the context of commodity money, the proposition to do so. This increased profitability may be actual
concerned attempts by coining authorities to debase or perceived but it must be a result of an increase in
coinage by clipping or alloying it with inferior differential between the interest (discount) rate
metal. These were ways in which the amount of borrowers are willing to pay and the rate at which
money could be altered by policy manipulation and banks can acquire liquidity. Banks can then choose
then exogenously act upon prices. But in a to expand the ratio of credit to the cash base and
commodity money regime, the stock of money sustain a higher volume. Banks create inside money
could also be altered by influx of precious metal and inside money can only be regarded as
through gold discoveries and greater influx. These endogenous. But the extent to which a single bank
were exogenous variations not susceptible to policy can create money will depend on the behaviour of
manipulation but presumed an open economy. The the b a n k i n g s y s t e m . The banking
first statement of the quantity theory of money by system can by the cloakroom mechanism choose
David Hume starts with an illustration of an influx any ratio of credit to cash base. It is conceivable
of gold from outside and traces its effects first on though not likely that in such a system of inside
real economic activity and eventually on prices. In money, banks could arbitrarily, i.e. exogenously,
Hume’s quantity theory, money is exogenous but increase money supply. They must however base
not subject to policy manipulation. The opposite such an action on considerations of expected
view (argued by James Steuart for instance) was profitability'. We can envisage a situation in which
that it was the volume of activity that elicited the banks guided by ‘false’ expectations can sustain a
matching supply of money. This could be done credit boom by a bootstraps mechanism. This is the
partly by dis-hoarding on the parts of those who way in which a Wicksellian cumulative process
now expected a better yield on their stock. It could could sustain itself. An arbitrary, exogenous
also be altered if banks were willing to ‘accom- increase in inside money by the banking system
modate ’ a larger volume of bills (see Desai ). though possible is not very likely. It runs into the
Dis-hoarding implies that a portion of the money problems caused by the leakage of cash either
supply in c i r c u l a t i o n is endogenously internally (finite limits to the velocity of circulation
determined in a commodity money economy. It of cash) or abroad. It was the international leakage
could be argued that even the influx of gold could that was normally regarded as the most likely
have been caused by the discrepancy between the constraint since it caused outflow of gold - the
domestic and the world gold price, which in the International Gold Standard which provided the
18th century before a world gold market existed context for 19th-century theories in this imposed
could be substantial. In the latter case money would exogenous constraints on money supply by
be weakly exogenous as long as there were lags imposing a uniform gold price in all countries. In
between the appearance of discrepancy and the such a case, money is exogenous and not subject to
inflow of gold. policy manipulation. In as much as gold movements
are triggered by internal variables, it is weakly
exogenous.
Inside Money

Once however one introduces banks into the Outside Fiat Money
scheme of things, the issue of exogeneity becomes
complex. Till very recently we have lacked a theory It is the case of fiat money printed as the state’s
of banking behaviour of any degree of liability, i.e. as outside money, that provides the
sophistication, although in terms of institutional best illustration of exogenous money not subject to
description we have much knowledge. If banks any constraint. In a world where only paper
currency was used and it was printed by the mon- a greater part of the money stock endogenous. Thus
etary authorities, the stock of money could be while the narrow money base - currency in
exogenously determined. This would be additionally circulation and in central bank reserves - can be
so even if there was inside money as long as the regulated by the monetary authority, the connection
monetary authorities could insist that banks obeyed between money base and total liquidity in the
a strict cash to deposit ratio and there were no economy becomes highly variable. Banks will
substitutes for cash available beyond the control of expand their loan portfolio as long as the cost of
the monetary authorities. It is this view of money replenishing their liquidity does not exceed the
that most closely corresponds to Keynes’s interest rate they can earn on loans. The relation
assumptions in the G e n e r a l T l i e o i y between broad money (M3) and narrow money
and it is also in the monetarist theory of Milton ( M 0 ) becomes a function of the funding policy
Friedman. The banking system is a passive agent in concerning the budget deficit and the structure of
this view and given the cash base is always hilly interest rates. Thus the stock of narrow money can
loaned up. Thus given the amount of high powered be exogenous and policy determined. But the stock
money in the system providable only by the mon- of broad money is endogenous. A crucial recent
etary authorities, the supply of money is determined. element has been the financial revolution of the last
Even if the stock of money were exogenous, its decade (De Cecco ). A variety of financial
impact on the non-monetary variables X can be instruments - credit cards, charge cards, money
variable. This is because the velocity of circulation market fluids, interest-bearing demand deposits,
which translates the stock of money into money in electronic cash transfer - has made the ratio of cash
circulation need not be constant but variable. If the to volume of financial transactions variable though
velocity of circulation were not only a variable but with a steep downward trend. It has also increased
also a function of the X variables, then although the the number of money substitutes and made the cost
monetary authorities can determine the stock of of liquidity lower. The non-banking financial
money the influence of money on real variables is system thus can create liquidity by
not as predicted by the Quantity Theory. Thus it is ‘accommodating’ a larger volume of business,
not the exogeneity of money issue that divides advancing trade credit, allowing consumer debt to
monetarists and Keynesians but the determinants of increase etc. The velocity of circulation of cash
the velocity of circulation. For the monetarist, the increases very sharply in such a world and liquidity,
velocity of circulation ( M / P ■ Y ) has to a broader concept than even broad money, becomes
be independent of P , Y , R and M . For endogenous. Here again profitability of liquidity
Keynesians, the demand for money depends on the creation becomes the determining variable. But the
rate of interest crucially and the interest elasticity of financial revolution has also integrated world
demand for money is a variable tending to infinity financial markets and economies are increasingly
in a liquidity trap. open. Thus capital flows are rapid and respond to
minute discrepancies in the covered interest parity.
In such a world money is at best weakly exogenous
Modern Credit Economy but more usually endogenous. The issue of
exogeneity or endogeneity of money thus crucially
In a world with inside and outside money with a
depends on the type of money economy that one is
sophisticated banking system as well as a non-
considering - commodity money, paper money,
banking financial sector, the question of exogeneity
credit (mobile) money. It also depends on the
is the most complex. In the previous case of outside
sophistication of the banking and financial system
fiat money we assumed, that the cash ratio was
within which such money is issued. Debates over
fixed and adhered to by banks. It is when the banks’
the last two hundred years have used the word
reserve base contains government debt instruments -
money to cover a variety of situations. It has also
treasury bills, bonds, etc. - that the profit-
not been clarified whether the issue is exogeneity
maximizing behaviour of the banks renders
of money or its controllability and whether it is Keywords
merely the stock of money or its velocity as well Aggregate production function; Capital accu-
which is being considered. Once these issues have mulation; Competition; Creative destruction;
been clarified, the notion of exogeneity needs to be Economic growth; Endogenous growth; Human
defined in the modem econometric fashion, relative capital; Innovations; Intellectual capital;
to a model in order to decide whether money can be Intermediate products; Intertemporal utility
exogenous. It seems likely that the narrower the maximization; Law of large numbers; Marginal
definition of money stock, the more likely is it to product of capital; Neoclassical growth theory;
fulfil the requirement of (weak) exogeneity. Such Physical capital; Product variety; Productivity
exogeneity is necessary but not sufficient to growth; Research and development; Saving rate;
demonstrate that money determines the price level Schumpeterian growth; Steady state;
or the real economy. Technological progress; Technology;
Technology frontier; Total Factor productivity;
Transfer of technology * 04

See Also

► Capital, Credit and Money Markets JEL Classifications

► High-Powered Money ai the Monetary Base 04
► ..mctaiy Base
► i ai icy rj . .. ply Endogenous growth is long-mn economic growth at
► Quantity Theory of Money a rate determined by forces that are internal to the
economic system, particularly those forces
Bibliography governing the opportunities and incentives to create
technological knowledge.
De Cecco, M. 1987. Changingmoney: Financial innova- In the long run the rate of economic growth, as
tions in developed countries. Oxford: Blackwell. Desai, M. measured by the growth rate of output per person,
1981. Testing monetarism. London: Frances Pinter.
Hendry, D., R. Engle, and J.L. Richard. 1983. Exogeneity. depends on the growth rate of total factor produc-
Econometrica 51(2): 227-304. tivity (TFP), which is determined in turn by the rate
of technological progress. The neoclassical growth
theory of Solow ( ) and Swan ( )
assumes the rate of technological progress to be
determined by a scientific process that is separate
from, and independent of, economic forces. Neo-
classical theory thus implies that economists can
Endogenous Growth Theory
take the long-run growth rate as given exogenously
Peter Howitt from outside the economic system.
Endogenous growth theory challenges this neo-
classical view by proposing channels through which
the rate of technological progress, and hence the
long-run rate of economic growth, can be
Abstract
influenced by economic factors. It starts from the
Endogenous growth theory explains long-mn
observation that technological progress takes place
growth as emanating from economic activities
through innovations, in the form of new products,
that create new technological knowledge. This
processes and markets, many of which are the result
article sketches the outlines of the theory,
of economic activities. For example, because firms
especially the ‘Schumpeterian’ variety, and
learn from experience how to produce more
briefly describes how the theory has evolved in
efficiently, a higher pace of economic
response to empirical discoveries.
activity can raise the pace of process innovation by 1 dY 8 ~Y 1 dK
-------= sA — 8.
giving firms more production experience. Also, ~dt K dt
because many innovations result from R&D
expenditures undertaken by profit-seeking firms, Hence an increase in the saving rate s will lead to a
economic policies with respect to trade, competi- permanently higher growth rate.
tion, education, taxes and intellectual property can Romer ( ) produced a similar analysis with
influence the rate of innovation by affecting the a more general production structure, under the
private costs and benefits of doing R&D. assumption that saving is generated by
intertemporal utility maximization instead of the
fixed saving rate of Frankel. Lucas ( ) also
AK Theory produced a similar analysis focusing on human
capital rather than physical capital; following
The first version of endogenous growth theory was Uzawa ( ) he explicitly assumed that human
AK theory, which did not make an explicit capital and technological knowledge were one and
distinction between capital accumulation and the same.
technological progress. In effect it lumped together
the physical and human capital whose accumulation
is studied by neoclassical theory with the Innovation-Based Theory
intellectual capital that is accumulated when
innovations occur. An early version of AK theory AK theory was followed by a second wave of
was produced by Frankel ( ), who endogenous growth theory, generally known as
argued that the aggregate production function can ‘innovation-based’ growth theory, which recognizes
exhibit a constant or even increasing marginal that intellectual capital, the source of technological
product of capital. This is because, when firms progress, is distinct from physical and human
accumulate more capital, some of that increased capital. Physical and human capital are accumulated
capital will be the intellectual capital that creates through saving and schooling, but intellectual
technological progress, and this technological capital grows through innovation.
progress will offset the tendency for the marginal One version of innovation-based theory was
product of capital to diminish. initiated by Romer ( ), who assumed that
In the special case where the marginal product aggregate productivity is an increasing function of
of capital is exactly constant, aggregate output Fis the degree of product variety. In this theory, inno-
proportional to the aggregate stock of capital K \ vation causes productivity growth by creating new,
but not necessarily improved, varieties of products.
Y = AK (1)
It makes use of the Dixit-Stiglitz-Ethier production
where A is a positive constant. Hence the term function, in which final output is produced by
‘AK theory’. labour and a continuum of intermediate products:
According to AK theory, an economy’s long-
run growth rate depends on its saving rate. For
Y = L 1 —a x(i)adi, 0 < a < 1 ( 2)
example, if a fixed fraction s of output is saved
and there is a fixed rate of depreciation 8 , the rate
of aggregate net investment is: where L is the aggregate supply of labour
(assumed to be constant), x ( i ) is the flow input
of intermediate product i , and A is the measure
dK of different intermediate products that are available
dt sY - 8K
for use. Intuitively, an increase in product variety,
as measured by A , raises productivity by allowing
which along with ( ) implies that the growth rate is society to spread its intermediate production more
given by: thinly across a larger number of activities, each of
which is subject to diminishing returns and hence in sector i consists of a new version whose pro-
exhibits a higher average product when operated at ductivity parameter A exceeds that of the previous
a lower intensity. version by the fixed factor y > 1. Suppose that the
The other version of innovation-based growth probability of an innovation arriving in sector
theory is the ‘Schumpeterian’ theory developed by i over any short interval of length d t is j i ■
Aghion and Howitt ( ) and Grossman and d i .
Helpman ( ). (Early models were produced by Then the growth rate of A ( i ) is
Segerstrom et al. and Corriveau ).
Schumpeterian theory focuses on qualityimproving dA(i) 1
innovations that render old products obsolete, A(i) dt
through the process that Schumpeter ( ) (y — 1 ) • ~ r with probability g •
d t
called ‘creative destruction.’ d t
In Schumpeterian theory aggregate output is
again produced by a continuum of intermediate 0 with probability 1 —
products, this time according to:
f t ■ d t

L 1—OCA(i)
1 a
Y x(i)adi, (3) Therefore the expected growth rate of A ( i )
Jo

where now there is a fixed measure of product is:

variety, normalized to unity, and each intermediate
product i has a separate productivity parameter E( gg)==1R/A
K y - !)• (6)
(5)
A ( i ) . Each sector is monopolized and
where R is the amount of final output spent on
produces its intermediate product with a constant
R&D, and where the division by A takes into
marginal cost of unity. The monopolist in sector i
faces a demand curve given by the marginal account the force of increasing complexity. That is,
product: a ■ (A ( i ) L / x ( i ) ) ] “ of that as technology advances it becomes more complex,
intermediate input in the final sector. Equating and hence society must make an ever- increasing
marginal revenue ( a time this marginal product) expenditure on research and development just to
to the marginal cost of unity yields the monopolist’s keep innovating at the same rate as before.
profit- maximizing intermediate output: It follows from ( ) that the growth rate g of
aggregate output is the growth rate of the average
productivity parameter A . The law of large num-
x(i) = ^LA(i)
bers guarantees that g equals the expected growth
where c = or" ' l >
. Using this to substitute for rate ( ) of each individual productivity parameter.
each A'(/) in the production function ( ) yields the From this and ( ) we have:
aggregate production function:

Y = 6AL (4) 8 = (7 - l)M/A.

where 0 = t“, and where A is the average produc- From this and ( ) it follows that the growth rate
tivity parameter: depends on the fraction of GDP spent on research
and development, n = R / Y , according to:
■I
A= A(i) di.
Jo 8 = { y - \ )MLn. (7)

Innovations in Schumpeterian theory create

improved versions of old products. An innovation
of output but to devote a large fraction of output to is, according to the growth Eq. an increase in the
research and development. The theory is explicit size of population should raise long-run growth by
about how R&D activities are influenced by various increasing the size of the workforce L , thus
policies, who gains from technological progress, providing a larger market for a successful innovator
who loses, how the gains and losses depend on and inducing a higher rate of innovation. But in fact
social arrangements, and how such arrangements productivity growth has remained stationary during
affect society’s willingness and ability to create and a period when population, and in particular the
cope with technological change, the ultimate source number of people engaged in R&D, has risen
of economic growth. dramatically. The models of Dinopoulos and
Thompson ( ), Peretto ( ) and Howitt
( ) counter this criticism by incorporating
Empirical Challenges Young’s ( ) insight that, as an economy
grows, proliferation of product varieties reduces the
Endogenous growth theory has been challenged on effectiveness of R&D aimed at quality improvement
empirical grounds, but its proponents have replied by causing it to be spread more thinly over a larger
with modifications of the theory that make it number of different sectors. When modified this
consistent with the critics’ evidence. For example, way the theory is consistent with the observed
Mankiw et al. ( ), Barro and Sala-i- coexistence of stationary TFP growth and rising
Martin ( ) and Evans ( ) showed, using population, because in a steady state the growth-
data from the second half of the 2 0 th century, that enhancing scale effect is just offset by the growth-
most countries seem to be converging to roughly reducing effect of product proliferation.
similar long-run growth rates, whereas endogenous As a final example, early versions of
growth theory seems to imply that, because many innovation-based growth theory implied, counter to
countries have different policies and institutions, much evidence, that growth would be adversely
they should have different long-run growth rates. affected by stronger competition laws, which by
But the Schumpeterian model of Howitt ( ), reducing the profits that imperfectly competitive
which incorporates the force of firms can earn ought to reduce the incentive to
technology transfer, whereby the productivity of innovate. However, Aghion and Howitt ( ,
R&D in one country is enhanced by innovations in ch. 7) describe a variety of channels through which
other countries, implies that all countries that competition might in fact spur economic growth.
perform R&D at a positive level should converge to One such channel is provided by the work of
parallel long-mn growth paths. Aghion et al. ( ), who show that, although
The key to this convergence result is what an increase in the intensity of competition will tend
Gerschenkron ( ) called the ‘advantage of to reduce the absolute level of profits realized by a
backwardness’; that is, the further a country falls successful innovator, it will nevertheless tend to
behind the technology frontier, the larger is the reduce the profits of an unsuccessful innovator by
average size of innovations, because the larger is even more. In this variant of Schumpeterian theory,
the gap between the frontier ideas incorporated in more intense competition can have a positive effect
the country’s innovations and the ideas incorporated on the rate of innovation because firms will want to
in the old technologies being replaced by escape the competition that they would face if they
innovations. This increase in the size of innovations lost whatever technological advantage they have
keeps raising the laggard country’s growth rate until over their rivals.
the gap separating it from the frontier finally Much more work needs to be done before we
stabilizes. can claim to have a reliable explanation for why
Likewise, Jones ( ) has argued that the economic growth is faster in some countries and in
evidence of the United States and other OECD some time periods than in others. But the fact that
countries since 1950 refutes the ‘scale effect’ of much of the cross-country variation in growth rates
Schumpeterian endogenous growth theory. That
is attributable to differences in productivity growth Peretto, P.F. 1998. Technological change and population
rather than differences in rates of capital accumula- growth. Journal of Economic Growth 3: 283-311.
Rorner, P.M. 1986. Increasing returns and long-run growth.
tion suggests that endogenous growth theory, which Journal of Political Economy 94: 1002-1037.
aims to provide an economic explanation of these Rorner, P.M. 1990. Endogenous technological change.
differences in productivity growth, will continue to Journal of Political Economy 98: S71-S102. Schumpeter,
J.A. 1942. Capitalism, socialism and democracy. New York:
attract economists’ attention for years to come.
Harper.
Segerstrom, P.S., T.C.A. Anant, and E. Dinopoulos. 1990. A
Schumpeterian model of the product life cycle. American
Economic Review 80: 1077-1091.
See Also Solow, R.M. 1956. A contribution to the theory of economic
growth. Quarterly Journal of Economics 70: 65-94. ""
► Schump Swan, T.W. 1956. Economic growth and capital accumu-
lation. Economic Record 32: 334-361.
Uzawa, H. 1965. Optimal technical change in an aggregative
model of economic growth. International Economic Review 6: 18-
31.
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Economy 106: 41-63.
Aghion, P., and P. Howitt. 1992. A model of growth through
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Aghion, P, and P. Howitt. 1998. Endogenous growth theory.
Cambridge, MA: MIT Press.
Aghion, P, C. Harris, P. Howitt, and J. Vickers. 2001.
Competition, imitation and growth with step-by-step
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Barro, R.J., and X. Sala-i-Martin. 1992. Convergence. Journal Endogenous Market Incompleteness
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Corriveau, L. 1991. Entrepreneurs, growth, and cycles. Christopher Sleet
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Dinopoulos, E., and P. Thompson. 1998. Schumpeterian
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Evans, P. 1996. Using cross-country variances to evaluate
Abstract
growth theories. Journal of Economic Dynamics and Control 20:
1027-1049. Endogenously incomplete models derive restric-
Frankel, M. 1962. The production function in allocation and tions on asset trading from primitive constraints
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available to societies. They have been applied to
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Hoselitz. Chicago: University of Chicago Press. a wide variety of macroeconomic problems. This
Grossman, G.M., and E. Helpman. 1991. Innovation and growth in article reviews some of these applications and
the global economy. Cambridge, MA: MIT Press. the models that underpin them.
Howitt, P. 1999. Steady endogenous growth with population
and R&D inputs growing. Journal of Political Economy 107:
715-730. Keywords
Howitt, P. 2000. Endogenous growth and cross-country Asset pricing models; Autarky; Bilateral insur-
income differences. American Economic Review 90: 829-846. ance games; Commitment; Default; Dynamic
Jones, C.I. 1995. R&D-based models of economic growth.
Journal of Political Economy 103: 759-784.
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Lucas, R.E. Jr. 1988. On the mechanics of economic devel- markets; Equity premium; Euler equations;
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Taxation of assets

JEL Classifications
D4; D10
An asset trading arrangement is incomplete if it is allocations; shocks that cannot be smoothed over
too restrictive to ensure a fully Pareto-optimal states are smoothed over time instead, ensuring that
allocation of risk. Endogenously incomplete models individual consumption is persistent even when
derive such trading arrangements from primitive aggregate consumption is not.
frictions. They are to be contrasted with models that Constrained-efficient allocations in limited
a s s u m e a particular incomplete asset markets enforcement economies can be decentralized using
structure. a complete set of Arrow security markets coupled
Recent contributions to the endogenous incom- with endogenous debt limits (see Alvarez and
pleteness literature have emphasized imperfections Jermann ). Intuitively, agents can borrow only up to
in the enforcement and monitoring technologies the amount that they are willing to pay back in the
available to societies. They derive endogenous future given that the penalty for default is
market structures, sometimes supplemented with a consignment to autarky. Thus, the limited
tax system, as decentralizations of planning prob- enforcement friction provides a micro-foundation
lems in which the planner faces one or both of these for the often-made assumption of a debt limit tighter
imperfections. These market-tax structures ensure than that implied by an agent’s intertemporal budget
that agents are provided with incentives to honour constraint. In the limited enforcement case,
promises that cannot be costlessly enforced or that however, the debt limit is state-contingent; it
are contingent on states that cannot be costlessly depends upon the value of autarky to the agent.
observed. By construction they admit equilibria that Since this value is a function of individual and
are constrained efficient. aggregate shocks, the parameters of the shock
Models with endogenous incompleteness have process and, in richer models, the agent’s
received a variety of applications in macroeco- opportunities for self- or public insurance after
nomics. They have been used to enhance under- exclusion from markets, so too is the debt limit.
standing of risk sharing, asset pricing and business When agents’ endogenous debt limits periodi-
cycles; on the normative side they have been cally bind, risk sharing is disrupted; individual
applied to analyses of optimal fiscal policy. Here 1 consumption, conditional on the aggregate state, is
review some of these applications and the models positively correlated with current and past indi-
that underpin them. vidual income. Qualitatively, such departures from
full risk-sharing cohere well with evidence on
individual consumption. In Alvarez and Jermann’s (
Limited Enforcement ) quantitative analysis of a cali
brated limited enforcement model, the endogenous
The canonical example of a limited enforcement debt limits bind fairly often and permit relatively
model is the bilateral insurance game of little risk sharing. This is consistent with evidence
Kocherlakota ( ). In this game, two risk- on the sharing of low- frequency risks. Alvarez and
averse agents are endowed with random and Jermann’s analysis also has implications for asset
imperfectly correlated income processes. Neither pricing. They obtain a volatile asset pricing kernel
agent can be compelled to deliver resources to the and risk premia that are large and time varying.
other, even if they have promised to do so in the These implications are consistent with asset pricing
past. data, but contrast with those of the benchmark
Equilibrium allocations in this setting can be representative agent asset pricing model.
implemented with strategies that revert to autarky Cross-country consumption data also exhibit
following an agent defection. Agents with high- apparent departures from full risk sharing. Standard
income shocks can be induced to share some of models (with complete markets) imply co-
their resources by the threat of such reversion and, movements in consumption that exceed those in
when this is insufficient, by promises of extra output, yet the data suggests the reverse. Kehoe
resources in the future. Such promises introduce
additional dynamics into optimal equilibrium
and Pern ( ) show that a limited enforcement the optimal consumption allocation, this equation is
model augmented with production and physical given by:
capital accumulation can go some way to explaining
this anomaly.
Recent papers have considered alternative = j8 A,+i {z‘+1)E, -\-1
-t

penalties for default including the confiscation of an w (c*{z‘,e‘)) U'iC t-\-1 /

endogenously valued collateral asset (see, Lustig ) (1 )
or the payment of a fixed default cost (Cooley et
al. ). These contributions illustrate the scope of Here 6‘ denotes an agent’s period t history of
limited enforcement models: Lustig explores the privately observed shocks, z and z * + 1 denote t
implications of endogenously valued collateral for and t + 1 histories of observable aggregate
asset pricing and obtains a large and time-varying shocks, /? is the agent’s discount factor and «' her
price of risk; Cooley, Marimon and Quadrini marginal utility of consumption. i is a social
examine the role of limited enforcement frictions in stochastic discount factor (SSDF) that ‘prices’
propagating business cycle shocks. Cordoba ( ) and resources delivered after each history z + 1 .
Arpad and Carceles-Poveda ( ), however, Golosov et al. ( ) show that such equations
sound cautionary notes. They provide calibrated hold in a large class of dynamic moral hazard
models in which the introduction of collateral models. They imply a wedge between an agent’s
relaxes endogenous debt limits so much that agents conditional expected intertemporal marginal rate of
can fully diversify risk. substitution (IMRS) and the SSDF. This wedge
provides a rationale for asset taxation; intuitively,
agents must be discouraged from saving at date t
since greater wealth at t + 1 undermines incen-
Private Information tives at that date. However, the implications for
asset taxation are subtle. The optimal allocation
An alternative line of research has analysed envi- cannot be implemented with an asset tax that merely
ronments in which risk-averse agents privately ‘matches the wedge’ and equates the conditional
observe shocks to their endowments, tastes or expectation of an agent’s IMRS to the SSDF.
productivity (see, for example, Atkeson and Instead, marginal asset taxes at t + 1 are used to
Lucas ). In this setting, agents must be provided generate a positive covariance between the after-tax
with incentives to reveal information. The socially asset return and the agent’s consumption that deters
efficient provision of incentives requires the savings. In some cases, the expected asset tax is
conditioning of current consumption on an agent’s zero and the wedge is entirely generated by this
history of shock reports. Intuitively, agents are covariance effect.
rewarded for reporting a low current need for Positive analyses of dynamic moral hazard are
resources with the promise of more consumption in relatively scarce. Green and Oh ( ) contrast
the future. Thus, intertemporal consumption the empirical implications of various incomplete
smoothing is enhanced and interstate smoothing market models, including those with moral hazard.
disrupted. Kocherlakota and Pistaferri ( ) identify
Albanesi and Sleet ( ) and Kocherlakota X t + ! with the market discount factor, assume that
( ) show that optimal information-constrained utility has the constant relative risk aversion prop-
allocations can be implemented with a mixture of erty and use ( ) to derive expressions for X t + i
non-contingent debt markets and taxes. Thus, these in terms of cross-sectional moments of the
authors derive joint restrictions on the market consumption distribution. They then investigate the
structure a n d the tax system from primitive implications of this dynamic moral hazard model for
informational frictions. Central to their analyses is asset pricing and, in particular, the equity premium
an ‘inverted Euler equation’. If {c*}“Q denotes and risk-free rate. They find that plausible
values of the coefficient of relative risk aversion set adopt a debt-trading policy consistent with truthful
the equity premium pricing error to zero. revelation of its spending needs. This limits its
In all of tiie dynamic moral hazard models ability to buy claims against high spending-needs
described so far, the consumption of agents is states and sell them against low spending-needs
observable. An alternative assumption is that agents ones. The outcome is enhanced intertemporal, as
can undertake asset trades that are hidden from opposed to inter-state, smoothing of taxes.
society. Agents must now be given incentives to The optimal allocations and market-tax
reveal information a n d save an appropriate implementations implied by dynamic moral hazard
amount. This places additional constraints on risk models also involve promises from a planner (or
sharing. When agents can control their publicly government) to an agent. These allocations often
observable histories and can save at the prices entail the absorption of almost all agents by a
implied by an exogenously given sequence of minimal utility immiserating state; they thus place
SSDFs, these constraints are severe. In this case, the strong demands on the planner’s ability to commit.
optimal allocation is identical to that in an economy Sleet and Yeltekin ( ) remove this
with riskless debt (see Cole and Kocherlakota ). ability. They show that optimal allocations without
This result is important as it provides a micro- planner commitment solve the problems of
foundation for models that exogenously restrict c o m m i t t e d planners who discount the
agents to the trading of such debt. future l e s s h e a v i l y than agents.
Coupling this result with the work of Farhi and
Weming ( ), who directly
Government Incentive Problems assume a planner discount factor in excess of the
agents, suggests that constrained optimal allocations
Governments or mechanism designers may also can be implemented with non-contingent debt, an
have difficulty keeping their promises. There is a income tax and a progressive estate tax. Analysis of
long tradition of considering commitment problems dynamic moral hazard models without societal
in Ramsey models. In these, a socially benevolent commitment is, however, still in its infancy and
government typically has access to a restricted set much remains to be done.
of linear tax mechanisms and an asset market in
which it can trade claims to resources. E x
a n t e optimal policy entails implicit promises See Also
over future allocations and, in particular, the
► . t and Enforcement Constraints
expected value of the government’s future stream of
►I: il Fiscal and Monetary Policy (Without
primary surpluses that it is rarely in the
government’s interests to keep. For example, if the
► • nice
government can default on its debt it will, since in
this way it can avoid the distortionary taxes
necessary for debt repayment. As in the limited- Bibliography
enforcement models described above, reversion to Albanesi, S., and C. Sleet. 2006. Dynamic optimal taxation
autarky after a default can sustain some equilibrium with private information. Review of Economic Studies
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Alvarez, F., and U. Jermann. 2000. Efficiency, equilibrium
implies a tight endogenous debt limit (Chari and
and asset pricing with risk of default. Econometrica 6K:
Kehoe ). Sleet ( ) 775-797.
and Sleet and Yeltekin ( ) consider models in Alvarez, F., andU. Jermann. 2001. Quantitative asset pricing
which the government’s true spending needs are not implications of endogenous solvency constraints.
Review of Financial Studies 14: 1117-1151.
publicly observable. Although the government has
Arpad, A., and E. Carceles-Poveda. 2005. Endogenous trading
access to a complete set of contingent claims constraints with incomplete markets, Working paper. University
markets, in equilibrium it is required to of Rochester.
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with private information. Review of Economic Studies 59: and regulatory structures; distributional and
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environmental consequences; economically
Journal of Economic Theory 60: 175-195. efficient use. The fact that energy use is dom-
Cole, H., and N. Kocherlakota. 2001. Efficient allocations inantly depletable resources, particularly fossil
with hidden income and storage. Review of Economic fuels, makes this study unique. The energy
Studies 68: 523 542.
Cooley, T., R. Marimon, and V. Quadrini. 2004. Aggregate
industry has moved into the 2 1 st century with
consequences of limited contract enforceability. Journal of promises of both profits and a short-term future.
Political Economy 1 12: 817-847. With added pressure from government, cleaner
Cordoba, J.-C. 2005. US inequality: Debt constraints or fuels are being introduced on a continual basis.
incomplete markets '. Working paper. Rice University.
Farhi, E., and I. Weming. 2005. Inequality, social discounting
Additionally, the expanding energy demand
and estate taxation, Working paper No. 11408. Cambridge, from developing countries is changing the
MA: NBER. energy market.
Golosov, M., N. Kocherlakota, and A. Tsyvinski. 2003.
Optimal indirect and capital taxation. Review of Economic
Studies 70: 569 587. Keywords
Green, E., and S. Oh. 1991. Contracts, constraints and Conservation; Depletable resources; Derived
consumption. Review of Economic Studies 58: 883-899. demand; Dynamic models; Ecological eco-
Kehoe, P., and F. Pern. 2002. International business cycles
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nomics; Energy economics; Energy policies;
907 928. Environmental economics; Essential goods;
Kocherlakota, N. 1996. Implications of efficient risk sharing Framework Convention on Climate Change;
without commitment. Review of Economic Studies Intertemporal choices; Kyoto protocol; Oil;
63: 595 609.
Kocherlakota, N. 2005. Zero expected wealth taxes: A
Organization of Petroleum Exporting Countries;
Mirrleesian approach to dynamic optimal taxation. Renewable resources; Strategic petroleum
Econometrica 73: 1587 1622. reserve (USA)
Kocherlakota, N., and L. Pistaferri. 2005. Asset pricing
implications of Pareto optimality with private information,
Discussion paper No. 4930. London: CEPR.
Lustig, H. 2005. The market price of aggregate risk and the wealth JEL Classifications
distribution, Working paper No. 11132. Cambridge, MA: Q4
NBER.
Sleet, C. 2004. Optimal taxation with private government
Energy is crucial to the economic progress and
information. Review of Economic Studies 71: 1217-1239.
social development of nations.
Sleet, C., and S. Yeltekin. 2006a. Optimal taxation with
Energy can be neither created nor destroyed but
endogenously incomplete markets. Journal of Economic
Theory 127: 36-73. its form can be changed. Energy comes from the
Sleet, C., and S. Yeltekin. 2006b. Credibility and endogenous
physical environment and ultimately returns there.
societal discounting. Review of Economic Dynamics 9: 410-
The demand for energy is a derived demand. The
437.
value of energy is assessed by its ability to provide
a set of desired services in both industry and in the
household.
Energy commodities are economic substitutes.
Energy Economics Energy resources are depletable or renewable and
storable or non-storable. On a global scale the 2 0 th
Robin Sickles and Hillard G. Huntington
century was dominated by the use of fossil fuels.
According to the US Department of Energy, in the
year 2 0 0 0 global commercial energy consumption
consisted of petroleum (39 per cent), coal (24 per
Abstract cent), natural gas (23 per cent), hydro ( 6 per cent),
Energy economics studies energy resources and nuclear (7 per cent) and others (1 per cent). In 1999,
energy commodities. It includes forces of the total sources of energy
motivating firms and consumers to supply.
consumed in the United States, 92 per cent were demand given a one per cent change in income
from depletable resources and only 8 per cent from holding all else constant, or
renewable resources (EIA ). No one doubts that
fossil fuels are subject to depletion, and that %Ae de y
y
depletion leads to scarcity, which in turn leads to %Ay dy e
higher prices. Resources are defined as ‘non-
conventional’ when they cannot be produced where e denotes energy demand and y denotes
economically at today’s prices and with today’s income. ‘The household sector’s share of aggregate
technology. With higher prices, however, the gap energy consumption tends to fall with income, the
between conventional and non- conventional oil share of transportation tends to rise, and the share of
resources narrows. Ultimately, a combination of industry follows an inverse-U pattern’ (Judson et al.
escalating prices and technological enhancements ).
can transform the non- conventional into the The price elasticity of energy demand is defined
conventional. Much of the pessimism about oil as the percentage change in energy demand given a
resources has been focused entirely on conventional one per cent change in price, with all else held
resources. constant, or

%Ae de p Sp %Ap
Demand for Energy dp' e

Bohi and Toman ( ) suggest a link between where p denotes the price of energy.
energy and economy. An abundance of empirical Cooper ( ) uses a multiple regression
research suggests a strong correlation between model derived from an adaptation of Nerlove’s (
increases in oil prices and decreases in macroeco- ) partial adjustment model to estimate both
nomic performance for oil-importing industrialized the short-run and the long-mn elasticity of demand
countries. Higher import costs may lead to higher for crude oil in 23 countries over a 30-year period
price levels and inflation. from 1971 to 2000. The estimates so obtained
Industrial energy demand increases most rapidly confirm that the demand for cmde oil
at the initial stages of development, but growth internationally is highly insensitive to changes in
slows steadily throughout the industrialization price.
process (Medlock and Soligo ). Energy demand for
transportation rises steadily, and takes the major
Demand Substitution Between Energy
share of total energy use at the latter stages of
Commodities and Others
developments.
Denny et al. ( ) used time-series data for
Elasticity of Energy Demand 18 US manufacturing two-digit industries (1948-
Is energy an essential good? In economics, an 1971) and 18 Canadian manufacturing industry
essential good is one for which the demand remains groups (1962-1975). Their results were also mixed:
positive no matter how high its price. Energy is for both the United States and Canada, energy and
often described as an essential good because human capital were substitutes in the food industry, but
activity would be impossible absent use of energy. they were complements in the tobacco industry.
Although energy is essential to humans, neither Energy consumption can be modelled either as
particular energy commodities nor any purchased providing utility to households or as an input in the
energy commodities are essential goods because production process for firms. To express the former
consumers can convert one form of energy into problem mathematically, a representative consumer
another. maximizes utility, U ( z , e ) , which is function
The income elasticity of energy demand is of energy consumption, e , and all other
defined as the percentage change in energy
consumption, z, subject to the constraint that subject to p,tz, + pele, + pk,it + s,
expenditures cannot exceed income, y . Let the <y, + (f + r ) s ,-1
energy variable be a vector of n energy products, e
= ( e i , e 2 , ... , e „ ) ; we could it = 8)k,-i
examine the substitution possibilities across energy
products. Allowing the price of good j to be z „ u h k , > Ofor t = 1, . . . ,
represented as p j , the consumer is assumed to
T
max 7 U Medlock and Soligo ( ) indicate that the
-------------U{z,e\, . ,.e„)
€ \ , .••C n income elasticity of passenger vehicle demand is
decreasing as the real GDP per capita increases, no
subject to : y > p : Z + p e i e i + ... + matter in the long run or in the short run. For
p e e n .
example, with 1988 purchasing power parity dollar,
The first order necessary conditions for a max- if the real GDP per capita is $500, the short- run
imum for this problem can be solved to yield elasticity is 0.74 and the long-run elasticity is 3.61;
demand equations for each of the energy products if the real GDP per capita is $20,000, the short-run
and for all other consumption. With some adjust- and the long-run elasticity are 0 . 0 2 and 0.09,
ments, the above method can be applied to a respectively.
representative firm.
Recent research focuses mainly on dynamic
models. Dynamic models allow for a more complete Energy Supply
analysis of the energy demand because they are
OPEC
capable of capturing factors that generate the
The Organization of the Petroleum Exporting
asymmetries. In addition, dynamic models incor-
Countries (OPEC) comprises countries that have
porate the intertemporal choices that a consumer/
organized for the purpose of negotiating with oil
firm must make when maximizing utilities or profits
companies on matters of petroleum production,
over some time horizon. Medlock and Soligo ( )
prices, and future concession rights. Founded on 14
developed a useful framework.
September 1960 at a Baghdad conference, OPEC
Let z, be multiple types of capital and e t be mul-
originally consisted of only five countries - Iran,
tiple types of energy consumption. Denoting time
Iraq, Kuwait, Saudi Arabia and Venezuela - but has
using the subscript t , the consumer will maximize
since expanded to include several others: Algeria,
the discounted sum of lifetime utility,
T Indonesia, Libya, Nigeria, Qatar and United Arab
f > ' U ( : t . e , ) , subject to the Emirates. The members of OPEC, which constitute
constraint whereby
t=o a cartel, agree on the quantity and the prices of the
capital goods purchases d j , purchases of other oil exported. OPEC seeks to regulate oil production,
goods ( z j , purchases of energy ( e t ) , and and thereby manage oil prices, primarily by setting
savings ( S f ) in each period cannot exceed this quotas for its members. Member countries hold
period’s income (v,), plus the return of last period’s about 75 per cent of the world’s oil reserves, and
saving ((1 + ;-).v, ,). It is assumed that capital goods supply 40 per cent of the world’s oil. Loury ( ) is
depreciate at a rate 8 , savings earn a rate return an excellent clar
r , the discount rate is 0 < j l < 1 , and all ification; it studies a dynamic, quantity-setting
initial conditions are given. duopoly game. The author considers a model of
Consumers will competition between two independent firms, A and
B , facing indivisibility in production, with given
T limitations on their cumulative capacities to
max P'U(zhe,) produce. At date t the flow rates of production of
2 , 6, 5 *—■f f=0

firms A and B are denoted by gfand ^respectively.

The demand side of the market is passively has been successful at increasing the price of oil for
modelled; buyers do not behave strategically. There extended periods. Much of OPEC ’s success can be
is an inverse demand function, P ( - ) , which is attributed to Saudi Arabia’s flexibility. It has
time invariant and dependent only on the total rate tolerated cheating on the part of other cartel
of flow of output of the two firms. Define the members, and cut its own production to compensate
discount factor 6 \ a dollar received on date t is for other members exceeding their production
worth dollars at date zero. Then their respective quotas. This actually gives them good leverage
payoffs are IT and V b where: because, with most members at full production,
Saudi Arabia is the only member with spare
[#/>(&)]; a n d V B capacity and the ability to increase supply, if
t
needed. The policy has been successful. However,
OPEC’s ability to raise prices does have some
t limits. An increase in oil price decreases con-
for / > , the lump sum equivalent of the flow of sumption, and could cause a net decrease in rev-
one dollar. It is shown that the ability to precommit enue. Furthermore, an extended rise in price could
can be disadvantageous. Loury ( ) also for encourage systematic behaviour change, such as
malizes the intuition that, when indivisibilities are alternative energy utilization, or increased conser-
important, tacit coordination of plans so as to avoid vation. As of August 2004, OPEC has been com-
destructive competition is facilitated by establishing municating that its members have little excess
a convention of ‘taking turns’, that is, a self- pumping capacity, indicating that the cartel is losing
enforcing norm of mutual, alternate forbearance. influence over crude oil prices.
Since worldwide oil sales are denominated in US The six major non-OPEC oil-producing nations
dollars, changes in the value of the dollar against are Norway, Russia, Canada, Mexico, the United
other world currencies affect OPEC’s decisions on States and Oman. Russian production increases
how much oil to produce. After the introduction of dominated non- OPEC production growth from
the euro, Iraq unilaterally decided it wanted to be 2 0 0 0 onward and was responsible for most of the
paid for its oil in euros instead of US dollars. non-OPEC increases since the turn of the century.
OPEC decisions have a strong influence on In 2001, a weakening US economy and increases in
international oil prices. A good example is the 1973 non-OPEC production put downward pressure on
energy crisis, in which OPEC refused to ship oil to prices.
Western countries that had supported Israel in its In response OPEC once again entered into a
conflict with Egypt, the Yom Kippur War. This series of reductions in member quotas, cutting
refusal caused a fourfold increase in oil prices, production by 3.5 million barrels per day by 1
which lasted five months, starting on 17 October September 2001. In the absence of the September
1973 and ending on 18 March 1974. OPEC nations 11, 2001 terrorist attack this would have been
then agreed, on 7 January 1975, to raise crude oil sufficient to moderate or even reverse the trend.
prices by ten per cent. The high and rising price of In the wake of that attack the cmde oil price
oil burdens industrial oil-importing countries in two plummeted. Under normal circumstances a drop in
ways. First, it renders the standard of living lower price of this magnitude would have resulted in
than otherwise. Second, it affects the economy in another round of quota reductions, but, given the
ways that are difficult for policymakers to manage: political climate, OPEC delayed additional cuts
on the one hand, the rising oil price spurs general until January 2002, when it reduced its quota by 1.5
inflation; on the other hand, it depresses domestic million banels per day and was joined by several
demand and employment. Unlike many other non-OPEC producers, including Russia, which
cartels, OPEC promised combined daily production cuts of an
additional 462,500 barrels. This had the
desired effect, with oil prices moving into the $25 duration affects customer response. The longer a
per barrel range by March 2002. By mid-year the programme has been operating, the more likely it is
non-OPEC members were restoring their produc- that its message has spread and the higher the
tion cuts, but prices continued to rise and US probability of strong programme success. Initial
inventories reached a 2 0 -year low later in the year. customer participants in green pricing programmes
By year’s end oversupply was not a problem. may not be highly sensitive to cost, and may be
Problems in Venezuela led to a strike at Petroleos willing to purchase higher quantities of renewable
de Venezuela (PDVSA) causing Venezuelan pro- energy, which makes the case for utilities focusing
duction to plummet. In the wake of the strike on maximizing renewable energy sales, not
Venezuela was never able to restore capacity to its customer participation rates. Price premiums and
previous levels. On 19 March 2003, just as some minimum monthly costs are not the primary
Venezuelan production was beginning to return, determinants of programme success. Price may
military action began in Iraq. Meanwhile, become a more important determinant as green
inventories remained low in the United States and pricing programmes expand beyond the early
other OECD countries. With an improving econ- innovator customers. And smaller utilities appear to
omy US demand was increasing, and Asian demand have a greater likelihood of achieving success.
for erode oil was growing at a rapid pace. The loss The prospect of producing clean, sustainable
of production capacity in Iraq and Venezuela, power in substantial quantities from renewable
combined with increased production to meet energy sources is arousing renewed interest
growing international demand, led to the erosion of worldwide. Hydroelectricity is the only renewable
excess oil production capacity. During much of energy source today that makes a large contribution
2004 and 2005 the spare capacity to produce oil has to world energy production. Its long-term technical
been less than one million barrels per day. A potential is believed to be 9 to 12 times current
million barrels per day is not enough spare capacity production, but increasingly environmental
to cover an interruption of supply from almost any concerns block new dams. The large areas affected
OPEC producer. In a world that consumes over 80 may have a negative environmental impact.
million barrels of petroleum products per day, that Hydroelectricity dams, like the Aswan Dam, have
adds a significant risk premium to crude oil price adverse consequences both upstream and
and is largely responsible for prices in excess of downstream.
$40 per barrel. For further information, see Energy Wind power is one of the most cost-
Information Administration (EIA). competitive renewable sources today. Its longterm
technical potential is believed to be five times
Future Energy Supply current global energy consumption. But this
Undoubtedly, depletable resource use cannot requires 12.7 per cent of all land area and the
dominate forever. Therefore, a future transition facilities have to be built at certain height.
from depletable resources, particularly from fossil Geothermal power and tidal power are the only
fuels, is inevitable. renewable sources not dependent on the sun, but are
However, which renewable energy sources will today limited to special locations. Most renewable
dominate future consumption is unclear. And there sources are diffuse and require large land areas and
is great uncertainty about the timing of a shift to great quantities of construction material for
renewable energy resources. Although this is a significant energy production. There is some doubt
formidable question, Wiser et al. ( ) that they can be built rapidly enough to replace
introduce green pricing programmes, which rep- fossil fuels. The large and sometimes remote areas
resent one way whereby consumers can voluntarily may also increase energy loss and cost from
support renewable energy. Their analysis yields distribution. On the other hand, some forms allow
several interesting results. Programme small-scale production and may be
placed very close to or directly at consumer bums more cleanly than either coal or oil and thus is
households, businesses, and industries. We may an attractive alternative for countries pursuing
forecast the future coexistence of multi-renewable reductions in greenhouse gas emission.
energy sources. Boyle ( ) provides a compre World coal consumption is projected to increase
hensive overview of the principal renewable energy at an average rate of 2.5 per cent per year. From
sources: solar thermal, biomass, tidal, wave, 2015 to 2025, the projected rate of increase in world
photovoltaic, hydro, wind and geothermal. coal consumption slows to 1.3 per cent annually.
Coal is expected to maintain its importance as an
energy source in both the electric power and
Forecasts of the Energy Markets industrial sectors.
Hydroelectricity and other renewable energy
According to Energy Information Administration sources are expected to maintain their 8 per cent
(EIA ), based on its expectations for world energy share of total energy use worldwide throughout the
prices, world energy consumption is projected to projection period. Much of the projected growth in
increase by 57 per cent from 2002 to 2025. World renewable electricity generation is expected to
oil use is expected to grow from 78 million barrels result from the completion of large hydroelectric
per day in 2002 to 103 million barrels per day in facilities in emerging economies, particularly in
2015 and 119 million barrels per day in 2025. The Asia.
projected increment in worldwide oil use would
require an increment in world oil production
capacity of 42 million barrels per day above 2 0 0 2 Energy Policies
levels.
Members of OPEC are expected to be the major The study of depletable resource economics began
suppliers of the increased production that will be with articles by H. Hotelling ( ),
required to meet demand, accounting for 60 per cent which examined economically intertemporal opti-
of the projected increase in world capacity. In mal extraction from a perfectly known stock of the
addition, non-OPEC suppliers are expected to add resource, with perfectly predictable future prices of
nearly 17 million barrels per day of oil production the extracted commodity. Sweeney ( ) and
capacity between 2002 and 2025. Substantial Stiglitz ( ) both clarified the Hotelling rale in
increments in new non-OPEC supply are expected the presence of monopoly, and Gilbert and Richard
to come from the Caspian Basin, Western Africa, ( ) and Salant ( ) extended this to the
and Central and South America. case of a dominant producer with a competitive
Natural gas is projected to be the fastest- fringe and several dominant producers, analogous to
growing component of world primary energy con- the case of OPEC. Pindyck ( ) and Kolstad
sumption. Consumption of natural gas worldwide ( ) extended the model to several imperfectly
increases in the forecast by an average of 2.3 per substitutable exhaustible resources.
cent annually from 2002 to 2025, compared with Energy security refers to loss of economic wel-
projected annual growth rates of 1.9 per cent for oil fare that may occur as a result of a change in the
consumption and 2 . 0 per cent for coal con- price of availability of energy. In the years follow-
sumption. From 2002 to 2025, consumption of ing the 1973 oil price rise, US energy policy could
natural gas is projected to increase by 69 per cent, be characterized as generally suspicious of the
and its share of total energy consumption is market. Supply augmentation was a major strategy
projected to grow from 23 to 25 per cent. pursued by the US government in addressing the
Natural gas is seen as a desirable alternative to ‘energy crisis’. The security dimensions of energy
electricity generation in many parts of the world, supply have always been viewed as appropriate
given its relatively efficiency in comparison with concerns of the government. One could argue that
other energy sources, as well as the fact that it the Gulf War in the early 1990s was
simply a form of energy policy, protecting Western Effects of Energy Demand
oil supplies originating in the Middle East.
Countries other than the United States (such as Energy and Macroeconomics
Japan and China) have tried to diversify their In fact, almost every recession since the Second
sources of energy to reduce the risk of disruption. World War in the United States, as well as many
Security was also viewed as threatened by sudden other energy-importing nations, has been preceded
fluctuations in the price of oil, hence the estab- by a spike in the price of energy (Hamilton ;
lishment in the United States of the Strategic Ferderer ; Mork
Petroleum Reserve (SPR): petroleum. et al. ).
Stocks are maintained by the federal govern- The oil price movement affects certain sectors:
ment for use during periods of major supply inter- oil-dependent manufacturing such as paper and
ruption. The idea is that, if the price of oil were to packaging, consumer-related sectors such as autos,
rise rapidly due to disruption in supply, then the refiners’ margins, the energy-intensive utility
SPR could be called upon to provide supplies, thus sector, and of course exploration companies and the
reducing the price shock. big oil majors themselves.
Nuclear power was declared dead in the United
Energy, Economy and Environment
States because it is too expensive and unacceptably
Many important environment damages stem from
risky. Around the world, nuclear plant ended up
the production, conversion, and consumption of
achieving less than ten per cent of the new capacity
energy. The costs of these environmental damages
and one per cent of the new orders (all from
generally are not incorporated into prices for energy
countries with centrally planned energy systems)
commodities and resources; this omission leads to
forecast in the early 1980. The industry has suffered
overuse of energy. It has been shown that estimates
the greatest collapse of any enterprise in industrial
of damage costs resulting from combustion of fossil
history. Scientists still have not developed reliable
fuels, if internalized into the price of the resulting
ways to handle nuclear wastes and decommissioned
output of electricity, could clearly lead to a number
plants, which remain dangerously radioactive for
of renewable technologies being financially
far longer than societies last or geological foresight
competitive with generation from coal plants.
extends.
Environmental impacts currently receiving most
Strong economic growths across the globe and
attention are associated with the release of
new global demands for more energy have meant
greenhouse gases in the atmosphere, primarily
the end of sustained surplus capacity in hydrocar-
carbon dioxide, from the combustion of fossil fuels.
bon fuels and the beginning of capacity limitations.
During combustion, carbon combines with oxygen
In fact, the world is currently precariously close to
to produce carbon dioxide, the primary greenhouse
utilizing all of its available oil-production capacity,
gas. Carbon dioxide accumulates in the atmosphere
raising the chances of an oil-supply crisis with more
and is expected to result in significant detrimental
substantial consequences than seen since the early
impacts on the world’s climate, including global
1970. These limits mean that the United States can
warming, rises in the ocean levels, increased
no longer assume that oil-producing states will
intensify of tropical storms, and losses in
provide more oil. Nor is it strategically and
biodiversity. Concern about this issue is common to
politically desirable for the United States to remedy
energy economics, environmental economics, and
its present tenuous situation by simply increasing
ecological economics. Cropper and Oates ( )
its dependence on a few foreign sources. As a
suggest measuring ben
result, expanding demand for energy will change
efits and costs with a review of cases where benefit-
US policy towards the Middle East, Russia and
cost analyses have actually been used in the setting
China. A recent example is that, in 2005, the state-
of environmental standards. Owen ( ) suggests that
owned Chinese company CNOOC eventually
penalizing high pollutant-
abandoned its bid for Unocal due to strong political
emitting technologies not only creates incentives
opposition in the United States.
for ‘new’ technologies but also encourages the A Concluding Comment
adoption of energy-efficiency measiues with
existing technologies and consequently lower pol- The world runs on energy, primarily energy gen-
lutants per unit of output. erated from coal and petroleum. The current war
World carbon dioxide emissions are expected to against terrorism and the tensions in the Middle
increase by 1 .9 per cent annually between 2 0 0 1 East have raised new questions about the reliability
and 2025. Much of this increase is expected to of America’s oil supply from that region. Concerns
occur in developing countries. The United States about global climate change have also focused
produces about 25 per cent of global carbon dioxide increased attention on the search for cleaner fuels
emissions from burning fossil fuels, primarily and energy-generating methods. Russia’s
because of it has the largest economy in the world determination to become a major petroleum
and meets 85 per cent of its energy needs through supplier, OPEC’s periodic moves to restrict oil
burning fossil fuels. The United States is projected production and the rising energy needs in China and
to lower its carbon intensity by 25 per cent from other developing countries are all important issues
2001 to 2025. There are numerous proposals aimed forming the future world energy market.
at reducing the carbon dioxide emissions, of which I would like to thank Robert Thomure, Rice
the Kyoto Protocol is a well-known and influential University, for his research assistance.
one. During 1-11 December 1997, more than 160
nations met in Kyoto, Japan, to negotiate binding
limitations on greenhouse gases for the developed See Also
nations, pursuant to the objectives of the
Framework Convention on Climate Change of
1992. The outcome of the meeting was the Kyoto
Protocol, in which the developed nations agreed to
limit their greenhouse gas emissions relative to the
►
levels emitted in 1990. The United States agreed to
reduce emissions from 1990 levels by seven per
cent during the period 2008 to 2 0 1 2 .
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replace energy-inefficient equipment with energy- Long before the emergence of a global market
saving equipment. Such energy price shocks and for crude oil in the 1970s, there was already a well-
their effects on the economy are the subject of a developed global market for coal. Well into the
large literature in economics. 20th century, coal was as important for the US
Much of this literature has focused on the price transportation sector as oil is today. It was the
of crude oil (see, for example, Barsky and Kilian ( ), primary fuel used in shipping until the 1920s and in
Kilian ( , ) and Hamilton ( , railroading until the 1950s. It also served as an
, )). Crude oil stands out among energy important source of home heating until the 1950s.
commodities because of its importance for the Coal continues to play an important role today in
transportation sector. Although crude oil is not producing electricity and heat as well as in the
consumed directly and is not used as a factor of manufacturing of chemicals and metals.
production outside of the refining industry, oil In producing electricity and in manufacturing
products such as petrol/ gasoline, diesel, heating oil coal competes with natural gas. The market for
or jet fuel are highly visible in everyday life. Their natural gas, in contrast to that of coal or crude oil,
prices affect, for example, the cost of commuting to has largely remained regional to this day. Natural
work, the cost of shipping goods, the cost of air gas is primarily transported by pipelines. Although
travel and in some areas the cost of home heating. natural gas may be cooled down and liquefied,
Until the early 1970s, the global market for allowing it to be shipped as liquefied natural gas
crude oil looked much different from typical (LNG) to any port in the world, both the cost of
industrial commodity markets, with the USA able to LNG shipping and the infrastructure required to
load and unload LNG are expensive, which has
produce most of the oil it consumed and regulating
prevented the integration of regional natural gas
the price of domestically produced erode oil, while
markets and the emergence of a global price to date.
other industrialised countries, such as Japan or
Thus, in studying energy prices over longer time
Germany, were heavily dependent on crude oil
periods one inevitably has to take the perspective of
imports. This situation changed when even the USA
one country. This article focuses on the US A
became heavily dependent on oil imports in the
because of its long history in producing coal, oil
early 1970s, following an increase in domestic oil
and natural gas and the availability of long
demand. Initially the required additional oil imports
continuous price series for these markets. The
came primarily from the Middle East, but later
objective is to document the history of energy price
increasingly from oil producers in other regions as
shocks and to examine whether price shocks in oil
well. As global oil trade expanded and national oil
markets are different from those in other energy
market structures were gradually broken up, a markets such as coal, which in the past were as
global market for crude oil emerged. From 1974 important as erode oil is today.
until 2010, the price of crude oil has been
determined in this global market place. As a result,
adjusting for transportation costs and the inevitable The Traditional Interpretation of Oil Price
differences in the quality of crude oil produced in Shocks
different regions of the world, the price of erode has
been largely the same worldwide. In recent years, as It is useful to begin with a review of the oil price
the production of unconventional erode oil singed in data in the post-Second World War period. Some-
the USA and Canada, the global market for crude times oil price shocks are associated with sudden
oil appears to have fragmented, with US oil prices increases in the price of oil. This idea can be traced
deviating from world prices because of bottlenecks back to the work of Hamilton ( ) who
in transporting crude oil and because of capacity studied the evolution of the nominal price of West
constraints in refining (see Kilian )• Texas Intermediate (WTI) erode oil in the USA
between 1948 and 1972. Figure illustrates that
Energy Price Shocks, 4.5
Fig- 1 Evolution of the
monthly WTI price of crude
oil during 1947.1-1973.12 4-
(the WTI data are from the
US Energy Information
3.5 -
Administration (EIA))

3-
(D
CO
“ 2.5 -
w
CO

in
d
1.5 -

1-

0.5 -

0 -------1 ---------1 ----------1 ----------1 ----------1 —

1950 1955 1960 1965 1970

this price series differs from most other commodity short, Hamilton’s review of the evidence suggested
prices in that it often remains unchanged for that the timing of the oil price shocks under the
extended periods, followed by discrete adjustments. Texas Railroad Commission regime was associated
When expressed in growth rates and adjusted for with oil supply shocks in the Middle East driven by
inflation, as shown in the left panel of Fig. , this political events unrelated to the state of the US
step-function pattern implies unpredictable spikes in economy, allowing us to treat them as exogenous
the growth rate that represent shocks to the price of with respect to the US economy.
oil. This regime came to an end in the early 1970s,
This pattern reflects the fact that the US price of when demand for oil grew much faster than US oil
crude oil during this period was regulated by state- production and the US economy became heavily
level agencies such as the Texas Railroad Com- dependent on oil imports. Much of the additional oil
mission, as discussed in Hamilton ( ). Under was imported from the Middle East. The fact that
normal circumstances the regulator was able to keep state-level agencies were unable to regulate the
the price of oil unchanged for extended periods. At price of imported crude oil spelled the end of the
irregular intervals, however, major oil price Texas Railroad Commission regime, even though
adjustments took place. Hamilton documents that the last vestiges of this system survived until the
these adjustments were associated with oil supply early 1980s. After 1974, the market for cmde oil,
disruptions in the Middle East that were unforeseen for all intents and purposes, became a global market
by the regulator and that justified ex-post with the price of oil being ultimately determined by
adjustments of the regulated price of oil. These the forces of demand and supply, much as in other
events could be used either to implement long global commodity markets. This structural shift in
overdue adjustments to the price of oil reflecting the cmde oil market is reflected in a structural break
domestic inflation and/or unexpectedly high in the evolution of the growth rate of the real price.
domestic demand for oil, or to accommodate Figure shows a
additional demand for US oil from abroad. In
 1947.2-1973.12 1974.2-2014.8
50 T T
WTI WTI
40
RAC Domestic'
30 - RAC Imported
20 - o
g 10
to
§0 c
<D
S -10 b
D.

-20 -30 -

-40

-50 _i_ _ 1_ -50

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Evolution of the growth rate of the monthly real price of oil (the data are from the
Energy Price Shocks, Fig. 2 US ELA and Federal
Reserve Economic Data (FRED). RAC denotes the US refiners’ acquisition cost)

dramatic increase in the volatility of three alterna- Libyan Revolution of 2011. The challenge for the
tive measures of the growth rate of the price of oil, traditional view of oil price shocks has been that the
but especially of the US refiners’ acquisition cost predictive power of these supply disruptions for the
for erode oil imports, which may be viewed as a price of oil is quite modest. Oil supply disruptions
proxy for the global price of crude oil. Rather than explain at most a quarter of the increase of the price
exhibiting occasional spikes, the growth rate of the of oil in 1973-74, for example, and with the
real price of oil as of 1974 begins to look like that exception of the 1990 spike in the level of oil price
of most other commodity prices. have not had a major impact on the evolution of the
real price of oil since 1974. The major oil price
fluctuations instead appear to be driven by shifts in
The Modern Interpretation of Oil Price the demand for oil, as has been shown in a series of
Shocks studies, including Baumeister and Peersman ( ),
Kilian ( ),
Initially, it was thought that this structural change Kilian and Hicks ( ), and Kilian and Murphy
was inconsequential and that at least the major
( , )•
fluctuations in the real price of crude oil after 1973
By far the most important determinant of the
could be explained by exogenous oil supply
real price of oil is shifts in the flow demand for oil
disruptions abroad, much like those in the 1950s
associated with fluctuations in the global business
and 1960s. Kilian ( ) demonstrated that this
cycle. Flow demand refers to demand for raw
is not the case. Examples of political events in oil-
materials to be consumed right away in the process
producing countries thought to have triggered oil
of producing more domestic goods rather than
supply disruptions include the 1973 Yom Kippur
being stored for future use. As China’s industrial
War and the subsequent Arab oil embargo, the
growth accelerates unexpectedly, for example, the
Iranian Revolution of 1978-79, the invasion of
flow demand for industrial raw materials, including
Kuwait in 1990, the Venezuelan unrest of late 2002
crude oil, increases. As the demand curve shifts to
and the Iraq War of early 2003, as well as the
the right along the upward-sloping
supply curve, the real price of crude oil (and of Finally, there are a myriad additional idiosyn-
other industrial raw materials) increases. Put dif- cratic shocks to the demand for oil, ranging from
ferently, the real price of oil is endogenous with politically motivated changes to the Strategic
respect to global macroeconomic conditions. This Petroleum Reserve before elections to shifts in the
phenomenon attracted much attention after 2003, demand for oil as a result of hurricanes in the Gulf
but is by no means new. Shifts in the flow demand of Mexico shutting down US refineries. These
for oil played a major role during almost all major idiosyncratic demand shocks, however, do not
surges in the real price of oil including the 1973-74 appear to be capable of explaining sustained
and 1978-80 episodes. changes in the real price of oil.
Another potentially important determinant of the Once it is recognised that not all oil price shocks
real price of oil is shifts in the demand for oil are the same, it becomes immediately clear that one
stocks, reflecting forward-looking behaviour by oil would expect the evolution of the US economy in
market participants. Such demand shocks are also the wake of an oil price shock to differ depending
known as speculative demand shocks. They arise, on the composition of the oil demand and oil supply
for example, when market participants expect the shocks underlying this price shock. If we ignore this
real price of oil to go up in the future, reflecting insight, we may find that the statistical relationship
expectations of a shortfall of future supply relative between the real price of oil and the US economy
to future demand. In this case there is an incentive appears unstable over time, even when the
to buy crude oil now and to store it in anticipation underlying structural relationship is stable. This
of rising oil prices. The resulting shift in the current point has been illustrated, for example, by Kilian
demand for oil stocks increases the current real and Park ( ) in the context of US stock
price of oil, as the demand curve shifts to the right markets.
along the supply curve. One can still ask how the US economy responds
Such forward-looking behaviour is crucial for on average to an oil price shock, of course, but there
understanding oil markets. It has been shown that are two important caveats in interpreting the
exogenous political events in the Middle East answer. First, these responses cannot be interpreted
matter for the real price of oil not so much because as the causal effects of the oil price shock, because
of the actual disruptions of the flow of crude oil nothing ensures that the price shock under
they cause, but because of the expectations of future consideration occurs holding everything else
supply disruptions that they may create. Likewise, constant. For example, an unexpected increase in
the anticipation of a global economic recovery or the real price of oil driven by increased flow
economic slowdown will affect expectations of demand would also be associated with increases in
future oil prices, as will any number of other events the real prices of other industrial raw materials,
and developments that are not commonly included violating the c e t e r i s p a r i b u s
in economic models. Even an increase in assumption. Thus the response we observe in the
uncertainty, all else equal, may cause a shift in the economy is the response to increases in the prices of
demand for oil stocks (see Pindyck ; Alquist and both oil and industrial raw materials, rather than the
Kilian ). As Kilian and Murphy ( ) and price of oil alone.
Kilian and Lee ( ) show, Second, the average response to an oil price
speculative demand shocks driven by expectations shock can be misleading when it comes to
of future oil price changes help explain, for interpreting specific episodes of rising oil prices.
example, the surge in the real price of oil in 1979 For example, traditional models of oil price shocks
(following the Iranian Revolution), the collapse of implied that the US economy should have gone into
the real price of oil in 1986 (following the collapse recession in 2005-06, following the surge in the
of OPEC ) and the spike in the real price of oil in price of oil that began in 2003. Such a recession
1990 (following the invasion of Kuwait ), but they obviously never occurred, because the preceding
played no important role during the 2003-08 surge increase in oil prices was caused by an
in the real price of oil. unexpectedly booming global
economy, not by oil supply disruptions or increased it unclear what exactly a financial speculator is, but
speculative demand. Unlike in the traditional view the claim of exogenous financial speculation
of oil price shocks as being driven entirely by moving oil markets is difficult to sustain in practice.
exogenous oil supply disruptions, in the modem Proponents of this view have not been able to
view, rising oil prices may very well be compatible provide convincing empirical evidence in support of
with an expanding economy and a rising stock the financial speculation hypothesis. For a review of
market, at least for some time. this debate the reader is referred to Fattouh et al. (
A final point to bear in mind is that the tradi- ).
tional question of how an oil price shock affects the Upon closer examination, it becomes clear that
economy becomes inherently ill-posed once we the real concern articulated by these pundits is not
recognise that the state of the economy in turn about a failure of the laws of demand and supply at
affects the price of oil. A more useful way of posing all, but about the perception that economic
this question would be to ask how an exogenous fundamentals, as measured by shocks to the flow of
shift in the demand for oil in some part of the world, oil being produced and shocks to the flow demand
for example, affects the real price of all for oil, are not capable of explaining the surge in the
commodities including crude oil, the US economy real price of oil, especially in 2007-08. This is a
and the economy in rest of the world. Answering misperception. Formal empirical models show that
the latter question requires a global structural model economic fundamentals do an excellent job at
of the economy and of commodity markets. An explaining the surge in the price of oil between
example of this type of analysis can be found in 2003 and mid-2008, as well as the collapse and
Bodenstein et al. ( ). recovery of the real price of oil thereafter (see, for
Related work also includes Nakov and Pescatori ( example, Kilian and Murphy ( ) and Kilian and
). Lee ( )).
The debate about financial speculation as a
driver of oil prices illustrates a tendency among
Other Explanations of Oil Price Shocks pundits to reduce complicated economic relation-
ships in oil markets to simple formulaic explana-
Especially near the peak of the real price of oil in tions. The notion of nefarious speculators in oil
2008, a popular view among some pundits has been markets is one example of trying to make sense of
that the real price of oil is no longer determined by the evolution of the real price of oil without
the laws of demand and supply, but by the actions engaging with economic models. Another example
of financial traders in oil futures markets is the tendency to attribute oil price increases to
(sometimes informally referred to as financial actions of the so-called OPEC cartel. OPEC is the
speculators). This view reflects several misunder- Organization of Petroleum Exporting Countries. It
standings. One is that it is logically impossible for includes oil producers in the Middle East as well as
the price of cmde oil to be determined by anything some oil producers in other parts of the world. The
else but demand or supply. The only question is presumption is that there is a concerted effort by
what determines the demand for and supply of cmde OPEC oil producers to prop up oil prices either
oil. In fact, economic theory suggests that prices in directly or by withholding oil supplies from the
the physical market for cmde oil and in the oil market. Until ten years ago, major oil price
futures market are jointly and simultaneously increases were routinely attributed to the machi-
determined by the same underlying shocks rather nations of this alleged cartel rather than to the
than changes in one price being caused by underlying forces of demand and supply. Only with
exogenous changes in the other. Another the rise of the debate about financial speculation
misunderstanding is that the actions of financial does interest among pundits in OPEC seem to have
speculators in the oil futures market are believed to waned.
be exogenous with respect to developments in the The evidence in support of the cartel explana-
physical market for oil. Not only is tion has always been thin (e.g. Smith ;
Almoguera et al. ). There is no evidence that OPEC Kilian ( ) discuss how oil price expectations
caused the 1973-74 or the 1979-80 oil price shock for a given horizon may be recovered by adjusting
episodes, for example, even if this claim is often the oil futures price by an empirical measure of the
repeated in macroeconomic textbooks. OPEC was risk premium. By comparing the three-month ahead
far from a unified body in the 1970s and incapable financial market expectations of the oil price to the
of acting as a cartel. Only in the early 1980s did realisations of the oil price three months later, for
OPEC attempt to curtail its oil production in an example, one can infer a time series of quarterly oil
effort to prevent oil prices from falling in response price shocks.
to the Volcker recession. As predicted by the More colloquially, the term ‘oil price shock’ is
economic theory of cartels, most OPEC members also used to denote episodes of unusually high (or
cheated on their cartel obligations, however, which in some cases unusually low) oil prices. Such
prompted Saudi Arabia to take responsibility for episodes typically extend over several years. In fact,
reducing oil production on behalf of the rest of most surges in the price of oil do not involve any
OPEC. This approach proved not only ineffective, large changes in the price of oil on a monthly basis.
in that the price of oil continued to fall (albeit at a Rather, they arise because for extended periods the
slower rate), but unsustainable in that falling price of oil experiences small but persistent
production in conjunction with falling oil prices increments. Examples are the 1979-80 and 2003-08
resulted in a substantial reduction in Saudi oil oil price surges. Sometimes appearances can be
revenues. By late 1985, Saudi Arabia was forced to misleading. A case in point is the sudden increase
reverse course, and the real price of oil collapsed in the price of oil in 1973-74. Kilian () shows that
along with fears of what OPEC might do. There has the real price of oil
been no indication of OPEC being able or willing to would have increased much earlier than late 1973,
control the price of crude oil since then. Indeed, it and more gradually, had the price ofMiddle Eastern
would be hard to explain why Saudi Arabia would oil not been constrained by the Tehran- Tripoli
have permitted the oil price to fall to $11/barrel in agreement of 1971. The sudden increase in late
1998 if it were endowed with the market power 1973 occurred when oil producers reneged on these
sometimes ascribed to it. contractual agreements and the oil price reverted to
market levels. In fact, overall the real price of
metals and non-oil industrial raw materials between
How to Measure Oil Price Shocks 1971.11 and 1974.2 increased by 75% as much as
the real price of oil, even in the absence of supply
So far we have defined an oil price shock infor-
shocks in these markets, suggesting that all these
mally as a change in the price of oil relative to the
prices were largely driven by the same forces of
price of oil that consumers and firms expected.
demand. Hence, historically, the oil price spike of
More formally, oil price shocks can be defined as
1990, following the invasion of Kuwait, is the only
the unpredictable component of the price of oil. One
example of a large and sudden increase in the price
approach is to measure oil price shocks within the
of oil since the 1960s. All other oil price shock
context of an econometric model as movements in
episodes have involved more gradual increases in
the price of oil that cannot be explained based on
the real price of oil.
past data. Such oil price shocks are also known as
Finally, yet another notion of oil price shocks
oil price innovations, and can be decomposed
has been proposed by Hamilton ( , ). The
further into mutually uncorrelated oil demand and
idea is that an oil price shock occurs only to the
oil supply shocks with the help of additional
extent that the price of oil exceeds the highest price
identifying assumptions. An alternative approach
of oil that consumers and firms have experienced in
would be to define oil price shocks based on the
recent memory. More formally, this n e t o i l
market expectation of the price of oil. For example,
p r i c e i n c r e a s e measure of oil price
Baumeister and
shocks is defined as the censored variable max ( 0 ,
p t — p * ) ,
 1975 1980 1985 1990 1995 2000 2005 2010

Energy Price Shocks, Fig. 3 Three-year net oil price Kilian and Vigfusson ( ). The business cycle dates are
increase in real US refiners’ acquisition cost for oil imports from the National Bureau of Economic Research)
with US recession dates imposed as shaded areas (Source:

where p t refers to the current oil price and p * that there is no mechanical link between net oil
refers to the maximum oil price over the preceding price increases and subsequent recessions.
year (or, more commonly, over the preceding three More formally, it can be shown that the evi-
years). By construction, the net oil price increase is dence that net oil price increases help forecast US
predictable based on its own past. At some point it real GDP growth is weak at best (Ravazzolo and
was believed that this statistical transformation of Rothman ; Kilian and Vigfusson ). For related
the price of oil would effectively isolate the discussion of net oil price increase measures and
component of the price of oil associated with their relationship with more conventional oil price
exogenous shocks to the flow supply of oil. It has shock measures, see Kilian and Vigfusson ( , ).
become readily apparent that this is not the case. An
alternative and more common interpretation has
been that net oil price increases are the relevant Putting Oil Price Shocks into Historical
measure of oil price shocks because they explain or Perspective
at least help predict variation in US real GDP.
Figure casts doubt on this interpretation. Crude oil is only one source of primary energy, but
Treating the net oil price increases of 2004-06 as it stands out because of its important role in the
one episode, there have been eight distinct episodes transportation sector. Historically, coal played
of net oil price increases since 1974, of which only much the same role for the transportation sector as
five were followed by recessions. In some cases the oil did starting with the increased adoption of the
net oil price increase occurred well before the automobile during the First World War. Steam
recession. A good example is the net oil price ships and steam locomotives were as dominant in
increase of 2000. In other cases it occurred imme- transportation then as oil is today for trucking,
diately before or at the same time as the recession. shipping, air transport and railroading. A natural
Examples are 1981 and 1990. In three cases, net oil question therefore is whether coal prices were
price increases were not followed by a recession at subject to shocks similar to the oil price shocks
all. These episodes are 1996 as well as 2004-05 and documented earlier.
2006 (the latter two may be viewed as one episode), This question can only be addressed with annual
and 2011-12. This evidence suggests data, because there are no quarterly or
60
Crude Oil Natural Gas
Coal 3.5
50

40
2.5 -

30 2 .....i

1.5 ......i
20

1-

10
0.5 -

1880 1900 1920 1940 1960 1980 2000 1880 1900 1920 1940 1960 1980 2000

Energy Price Shocks, Fig. 4 Historical

evolution of US coal and gas prices are based on Manthy ( ) and EIA
real energy prices: 1870-2013 (expressed in real US$ per sources; the oil price series is from British Petroleum
barrel (crude oil), per metric ton (coal) and per MMBtu ( ))
(natural gas). The coal price refers to anthracite coal. The

monthly oil price series prior to 1947. The left panel discounting the early 1970s, however, the volatility
of Fig. plots the historical evolution of the real in the growth rate of the annual price of oil appears
prices of coal and crude oil since 1870. The plot to be more than twice as high as the corresponding
deliberately ignores the oil price data prior to 1910, volatility in the price of coal. This is not to say that
because, before the adoption of the automobile, there are no sustained increases in the real price of
crude oil was used primarily to produce kerosene to coal - in fact the sustained increases in the level of
be used for lighting, heating and cooking. It the real price of coal during the 1920s and 1940s
therefore makes sense to discount the history of oil dwarfed those in crude oil - but that the year-on-
prices prior to 1910. Figure shows that prior to 1970 year changes tended to be smaller. In this sense,
the degree of comovement between the prices of oil there is a clear difference between the crude oil
and coal was quite low. Subsequently, there is market and the coal market.
increased comovement, but the increase in the real It is also instructive to compare the real price of
price of coal during the 2 0 0 0 s was not nearly as oil with the real wellhead price of natural gas.
dramatic as that in the real price of oil. Although natural gas prices are available as far
Because these prices are measured in different backas 1919,asshownintherightpanelofFig. , it was
units, it is useful to express them in percentage only with the creation of a nationwide network of
changes. Figure suggests that the Texas Railroad natural gas pipelines in the 1950s that natural gas
Commission era, which was characterised by became an important energy resource for the US
unusually low volatility at annual frequency economy (see Davis and Kilian ). Figure shows that
followed by an extreme spike in 1973-74, was a the volatility of the growth rate of the real price of
historical aberration. In contrast, the volatility of the natural gas since the late 1950s has been quite
real price of oil prior to the Second World War similar to that of the real price of oil before and
largely resembles that since the 1970s. Even after the Texas
 Crude Oil Coal Natural Gas
250 250 250

200 200 - 200 -

150 150 150 -4

100 „ 100 - - „ 100

<1 )
50 50 - 50

0-

-50 -50 - -50

-100 -100 -100 J____|____|____|____|_

qO 0® Isp Q? r& nO 0O tsP Q? r© f® (P IjP pO fO

^ # *°r ^ N °r N°>° r j P P ^ ,°r jP fp ^
Energy Price Shocks, Fig. 5 Percent
growth rates of the real US price of energy: 1871 2013 (all results are obtained
from the data underlying Fig. )

Railroad Commission interlude. Figure in turn gas in US power plants, and the process of replacing
suggests that traditionally US natural gas and crude coal power plants by natural gas power plants is
oil prices have moved in the same direction. There quite slow. Finally, especially in transportation,
are indications, however, that with the rapid growth there is only very limited substitutability between
in US shale gas production in recent years this oil and natural gas to date. Even the indirect
traditional pattern no longer holds. Figure shows a substitution of coal, natural gas or nuclear power for
dramatic fall in the real price of natural gas after oil in the form of electric power has not played a
2008, even as the annual real price of oil recovered large role in US transportation so far.
after the financial crisis. In contrast, there remains Thus, much of the observed comovement in real
some degree of positive comovement between coal energy prices appears to reflect common shifts in
and crude oil prices going back as far as the 1970s. the demand for all forms of primary energy
The observed pattern of positive comovement associated with shifts in flow demand. This
across coal, oil and natural gas prices between the comovement only breaks down when there are large
1970s and the 2000s reflects in part the fact that increases in the supply of an energy commodity, as
industrial consumers of energy often had the ability occurred in the natural gas sector after 2008. In
to use dual technologies that allowed them to contrast, there is no indication that a similar
switch between natural gas and fuel oil, depending structural shift is under way in the oil market. At the
on price and availability. Such substitution tends to global level, the quantitative importance of US
be more difficult for residential consumers of shale oil remains small compared with the size of
energy, however. For example, to this day there are the market for erode oil. Thus, the response of the
parts of the USA in which heating oil remains the global price of oil to the US shale oil revolution has
main source of home heating because there are no been muted (see Kilian ). In contrast, in the natural
natural gas pipelines in that region. Likewise, there gas sector, US gas production must be balanced
is essentially no substitution between oil and either against domestic demand rather than global
coal or natural demand, with correspondingly larger effects on the
price.
 An interesting question for future research will case can be made that policies preventing such
be to compare the evolution of energy prices across misalignments in the economy may be the most
countries and to disentangle the contributions of effective approach to reducing the volatility of oil
various demand and supply shifts to the evolution of prices and other primary energy prices.
these historical energy price series. The latter
question has received increasing scrutiny in years,
including contributions by Hamilton ( ), van
de Ven and Fouquet ( ), and See Also
Stunner ( ). For very long run trends in
energy prices such as those of charcoal, coal, town ► Business Politics in the Gul:
gas and kerosene see Fouquet ( ). ► Energy Economics
► 0 md Politics in the Gul: luwait and Qatar
► Oil and the occo
Conclusions ► Oman, Economy of
► Organization ofthe Petroleum Expoiting Court
Why do we care about oil price shocks (and by
extension other energy price shocks)? One reason is ► 'emen, Economy of
that positive oil price shocks historically have been
Acknowledgments I thank Martin Sturmer for providing
associated with recessions in oil-importing access to the annual energy price data used in this article. I
countries, although the recessionary effects asso- have also benefitted from helpful discussions with Christiane
ciated with oil price shocks do not appear to be as Baumeister, Ryan Kellogg and Roger Fouquet, and the
large and systematic as originally thought. comments of a referee.
Of course, not all increases in the real price of
oil are bad. Increases in the price of oil may also
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Journal of Applied Econometrics 29: 454-478. entertainment and computing). This piece
introduces the reader to the concept of energy
services, and explains why it is important to
analyze energy markets and climate policies
from the perspective of energy services. The
 paper discusses the theoretical foundations and specified surface area. For example, a 100 square
empirical evidence, particularly related to the metre house is warmed 10°C for two hours - which
rebound effect and the demand in developing is the equivalent to warming
economies. The paper concludes that govern- 2.1 square metres 1°C for one hour. Transport is
ments should encourage the collection of sta- measured in terms of passenger-kilometres (or
tistical information about energy services in -miles), or tonne-kilometres (or ton-miles) for
order to help economists analyse markets and freight. The more efficient the vehicle, then the
policies through this lens. Most importantly, more passenger-kilometres can be achieved with,
governments should formulate more integrated say, a litre or gallon of gasoline. The number of
policies that focus explicitly on energy services, vehicle-kilometres in a country, divided by the
connecting markets for energy and for energy- gasoline consumed in that country, offers an indi-
using equipment with the development of cator of the average fuel efficiency of vehicles
technologies. Careful and balanced energy (Frondel et al. ; Stapleton et al. ). For lighting, the
service policies are especially important as unit of measurement is lumen-hours, which
economies industrialise because they can help indicates the amount of illumination generated by a
reduce economic, political and environmental light source (Nordhaus ). A 100 watt incandescent
vulnerability. bulb provides about 1,300 lumens. So, if it is left on
for 10 hours, it will have generated 13,000 lumen-
hours and used
Keywords
1.1 watts. The same amount of fighting could
Energy consumption; Energy services; Energy
have been produced over the same amount of time
policy; Climate change; Consumer behaviour;
using a 20 watt CFL bulb, but consuming only 2 0 0
Direct rebound; Price elasticity
watts.
Energy services are closely related to end-use
energy consumption and the concept of exergy.
JEL Classifications
Q32; Q38; Q43; Q48; Q58 End-use energy consumption refers to the energy
consumed for individual services. However,
focusing on end-use energy consumption or prices
does not take account of the efficiency of conver-
sion of the energy into the service. Exergy, on the
What Are 'Energy Services'?
other hand, does take account of the efficiency and
Energy services refer to the services that are gen- refers to the amount of ‘work’ produced (Ayres and
erated from consuming energy combined with Warr ). The strength of the concept of exergy is that
appliances. For residential consumers, these ser- it looks at all energy services in the same unit;
vices include space heating and cooling, water however, it does not focus on the nature of the
heating, cooking, refrigeration, lighting, computing, specific output, which risks ignoring important
entertainment and passenger transport (Reister and dimensions of the analysis (Sovacool ).
Devine , ; Goldemberg The purpose of this piece is to introduce readers
et al. ). For firms, these include high temperature to the concept of energy services. The next section
processes, such as iron smelting, low temperature explains why energy economists are increasingly
processes, moving of motors and machinery, analyzing energy service consumption, rather than
separation, drying, and compressing air, as well as only energy use. The third section presents the
refrigeration, lighting, space and water heating, and foundations for analyzing the demand and provision
freight transport. of energy services. In the fourth section, empirical
For space heating and cooling, the service is evidence of the demand for energy services in the
measured in terms of the increase or decrease in residential and transport sectors is presented,
temperature compared with the existing temperature focusing on price elasticities and the size of direct
(in degrees Centigrade or Farenheit) for a rebound effects. The fifth
section discusses the two-way relationship between in the (nominal and real) price of an energy service
energy services and economic development. Due to diverges from the trend in the price of energy for
space constraints, other topics related to energy this service in the long run. While the average
services are not discussed in detail - including fuel energy price has not shown a discernible trend in
poverty (Boardman ), exergy (Ayres and Warr ), the the long run, the price of energy services has tended
impact of smart meters (Romer et al. ) and of net- to fall. The divergence implies that focusing
metering (Gillingham et al. ), energy service exclusively on energy prices and consumption
companies or ESCOs (Weiller and Pollitt ), and rather than energy services will generate misleading
energy systems planning and operation, such as conclusions about energy consumption behavior.
demand-side management (Strbac ). The final This long run perspective is particularly relevant
section draws conclusions about our knowledge of when thinking about climate change mitigation.
energy services and its role in improving policy- As Fouquet and Pearson ( ) argued, by not
making. focusing on energy services, the analyst is making
an implicit assumption about the price elasticity of
demand for the energy service. Two ‘straw-man’
The Importance of Energy Services examples can be used to show this. First, the
‘efficiency optimist’ might suggest that if energy
Energy consumption is driven by the demand for efficiency improves by 1 0 %, energy consumption
energy services. Individuals do not consume elec- will fall by 10%. However, since the efficiency has
tricity for the voltage that speeds down the wires, or improved by 1 0 %, the consumer can get the same
put gasoline in their cars for the pleasure of having quantity of service with 1 0 % less energy. This
a full tank. Instead, they consume them because of implies that the price of the energy service has
the lighting the electricity creates or the mobility fallen 10%. For energy consumption to fall by 1 0 %,
the gasoline provides. energy service use must remain unchanged. So, the
Consequently, studies of energy demand may ‘efficiency optimist’ implicitly assumes that the
strongly benefit from considering the relationship price elasticity of demand for energy services is
between energy services, technologies and energy zero. Alternatively, the ‘laggard economist’ might
consumption (Haas et al. ). If the relationship propose that since the price of energy is unchanged
remains constant, it may not be crucial to focus consumption of energy will remain the same. In this
explicitly on energy services. For instance, in the case, since the price of this energy service has fallen
short run, the relationship does stay broadly con- by 1 0 %, for energy consumption to remain
stant, because the efficiency of the technology (that unchanged, energy service use must increase by
is, the amount of service generated for a given unit 10%. So, the implicit assumption here is that the
of energy) does not change much and, so, the focus price elasticity of demand for energy services is
on energy services may not alter the results of the one. Thus, focusing on energy rather than energy
analysis. services forces the analyst to make assumptions
However, analyzing energy services is espe- about consumer behavior and is likely to create
cially important in the long run, as technological misleading estimates of consumer responses to long
change can radically alter energy consumption run energy price and efficiency changes. Ultimately,
behaviour. Nordhaus ( ) showed how the the size of the price elasticity of demand is an
price of fuel for lighting fell three-fold and the price empirical question and needs to be estimated in
of lighting (measured in lumen-hours) fell 75-fold order to help identify the scale of the ‘rebound
in the last century, thus, traditional methods of effect’, which will be discussed in the fourth
measuring the price of lighting using the fuel price section.
were off by a factor of 25. Fouquet ( ) and Muller ( Hunt and Ryan ( ) have made this point
) showed that this is not explicit, emphasizing the misspecification of
an isolated example and that, in general, the trend models that fail to incorporate energy service
demand and the biased elasticity estimates that of a good into a service is underestimated. In fact,
result. In their analysis, the income elasticity of Nordhaus ( , p. 60) suggests that ‘estimates of
demand for energy is underestimated and the price the growth of real consumption services is ham-
elasticity is overestimated, because of the failure to pered by significant errors in the measurement of
model energy services and include energy effi- prices and that for almost two-fifths of consumption
ciency improvements. However, they explain that the price indexes are virtually useless. ’
the bias depends on the trends in income, real prices In other words, focusing on energy services
and efficiency improvements, implying that it is not rather than energy consumption can greatly improve
possible to generalize the direction of bias (Hunt our understanding of energy consumption behavior,
and Ryan , p. 283). including the rebound effect (see the fourth section),
An additional advantage of focusing on energy of the relationship between energy markets and
services is that the demand for energy services stays economic growth, and even of fundamental
relatively stable with the introduction of new energy measurements of cost-of-living and economic
sources and technologies. Traditional analysis sees activity. The main reason economists have tended to
energy transitions as dismptive events - with a ignore energy services has been a lack of data on
radically declining demand for, say, biomass fuels energy efficiency to convert data into services. As
and rapidly rising demand for coal - with no Sorrell ( , p. 25)
continuity. However, they can be seen as competing explains: ‘For many energy services, the relevant
technologies and sources for producing the same data is simply unavailable, while for others the data
energy service. In this way, long ran patterns in must be either estimated or subject to considerable
energy service consumption can be identified that error.’
would be hidden by focusing only on the uptake and
decline of energy sources and technologies
(Fouquet ). The Demand for Energy Services and Its
In addition, Smulders and de Nooij ( ) Household Production
highlight the limitations of a study of economic
growth that ignores energy services. They show Having discussed the importance of focusing on
that, within their model, energy conservation pol- energy services, and before reviewing the empirical
icies, which reduce energy consumption, lower evidence, it is valuable to outline briefly the basic
economic growth. However, this assumes that theory underlying the demand and provision of
growth in energy use is a key source of the growth energy services. Energy service markets often
in economic output, rather than energy service involve the same agent demanding and providing
consumption, which is unlikely to decline following the service by consuming energy and acquiring
energy conservation policies. Indeed, Toman and related equipment (that is, the physical capital).
Jemelkova ( ) emphasize the importance Here, the focus is on the residential and transport
of energy services in driving economic develop- sector, although similar issues apply to energy
ment. They show that energy services can affect service markets in industrial and tertiary sectors.
economic development through a number of dif- One difference is the increasing separation of
ferent channels, and that these effects can change at demand and supply with ESCOs (Energy Service
different levels of economic development, and it is Companies) providing the services, which will be
essential to model them explicitly. briefly discussed.
Finally, the Nordhaus ( ) piece sought to The first modelling of the derived demand for
highlight that the consumer price index (CPI) and energy, combining complementary durable equip-
the gross domestic product (GDP) are mis- ment, dates back to Houthakker ( ). Early
measured if they do not take account of increases in studies highlighted the fundamental importance of
the quality of service provision, which result from the relationship between energy use and appliances,
technological improvements. Lighting is just one but were not explicit about the consumer’s
example amongst many in which conversion objectives related to energy services (Bemdt and
Wood ; Pindyck ; Hausman ; Khazzoom ; Dubin Based on the above analysis, but for simplicity
and McFadden ; Dubin et al. ) - for a review of the assuming only economic constraints, utility depends
early literature on energy demand modelling, see indirectly on prices and income; the indirect utility
Taylor ( ). Then, a growing literature emphasized function is
the
importance of modelling energy end-use or service U{ = (PEst,Px,,Y,). (3)
consumption, starting with Reister and Devine (
The fact that the indirect utility function repre-
, ), Neels ( ), Goldemberg
sents the consumption of energy services and
et al. ( ), Quigley ( ), Klein ( ), and
composite goods as a function of prices and income
Quigley and Rubinfeld ( ), though focusing
is particularly valuable for analyzing economic
on the production of services.
behaviour since neither utility nor preferences can
However, economists have been slow to
be observed, whereas prices and income can. Thus,
explicitly model the demand for energy services,
for example, the demand function for energy
and were eventually stimulated by Nordhaus’ ( )
services is
seminal piece on the price of lighting, by
Modi et al.’s ( ) emphasis on the provision of
ESt = f(PES,,Px,,Yt). (4)
energy services in developing economies and by the
interest in the rebound effects that hamper efforts to By specifying the nature of theoptimization
mitigate climate change through energy efficiency problem, principally the constraints faced by con-
improvements. The following outline summarises sumers, and solving it, we can examine the way
the demand-side perspective presented in Hunt and optimal choices vary with changing constraints.
Ryan ( ), while incorpo Tracing out these variations in consumption, the
rating the supply-side approach proposed by Neels ( behavioural relationships between consumption and
) and Quigley ( ), which is also constraints, such as described in the energy service
discussed in Frondel et al. ( ). demand function, can be identified.
A consumer or household’s objective is to Knowledge of the energy service demand function,
maximize utility - here, the focus is explicitly on for example, can then be used to assess the
taking account of the energy services consumption implications of changing economic activity and
(ES) generated for meeting this utility: policies on fuel consumption. The effects of these
changing constraints can be analyzed in the form of
Max Ut = u(ESt, Xt), (1)
the own price elasticity of demand:
subject to constraints
SpESt = (9ESt/ESt)/(c)PEst/PESt)> (5) the
Y t = P ES fES t +P X fX t (2)
income elasticity of demand:
where Xt is a composite of goods and services, PESt
and Pxt refer to the prices of the energy services and
By, = (0ES,/ESt)/(3Yt/Yt), (6 )
of the composite goods, and Y t is the consumer’s
budget, which should be permanent wealth and the cross price elasticities:
(although it is often proxied by income). Other sPxt = (<9ESt/ESt)/(o»Pxt/Pxt). (7)
constraints, for example, relating to the availability
of information, technical problems using certain This conventional model of consumer behavior
products and the existence of institutional factors outlines the demand for energy services. The supply
which influence the ability to make decisions and to of energy services is less conventional, however.
choose goods, might also be included for a more Rooted in Becker’s ( ) theory of
realistic (but more complicated) optimization the allocation of time, households produce their
problem.
own services by combining labour, capital and efficiency of the appliance being used (see
energy. At a larger scale, firms similarly generally Nordhaus ):
produce their own energy services.
Technological developments over the last two PESt =Pet/<Pef (9)
centuries have led to a move away from labour
Feeding Eqs. and into Eqs. and enable energy
inputs and towards physical capital and energy
economists to estimate the own-price and income
sources, implying that many energy services, such
elasticity of demand for energy services.
as heating and lighting, are now provided with
This section presented a simple model of the
virtually no labour requirements. Car driving is the
demand for energy services in which the consumer
only energy service where substantial labour is
also produced the service. This implies that the
required today - and suggests that the diffusion of
same consumer and producer is actively involved in
driver-less cars, and the associated decline in the
selecting the production technology and the energy
labour costs (in time), may have a significant
sources. Recently, energy service companies
impact on the consumption of passenger transport
(ESCOs) have begun to take on the responsibility
services. With this feature of the modem provision
for producing these services. While this can create a
of most energy services, a simplified model of the
principal-agent problem, it is also seen as a way to
household production would include only capital
stimulate energy efficiency improvements and
(kt) and energy used (et).
reduce the energy efficiency gap (Gillingham and
The relationship depends on the efficiency of the
Palmer ). If these companies expand their role
technology (4>t) - that is, the amount of energy
beyond the provision to firms, in the future, energy
services generated by a specified quantity of energy.
service markets may become more conventional, in
As Hunt and Ryan ( , p. 274) explain:
the sense of the consumer and producer being
‘three particular characteristics of energy-using
different agents - for more on this particular
equipment are of relevance: much of it is longlived
development, see Groscurth et al. ( ),
- once installed it may have a useful life that spans
Olerup ( ), and
decades; much of it is ftiel(s)- specific; and its
Weiller and Pollitt ( ).
technical characteristics tend to be fixed, requiring a
The opposite may be occurring in the market for
given level of energy use per unit of services
power. While the final services associated with
produced.’ Given that this relationship is often a
power (for example some heating, cooling, lighting,
constant at any point in time, the provision of
entertainment, computing, and so on) are provided
energy services can be determined by the energy
by consumers, they have not produced their own
consumption multiplied by the efficiency of the
power since the early days of electricity generation.
appliance:
However, since the introduction of micro-wind
ESt = <pet • et. (8) turbines and the drop in the price of solar panels,
more households are becoming ‘prosumers’. That
Frondel et al. ( ) highlight that improve is, consumers are entering the market for the
ments in energy efficiency may be associated with production of electricity (and, in some cases, selling
higher capital costs. Therefore, ideally, the cost of their surplus, known as ‘net- metering’), and
producing energy services should take account of an blurring the roles (Romer et al. ; Gillingham et al. ).
estimate of these capital costs, as well as any time In other words, no single model can capture the
expenditure and the price of energy. However, a different characteristics of all energy service
common assumption made is that the price of consumption and provision. Nevertheless, the model
energy services is determined by the marginal cost presented above outlines a simple framework for
of production, which is generally simplified to the thinking about the market for energy services.
price of energy (Pet) divided by the technical
The Direct Rebound Effect and the Price lead to increases in energy consumption became
Elasticity of Demand for Energy Services known as Jevons’ Paradox.
Jevons’ Paradox (also now known as ‘back-
The main reason energy services have received a fire’) is effectively an extreme case in which the
great deal of attention in the last decade is due to rebound effects are sufficiently large that the effi-
the debate about rebound effects. They refer to ciency improvements lead to increases in con-
consumer, producer and market responses to energy sumption. There is now a large theoretical literature
efficiency improvements (Sorrell and supporting the existence of rebound effects which
Dimitropoulos ; Gillingham ). As mentioned before either implicitly or explicitly analyze the price
in the second section, they include a direct effect on elasticity of demand for energy services (Khazzoom
the consumption of energy services and, thus, E
; Saunders ; Howarth ; Turner ; Gillingham and
energy in response to a higher efficiency Chan ). However, empirical studies have tended to
improvement and lower energy service price. There estimate much smaller rebound effects than Jevons
are also indirect effects on consumption behaviour ( ) anticipated. So, in the recent
related to complements and substitutes of the cases investigated, energy efficiency improvements
cheaper energy service (and associated energy led to savings in energy consumption, all other
source), to a probable increase in purchasing power things being equal (Greening et al. ; Sorrell ). Thus,
(after taking account of the expenditure on the new the inconsistency between Jevons’ predictions and
efficient technology) and, therefore, to an increase the recent empirical evidence suggests a paradox to
in the consumption of other goods and services. the Jevons’ Paradox.
Finally, macroeconomic rebound effects occur Ultimately, measuring all the different (i.e. the
because the reduction in the price of energy services direct, indirect and macroeconomic) rebound
tends to boost the economy, stimulating further effects empirically at the same time is challenging
energy service and energy consumption. Thus, for (Gillingham ; Gillingham et al. ).
instance, a 10% improvement in energy efficiency “Measuring the rebound effect is not an easy task,
is unlikely to lead to a 10% saving in energy use. as it involves an estimation of the elasticity of the
Instead, the sizes of the different and combined demand for a particular energy service with respect
rebound effects are empirical questions (see, for to energy efficiency. Instead of using this original
instance, Sorrell ; Gillingham ). definition, the majority of available studies have
Despite the recent interest, the origins of the estimated the rebound effect using price elasticity,
debate on the size of the rebound effects began 150 since data on energy efficiency has always been
years ago. In 1865, William Stanley Jevons limited. In principle, rational consumers should
published T h e C o a l Q u e s t i o n . respond in the same way to a decrease in energy
As a leading political economist of the time, his prices as they do to an improvement in energy
book sought to shed light on the murky debates efficiency. This assumption, however, does not
surrounding the potential exhaustion of coal always hold up, as energy efficiency itself may be
resources that were central to Britain’s economic affected by changes in energy prices” (Sorrell , p.
supremacy (Madureira ). One of his most 4).
controversial passages in the book warned that ‘....it Nevertheless, the price elasticity of demand for
is wholly a confusion of ideas to suppose that the energy services offers a means of estimating the
economical use of fuel is equivalent to a diminished direct rebound effect associated with efficiency
consumption. The very contrary is the truth.... Every improvements. As Hunt and Ryan ( ) explain,
improvement of the engine when effected will only a number of early studies tried to include data on
accelerate anew the consumption of coal...’ (). The energy efficiency, either by using a deterministic or
idea that energy efficiency improvements could a stochastic trend (Beenstock and Willcocks
 ; Dimitropoulos et al. ) or by measuring elasticity of demand for car transport to be
energy efficiency directly or indirectly (Walker and 1. 2 2 in the second half of the twentieth
Wirl ; Haas and Schipper ; Haas and Biermayr ; century, falling to —0.06 between 2001 and 2004.
Fouquet and Pearson ; Fouquet ; Schleich et al. ). This implies that the direct rebound effect
Earlier studies used the efficiency indicator as an associated with a 1 0 % efficiency improvement fell
additional explanatory variable. The more recent from 2 . 2 to 0.6%. Focusing on the more expensive
studies used these measures of efficiency to and densely populated Great Britain, Stapleton et al.
produce indicators of the price and consumption of ( ) estimated the direct rebound effects
energy services, which were used to estimate the for car transport over a similar time period to have
price elasticity of demand for energy services. ranged from 0.9 to 3.6%. The similar results for
Frondel et al. ( ) outline the assumptions these two studies suggest that the widely different
made in efforts to estimate this price elasticity and economic, political and behavioural characteristics
direct rebound effects. Ideally, as explained in the may not have influenced greatly the sensitivity to
third section, the price elasticity of demand for changes in the price of car transport. On the other
energy services can be estimated based on varia- hand, Frondel et al. ( ) found substan
tions in the fixed costs of capital (and labour, tially laiger direct rebound effects for Germany -
associated with the capital investment), and the averaging 5.8% for a 10% efficiency improvement,
marginal costs of labour and energy services. which they explain as due to greater potential for
However, this is rarely done or even possible, and a substitution between modes of transport.
second-best is to estimate the elasticity based on While some uncertainty about the scale of the
variations in the marginal cost of energy services - direct rebound effect still remains, the growing
as a number of the later studies above did. These number of studies are offering a range of values for
studies ignore the endogeneity of the fixed costs of the price elasticities of demand for various energy
capital and the marginal cost of the energy services services. The first effort to summarise the finding
(as often more efficient equipment is more was in Greening et al. ( ), indicating
expensive). Finally, traditional studies have used the range to be between 0 to —0.5, with a concen-
the price elasticity of demand for energy as a proxy tration in the range of —0.1 to —0.3. More recent
for energy services. Frondel et al. ( ) offer a rare efforts include Sorrell ( ), Azevedo ( ),
study where all three Gillingham ( ), and Gillingham
methods were used on the same data, and so et al. ( ). The latter selected estimates from
provide an opportunity to compare the results. The nine studies based on rigorous identification strat-
authors were surprised to find that the price egies, and argued that this lowers slightly the range
elasticity estimates using the three different (between —0.05 and —0.40). An early example of
methods were similar, but the coefficients on other a randomized controlled trial (that is, an experiment
explanatory variables were substantially different. set up purposefully to identify the causality)
Thus, their study highlights the ambiguity of using associated with energy efficiency improvements
only energy data given that consumer behaviour is found that the price elasticity of demand for clothes
driven by energy service demand. washing was —0.06 (Davis ). Table presents
Given the greater availability of data on trans- estimates for a few key energy services based on a
port use and energy consumption related to trans- general review of the literature. The broad
port services, tins service has been studied most conclusion is that direct rebound effects are an
extensively and has offered an opportunity to important issue, but they are unlikely to lead to
estimate actual price elasticities of energy services Jevons’ Paradox (or ‘backfire’) for households or
and measure the direct rebound effect. For instance, personal transport in developed countries - without
using a panel data set of US states between 1960 drawing a conclusion about the combined impact of
and 2004, Small and van der Dender ( ) direct, indirect and macroeconomic rebound effects
estimated the long run price - see
Energy Range of estimates Number of studies
service
Space heating -0.02 to -0.60 9
Space cooling 0.00 to
Chitnis and Sorrell ( —0.50 9) for an attempt to mea the evidence, and the assumptions made in the
Water heating
sure the combined effects. 5
-0.10 to -0.40 model tend to remain constant through time. Indeed,
Lighting -0.05 to-0.12 4
As discussed
-0.05 to -0.87earlier, modelling energy service
a key issue raised in the literature reviews, such as
Transport demand is important for explaining
20 past behaviour, Azevedo ( ), Gillingham ( ) and
(car)
Residentialforecasting future consumption and anticipating the
sector services Gillingham et al. ( ), is about the ‘external
Estimates ‘Service’ sector services Estimates Transport services Estimates
impact of policies, including efforts to mitigate validity’ of the studies. That is, it is unclear whether
Electrical appliances -0.31 Electrical appliances -0.32 Car -0.54
climate change and potentially begin the transition those estimates will be the same if different
Gas appliances -0.33 Cooking -0.23 Bus -0.38
towards a low carbon energy sources (Pearson ). An methods or models are used and in different time
Space heating -0.34 Space heating -0.26 Rail (passenger) -0.24
important issue is the projection of dramatic periods or contexts. Gillingham et al. ( )
Water heating -0.34 Water heating -0.26 Rail (freight) -0.24
increases in air conditioning demand
Lighting and use over emphasize
-0.32
the empirical
Goods Vehicles
strategy -0.61
the next few decades, because Cooling
of declining costs of used,
-0.32
and that these studies tend
Air travel
to assume other
-0.38
air conditioning and electricity, improving energy characteristics related to the energy source and
efficiency, and rising incomes and temperatures in technology remain unchanged and increases in
developing economies, with potential positive energy efficiency are costless. Azevedo ( )
feedback loops (Davis and Gertler ). Other studies, stresses that most studies are for the residential and
such as Anandarajah et al. ( ), Anandarajah transport sectors in developed economies,
and Strachan ( ) and Fujimori et al. ( ), particularly in the US.
also explicitly model energy service demands for In fact, over decades, price elasticities of
their long run scenarios - see Table , as an example. demand for energy services appear to have changed
These studies show the relevance of the estimates considerably as per capita income has increased
for practical purposes. However, these are generally (Fouquet ). Estimates for residential heating,
based on limited reviews of transport and lighting in the United Kingdom
indicate that price elasticities peaked (at values of
about —1.5) at levels of per capita income of
between $(2010) 4,000 and $(2010)
Energy Services, Table 1 Estimates of price elasticities of 5,1 (see Fig. , bottom-half). That is, in Britain in
demand for energy services in industrialised economies the 1870s and 1880s, a 10% reduction in energy
prices or a 1 0 % improvement in energy efficiency
(both reducing the price of energy services)
increased transport and lighting use by around 15%.
This implies that energy efficiency improvements
associated with transport and lighting led to rises in
energy consumption, as Jevons ( ) had
predicted - offering an explanation for the paradox
of Jevons’ paradox. Furthermore, given that
Source: Greening et al. ( ), Sorrell ( ), Sorrell and elasticities of demand for energy services change,
Dimitropoulos (2007), Azevedo ( ), Gillingham
( I and Gillingham et al. ( )
efforts should be made to incorporate more

Energy Services, Table 2 Price elasticities of United Kingdom demand for energy services used in scenarios towards a low
carbon pathway

Source: Adapted from Anandarajah et al. ( )

 4.0

3.5
Lighting
3.0

2.5

w
2.0 Passenger
Transport
1.5

Domestic Heating
1.0

0.5

0.0

-0.5 Domestic Heating

■5 -1.0
Passenger
w Lighting
Transport
-1.5
$(2010)3,300 $(2010)11,800 $(2010)28,500
$(2010)6,400
2.0
-

1800 1825 1850 1875 1900 1925 1950 1975 2000

Energy Services, Fig. 1 Income and price elasticities of demand for energy services in the United Kingdom, 1800-2010
(Source: Fouquet ( ))

realistic assumptions, including changes in energy evidence of increased electricity consumption

service demand at different phases of economic associated with air conditioning following
development (as will be discussed in the next improvements in the efficiency of equipment - in
section), in long ran scenarios of energy con- other words, there appear to be very large rebound
sumption and climate mitigation strategies, as effects. Sorrell ( ), for
prepared by the IPCC and the IEA. instance, argued that the direct rebound effect in
developing countries may be larger since the
demand for energy services may be far from sat-
Energy Services and Economic urated. In general, the hypothesis is, and the limited
Development evidence suggests, that price and income elasticities
of demand for energy services are greater in
Energy services have been increasingly linked to
developing economies.
the debate about the role of energy access for The main finding from Fouquet ( ) is that,
economic and sustainable development. Energy
as the United Kingdom’s economy developed over
services are seen as key to stimulating economic the last 2 0 0 years, trends in income elasticities
growth and development, and to ensuring improv-
followed an inverse U-shape curve (see Fig. , top
ing living standards (Modi et al. ; AGECC ; half). For instance, they reached a peak (about
UNDP ).
23,3.1 and 4.0 for income elasticities of demand
This then feeds through into greater consump- for heating, transport and lighting, respectively) in
tion of energy services. Davis et al. (2014), in a
the nineteenth century (at levels of GDP per capita
rigorous analysis of Mexican households, find below $(2010) 6,000). After the peaks, there were,
at first, rapid declines, then more gradual declines. do not take account of the likelihood of peaking
Income elasticities took almost 100 years to reach elasticities in developing economies.
unity (that is, a 1 0 % increase in income led to a As mentioned at the beginning of this section,
1 0 % rise in energy service consumption), in the while rising income drives up demand, rising con-
mid-twentieth century, at between $(2 0 1 0 ) sumption of energy services is likely to stimulate
9- 12,000 per capita. The results also indicate economic and social development - although it is
that income elasticities were significantly different hard to disentangle the direction of causality. This is
from zero at high levels of per capita income in the made even harder by the idea that energy services
twenty-first century, implying that current increases can affect economic development through a number
in income generate rises in energy service of different channels, and that these effects can
consumption (roughly, around 5% rises for a 10% change at different levels of economic development
increase in income). These rises feed through (Toman and Jemelkova ). Access to modem sources
directly into greater energy consumption. of energy for heating, cooking and power can bring
Developing economies may well also experience about substantial health benefits, associated with
inverse U-shaped income elasticities, given satura- reducing exposure to indoor air pollution or
tion effects - that is, an additional unit of energy providing clean water and refrigeration, which can
service generates less benefit or utility to the con- in turn yield improvements in productivity. Equally,
sumer. However, whether they peak and reach unit they can enable a reallocation of household time
elasticity at similar levels of per capita GDP as die (particularly for women) which can stimulate
United Kingdom is unclear. Because today’s devel- additional livelihood opportunities and improved
oping economies have access to cheaper energy education. Lighting may allow for greater flexibility
services (compared with the United Kingdom at the in time allocation through the day and evening, as
same level of income), they may experience earlier well as better conditions for education. Finally,
peaks (Fouquet ; van Benthem ). lower transportation and communication costs may
These results offer the beginnings of a stylised enable greater market size and access. In other
fact about the relationship between elasticities of words, although it can sometimes be hard to
demand and economic development (Fouquet , ). identify in the macroeconomic data, there appears to
Sovacool ( ) describes the pro be a close relationship between electricity access
cess as the ‘energy service ladder’. That is, at very and economic development (Toman and
low levels of economic development, consumers Jemelkova ; Modi et al. ; AGECC ; UNDP ).
focus on meeting basic needs, particularly food and Fuel poverty in general, and especially in
cooking. As income grows, shelter and indoor developing economies, has major social conse-
climate become important - such as space and water quences. ‘Worldwide, approximately 3 billion
heating, in temperate climates. As income rises people rely on traditional biomass for cooking and
further, these demands start to grow less heating, and about 1.5 billion have no access to
proportionately than income (for example, income electricity. Up to a billion more have access only to
and price elasticities for heating fall). In turn, other unreliable electricity networks. The “energy-poor”
demands are met, for instance, mobility, lighting suffer the health consequences of inefficient
and entertainment (implying rising income and combustion of solid fuels in inadequately ventilated
price elasticities for transport and lighting demand). buildings, as well as the economic consequences of
As income increases further, these income and price insufficient power for productive income-generating
elasticities start to fall. Thus, pending confirmation activities and for other basic services such as health
from further studies, these general patterns could and education. In particular, women and girls in the
help to guide forecasts of energy service and, developing world are disproportionately affected in
therefore, energy consumption. For example, while this regard’ AGECC ( , p. 7).
the IEA ( )
does incorporate saturation into its models (thus
implying declining elasticity through time), they
 However, these health, education and welfare provided to poor populations. However, they find
benefits tend to be ignored by policy-makers in that there is a relatively rapid declining marginal
developing economies (Reddy et al. ). Looking at utility as energy service uses and incomes rise.
experiences in Brazil, Bangladesh and South
Africa, Winkler et al. ( ) stress
that, despite access, affordability limits the ability Concluding Discussion
to meet demands for specific energy services, and
This piece has sought to introduce the reader to the
that policies addressing affordability appear to have
concept of energy services. This piece has shown
more success in stimulating low energy- intensive
why it is important to take account of energy
services, such as lighting and entertainment, than
service demand. Ignoring services, when analyzing
high-intensive ones, such as cooking and cooling.
energy markets, (especially when looking at the
Reddy ( ) discusses practical
long mn, where technical efficiencies of appliances
ways to make available affordable and reliable
and equipment can change considerably) is likely to
energy service to poor and often rural populations.
lead to mis-estimation of price trends, mis-
One recommendation is to promote the
specfication of models, and biases in estimates.
development of small enterprises to provide
The debate about the rebound effect, and iden-
relatively basic energy technologies. However, the
tifying the actual energy savings resulting from
implementation and scaling-up of the provision of
efficiency improvements, has created a major
energy supplies to meet service demands will need
increase in the interest in energy services. These
the close collaboration among numerous different
empirical studies have shown that the non-zero
stakeholders including households, local bodies,
price elasticity of demand implies that, after
energy utilities, governments, entrepreneurs,
improving technical efficiency, consumers increase
research organisations, non-governmental
their consumption of energy services, but also
organisations, community groups, financial insti-
generally reduce their energy consumption - though
tutions, and international agencies. Inevitably,
not by the same percentage as the efficiency
coordination failures are a major barrier to enabling
improvements due to generally small, but non-
these multiple stakeholders to achieve the
negligible, rebound effects.
objectives in socially desirable ways.
One of the historical barriers to using energy
Sovacool ( ) highlights how thinking
services in energy economics was that it ‘distanced’
about energy services emphasizes the role culture
the analysis from the influence of energy producers
and social values play in influencing energy use.
and suppliers. Particularly following the 1970s oil
Indeed, the challenges of governing the develop-
crises, and the growing role of OPEC, energy
ment and expansion of energy markets will differ in
economics had tended to focus on energy supply
each country partly because of the cultural aspects.
and market structures (Fouquet ). Since the 1990s,
For instance, an awareness of the value of travelling
environmental concerns have driven energy
long distances to eat turkey with relatives in late
economists’ research agendas, and issues related to
November in the US or the value placed on well-
the demand have become more important. This has
ironed clothes on Sunday mornings in Uganda
meant a growing interest in incorporating energy
inform us about national patterns of energy service
end-use and service consumption.
demands.
As mentioned before, another limitation of this
Providing an in-depth study of energy service
approach to understanding energy consumption
behavior in Mexico, Cravioto et al. ( ) con
behaviour (and a barrier to becoming the dominant
firm that services are prioritised differently as
modelling method) is the lack of data. Information
incomes rise. Furthermore, they stress that the
about aggregate production and consumption by
ability to measure the levels of satisfaction or utility
broad fuel categories is readily
generated may be easier by focusing on energy
services. With this in mind, they find high levels of
utility associated energy services
available. Detailed data on end-use energy con- standards, which have received considerable crit-
sumption, on energy efficiency or on energy ser- icism (Anderson et al. ). Finally, the active
vices require far more effort and expense for development of energy service policies should seek
statistical agencies. a broader and more strategic approach to thermal
A conclusion of this paper is, therefore, that comfort, mobility, illumination, entertainment and
there is a need to coordinate the methodological computing.
development for the collection of data on energy The need to integrate policies related to energy
end-use and energy services consumption and services is particularly important for developing
prices across national statistical agencies, and economies. Indeed, Fouquet ( ) stresses that
encourage the collection of this data. Once this data policies promoting cheap energy (through large
becomes readily available, over time and across energy infrastructure projects and fuel subsidies)
countries and regions, energy economists will be tend to discourage energy efficiency investment and
able to model and analyze the drivers of energy lock economies into energy-intensive consumption
demand more accurately. This is likely to improve patterns for decades. In turn, this behaviour leaves
the reliability of future energy consumption and these economies vulnerable to energy price shocks,
carbon dioxide emission scenarios. Furthermore, inflation, trade balance deficits, political pressures
this information will enable stakeholders to observe from energy companies and environmental
the success of policies aimed at providing cheaper pollution. Thus, successful long run economic
energy services while reducing energy use. development depends partly on careful and
With this in mind, another important recom- balanced policies related to energy services.
mendation is that governments should be devel- Despite the statistical and institutional barriers,
oping policies that seek the decoupling of energy it is hoped that there is sufficient grounds to con-
services from energy (Fouquet ). They ought to vince analysts and policy-makers of the value of
create packages of measures, including targeted focusing on energy services in analyzing energy
energy efficiency investments, that encourage more markets and in formulating climate policy. For
service consumption (which is welfareenhancing), analysts, their models and data ought to be based on
and less energy use and carbon emission (which is energy services. Policy-makers need to, first, set up
welfare-reducing). In other words, they need to the framework for collecting data on energy
develop policies that focus explicitly on energy services, combining information about energy price
services. For instance, there is a long run trade-off and consumption with the technical efficiency of
between lower energy prices and higher investment equipment, then use models and analysis to
in energy efficiency (Newell et al. ; Popp ). Here, it determine the appropriate strategies. This may help
is proposed that governments should take account formulate policies that are more effective at
of the trade-offs between energy prices and achieving their economic, social and environmental
efficiency investment in the long run and ideally objectives.
find the optimal tradeoff between them. Indeed,
energy service policies should go beyond simply
looking at balancing energy prices and technical
efficiency. They should seek to integrate policies
related to the pricing and provision of energy See Also
sources with those focusing on promoting energy
efficiency improvements, including research, ► Energy-GDP Relationship
development and demonstration (R,D&D) and ► Energy Transitions
considerations about behavioural features to address ► Rebound Effects
the energy efficiency gap (Gillingham and Palmer ) Acknowledgments I would like to thank Mona Chitnis and
- and not exclusively through efficiency Ken Gillingham for their valuable comments on this paper.
Naturally, the usual disclaimer applies. Support for this
research from the ESRC is gratefully acknowledged.
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Development 39(6): 1037-1050. Keywords
Biomass fuel; Climate change; Energy policy;
Energy service; Energy transition; Environment;
Fossil fuel; Greenhouse gas; Industrial
Energy Transitions revolution; Nuclear power; Path dependence;
Primary energy; Renewable energy; Socio-
Peter J. G. Pearson technical transition

JEL Classifications
Q32; Q43; Q57; 040
Abstract
This article explains why past, present and
future energy transitions matter and why there What are Energy Transitions and is so much
current interest in them in both Why Do They Matter? developing and industrialised
countries. It
explores past transitions, including the first An energy transition is often simply described as a and
subsequent industrial revolutions - and shift from one dominant energy carrier to another, shows that
although energy transitions have In practice, energy transitions involve changes or
shifts in how, where and by whom energy is Policy on current transitions includes a focus on
produced, converted, supplied and used. These moves towards low-carbon fuels and technologies
changes lead to new patterns, quantities and qual- to reduce greenhouse gas emissions, particularly
ities of fuels, technologies and uses that interact and those from fossil fuels, and so address the threat of
co-evolve with wider socioeconomic, demographic, climate change (IPCC ). In most past transitions,
technological and environmental developments and however, there were obvious benefits that producers
patterns: consequently, energy transitions are now and consumers could gain from switching to the
often known as socio- technical transitions. new energy sources and their uses, so such
Energy transitions have included shifts from the transitions were largely endogenous. Such private
dependence of early humans on firewood and benefits are as yet much less evident for low-carbon
human labour, to the growing use of animal labour technologies and practices. Both this gulf between
and more sophisticated processing and uses of private and social benefits and the widely (although
biomass fuels (peat, wood, grass, crop residues, not universally) perceived urgency of addressing
charcoal), to wind and water power, coal, oil, gas climate change (Capstick et al. ) mean that a low-
and electricity. Such transitions have unfolded over carbon transition has to be purposefully guided
decades and even centuries and are ongoing through public policy, a challenging contrast with
(Fouquet ; Smil , ). Although the most previous transitions (Pearson and Foxon ).
new sources may grow and dominate, the incum- Moreover, the avoidance of damages from climate
bent energy source(s) and technologies often con- change constitutes a global public good, i.e. one that
tinue to be used for several decades or longer is non-rival (one nation’s benefit from avoided
(Fouquet ; Kander et al. , Ch. 5). emissions and concentrations does not reduce the
Energy transitions matter because they have benefit available to others) and non-excludable
enabled - and been influenced by - increases in (nations cannot be excluded from the benefits of
economic growth, welfare and population and the avoided damage, even if they have not contributed
exploitation of natural resources. Economic history towards such avoidance); this implies that it needs
has shown how they have contributed greatly to to be provided and financed via a form of global
human welfare through enabling significant, governance that is proving hard to construct.
sustained increases in productivity and economic Studies of past energy transitions include: Smil (
output and the production of new commodities and , ) at an international scale; a range of
services (Kander and Stem ; Mokyr ). For many international studies in Fouquet and Pearson ( );
developing and emerging nations, transitions that Kander et al. ( ), on five centuries
provide affordable access to modem fuels, energy of European experience; Schurr and Netschert (
technologies and end-uses to large and growing ) on energy in the USA from 1850s, and
populations are crucial elements of their more recently O’Connor and Cleveland ( )
development strategies (Barnes et al. ; IEA ; , ). on US transitions since 1780; and for the UK,
Transi Fouquet and Pearson ( ), Warde ( ) on
tions also matter because different transitions and primary energy transitions since 1760, Fouquet (
fuel mixes lead to different profiles of resource use , ) on energy services and Arapostathis
and depletion (for renewable and fossil fuels et al. ( ) on the gas industry. Reviews and
respectively). And because fuels have different commentaries on energy transitions include Araujo
chemical properties (e.g. different fossil fuels have ( ), Elzen et al. ( ), Fouquet
different ratios of hydrogen to carbon), and ( ), Grin et al. ( ), Grubler ( , ),
footprints in extraction, capture and use, transitions Markard et al. ( ) and Smil ( ).
lead to different spatial and temporal environmental Transitions occur in the use of forms of primary
implications in the form of short-or long-lived local, energy (energy embodied in sources which involve
regional and global impacts on air, land and water. human induced extraction or capture, so
as to make the energy available for trade, use or related environmental pollution, especially in the
transformation), such as coal, oil, sunlight and industrialised world, following the 1973-74 and
wind. Transitions also occur in secondary energy 1979-80 oil price shocks; and in the developing
forms or carriers delivered to the final user, such as world over ‘the other energy crisis’ (Eckholm ), i.e.
gasoline, electricity and hydrogen. They help worries about shortages of biomass fuels (e.g. wood
produce valued energy services, such as heat and fuel, charcoal, crop residues and animal dung),
comfort, mobility and illumination, with the aid of postulated impacts of wood fuel collection on
delivery infrastructures (pipes and wires) and end- deforestation (contested, since deforestation has
use devices, such as light bulbs or passenger cars many other more significant causes, such as land
(Fouquet ). These secondary forms of energy are clearance for agriculture) (Anderson ) and other
often of higher quality, such that they can be used forms of environmen
for a wider and/or more valuable range of tal degradation, including soil erosion and health
economically productive or satisfying activities impacts from indoor air pollution from unenclosed
(Cleveland et al. ; Stem ; Gentilvaite et al. ). They stoves (Barnes et al. ; Fullerton et al. ).
often cost more because of the conversion processes From the late 1980s, along with continuing
and losses involved (e.g. electricity and gasoline debate about petroleum resource depletion, the
cost more than the fuels used to obtain them). volatile geopolitics of oil and gas and ideas of
However, users have been willing to pay for them sustainable development, we have seen a tightening
because of their greater value and range of policy focus on transitions to low-carbon forms of
application in particular uses. For example, energy (renewables and nuclear electricity) and
electricity is more flexible in use and, with efficient behavioural changes towards more efficient and
electric motors, enabled higher productivity than reduced use of energy.
mechanical power from coal; gaseous and liquid This arose i n t e r a l i a from studies of
fuels were essential for the internal combustion the global climate impacts of concentrations of
engine and more efficient, more flexible transport. greenhouse gases associated with emissions from
Consequently they and their associated end-use fossil fuels and other energy-related human
devices tend to be increasingly demanded when activities, including cement production and land use
incomes and living standards rise (Fouquet , ; change (IPCC ), and growing emphasis on the
Grubler ), as recent experience in India, China and bringing together of climate policy and energy
elsewhere confirms. policy (Pearson and Watson ). Recent developments
in seismic and drilling technologies, along with
hydraulic fracturing (‘fracking’), have led to sig-
Recent Growth of Interest in the Study nificant exploitation of shale and unconventional
of Energy Transitions gas and oil resources, especially in the USA. This
has also brought a new set of environmental impli-
Although energy transitions have long been of inter-
cations, both negative and positive, as well as
est to many disciplines, academic and public policy
impacts beyond the USA on the relative price and
interest in energy transitions grew steeply from the
availability of coal and its use in power generation,
1970s, partly in response to the stimuli of higher oil
and in some jurisdictions issues about the public
prices and environmental concerns. While economic
acceptability of fracking (Hammond et al. ;
historians have long studied them, energy
Joskow ; Rasch and Kohne ; Stevens ).
transitions were of much less importance to main- Today, there are serious concerns about various
stream economics until the past half-century or so ongoing and prospective transitions and their eco-
of growth in the sub-disciplines of energy and envi- nomic, environmental and social implications.
ronmental and development economics. These concerns include the challenges of mitigating
The 1970s saw rising concerns over oil availability and adapting to the very long-run impacts of
and prices, resource depletion and energy-
potential climate change; disquiet over the impli- particularly striking developments in the USA and
cations of the very rapid growth in fossil fuel use Germany, was intimately bound up with develop-
and associated urban air pollution and greenhouse ments in petroleum, the internal combustion engine
gas emissions in recently industrialising countries and electricity. Today, developments in the use of
like China and India; and the desire in many ICT in the energy system, including in ‘smart
developing countries for rapid transitions from grids’, ‘smart controls’ and the ‘internet of things’,
traditional biomass to modem fuels. As noted, sometimes described as part of a third Industrial
common to all these areas is that they imply active Revolution, could have major implications for
management and guiding of transitions, which was energy use and economic growth and welfare;
largely absent from earlier energy transitions, while moreover, energy transitions in the developing
low-carbon energy transitions require a new form of world have the potential to transform - or not - the
global energy governance. They also imply largely lives and life chances of billions whose living
unprecedented moves away from highly valued standards are constrained by lack of access to
energy-dense fossil fuels towards less energy-and affordable modem fuels and technologies (GEA ).
power-dense (and in some cases intermittent) forms The long-drawn-out transition from wood and
of renewable energy (such as wind), which bring charcoal to coal in Britain before and during the
their own challenges and opportunities (Smil ). first Industrial Revolution offers valuable insights
into the complexities, causes and consequences of
energy transitions, even though so much has
Past Transitions: The First changed since then. Figure shows how the shares of
and Subsequent Industrial Revolutions different energy sources in Britain evolved over 500
years.
Although the past does not offer a blueprint for the
Wrigley ( , ) shows how the 16th to
future (Allen ), a knowledge of the characteristics,
19th century transition from the limited energy
patterns and key relationships involved in past
flows possible in a constrained ‘organic’, largely
transitions can yield insights, parallels and partial
biomass-based energy system to one based on coal
analogues that may be instructive for policy
helped transform Britain’s economy in the
thinking today. Indeed, Grubler ( ) sug
Industrial Revolution. In the ‘organic’ economy -
gests that part of the value of historic transitions
apart from intermittent wind and water power,
work is that it helps develop ‘storylines’ for future
energy f l o w s were limited to what could be
transitions and invites us to question prevailing
captured each year with available technologies and
policy wisdom. It is not surprising, therefore, that
knowledge via photosynthesis. The organic material
part of the attention now paid to past transitions has
could feed people and draft animals and their labour
been stimulated by the current concerns just
and be used to provide heat and other energy
described.
services. The growing exploitation of s t o c k s
There has been rising interest in understanding
of coal, the fossilised, energy-dense accumulation
how past transitions unfolded and in collating,
from past photosynthesis, relaxed these constraints:
recovering and analysing data on them (Fouquet ;
‘To us the evidence points to the impossibility of
Kander et al. ). Energy transitions have
sustaining high levels of growth or transformation
played major roles in industrial revolutions that
in a world wholly dependent on ‘organic’ or
have transformed economy and society. One of the
vegetable sources of energy’ (Kander et al. , pp. 14-
most studied examples of a long, slow transition is
15).
that to coal before and during the first Industrial
Innovations, including the steam engine, the
Revolution in Britain (in which much of the key
substitution of coal and coke for wood and charcoal
activity took place in the 18th and 19th centuries).
in metal manufacture, new spinning and weaving
The second Industrial Revolution in the late 19th
technologies and textile mills, along with other
and early 2 0 th centuries, which saw
socio-economic changes, helped lead
 Nuclear
100%

Hydro
Gas
80%

>, Coal
60%

CD Wind

Biomass Petroleum
O 40% -
co
-C Provender for Animals
C

20% -
Food for Labour

0%
1500 1600 1700 1800 1900 2000

Shares of primary energy consumption in

Energy Transitions, Fig. 1 author and Elsevier.
Britain, 1500-2000 (Source: Reproduced from Fig. in aD ce/artidle/p i/S03 014215100( . Original data from
Fouquet ( ), with permission from the Fouquet ( ), with updates.)

and sustain the urbanisation, mechanisation and Industrial Revolution... High British wages and
industrialisation of the Industrial Revolution. They cheap coal underpinned the Industrial Revolution by
led to striking declines in the cost of direct energy creating a demand for technology that substituted
services (Fouquet ; Fouquet and Pearson , , capital and energy for labour. In Asia and much of
; Pearson and Fouquet Europe, low wages and dear energy had the
) and increases in their consumption (see opposite effect.’
Fig. ). They also led to efficiency improvements in The high wage/cheap energy price structure
manufacturing and other processes that yielded came from Britain’s foreign trade boom in the 17th
higher productivity and economic growth and better and 18th centuries. London’s growing demand for
quality products. And they gradually meant much fuel for industrial and domestic heating energy, a
higher standards of living for the general rising price of wood fuel relative to coal and the
population, as well as producing new problems of development and construction of the coal-burning
land, air and water pollution. house also created incentives to shift to coal and the
Unlike later transitions outside the UK, much of means of doing so. On the supply side, Allen
the transition to coal was pre-industrial; however, concentrates on the role of increased literacy and
by around 1750, on the eve of the main years of the numeracy and the connections between the
Industrial Revolution, coal already provided half of scientific discoveries of the 17th century and
England’s fuel (see Fig. ). By 1900, 140 years later, technological advances. For steam power he argues
almost all of the country’s energy came from coal. that the kind of R&D needed to bring the pan-
Allen ( , p. 17) states European science to fruition, ‘was more profitable
that ‘Britain’s transition to coal was bound up - in Britain than elsewhere, which is why the
both as cause and as effect - with the Industrial Revolution was invented in
Energy Transitions, Fig. 2 Consumption of energy ser- permission, under a Creative Commons license, vices in the
UK, 1700-2000 (index 1900 = 100) (Source: .)
Fig. in Fouquet ( ). Reproduced with author’s

Britain.’ The ‘macro-invention’ of the Newcomen The period between the late 1900s and the early
engine was followed by a series of ‘micro- 2 0 th century, sometimes said to run between 1870
inventions’ that more than decimated the steam and 1914, with some precursor activity from the
engine’s coal consumption, to the point where the 1850s (although the boundaries are disputed), ‘saw
cost of coal became irrelevant to its commercial the lusty childhood, if not the birth... of a cluster of
application and the steam engine became an innovations that have earned the name of the
‘appropriate technology’ for other countries with Second Industrial Revolution’ (Landes , p. 235),
different relative price structures. which variously influenced the economies of the
Mokyr places much more emphasis than Allen USA and Western Europe (especially Germany),
on the view that the Industrial Revolution grew out with smaller and later effects in Eastern Europe and
of ‘the social and intellectual foundations laid by some parts of Asia and South America. These
the Enlightenment and the Scientific Revolution’ inventions and activities included many that were
(Mokyr , p. IT). Britain led the Industrial directly to do with energy, including electrical
Revolution because it could exploit its favourable power, motors and lamps, telegraphy, the telephone
human and physical resource endowment ‘thanks to and radio, the internal combustion engine and
the great synergy of the Enlightenment: the vehicles that used it and the growing use of oil and
combination of the Baconian program in useful its products, as well as developments in organic
knowledge and the recognition that better chemicals and synthetics, in steel production, in the
institutions created better incentives’ (Mokyr , 122). factory system and mass production and a range of
What was needed ‘was the right combination of advances in medical knowledge, public and private
useful knowledge generated by scientists, engineers health and sanitation.
and inventors to be exploited by a supply of skilled Mokyr ( ) argues that the path-breaking
craftsmen in an institutional environment that inventions of the second Industrial Revolution were
produced the correct incentives for entrepreneurs’ crucial not because they necessarily had a
(Mokyr , p. 116).
Total Food Fodder Wood Wind
Water----Coal Oil Gas Nuclear

Year

Energy Transitions, Fig. 3 US energy consumption 1780- Commons license and with the author’s permission.
2010 (in petajoules) (Source: O’Connor and Cleveland ( See also
, Fig. 13); reproduced under a Creative O’Connor ( ).)

major direct impact on production but because they Revolution, not the first, that created the golden age
raised the effectiveness of research and of productivity growth’ that was to follow, with
development in microinventive activity and led to a concomitant rises in income, wealth and living
range of further applications. While the first standards.
Industrial Revolution had a very limited scientific It should not be thought, however, that the
base, ‘the persistence and acceleration of techno- pattern and duration of the energy transitions
logical progress in the last third of the nineteenth experienced in Britain during and after the Indus-
century was due increasingly to the steady accu- trial Revolution would be simply replicated in other
mulation of useful knowledge’ from science and the countries with different economies and resource
interplay with novel techniques and learning from endowments. For example, O’Connor and
experience. Along with this, changes in the Cleveland ( ) undertook a comprehensive
organisation of production and the growing study of US energy transitions, through the
exploitation of economies of scale and scope, partly assembly and use of a database of energy use for
through mass production, meant that the second 1780-2010 that includes both traditional forms of
Industrial Revolution saw the rise of the large energy (food, fodder, firewood, wind, water etc.)
technological system, as with electrical power and the usual commercial forms (fossil fuels,
(Hughes ). Indeed, Gordon ( , nuclear and renewable electricity etc.). Figure
p. 1) argues that ‘it was the Second Industrial shows the remarkable rise in total energy use of
Nuclear Gas Oil ■ Coal Water
Wind Wood Food Fodder

Energy Inputs (Shares)

> i—i—i—i—i—i i i i i i i i i i i—i—i—i—i—i—i—i—i 1780 1800 1820 1840 1860 1880 1900
1920 1940 1960 1980 2000

Energy Transitions, Fig. 4 Shares

of inputs to US Commons license and with the author’s permission.
energy consumption, 1780-2010 (Source: O’Connor and . See also O’Connor
Cleveland ( , Fig. 14); reproduced under a Creative ( )■)

well over 300 times in 230 years (around 300 PJ electricity generation); its share peaked at about 75
(petajoules) in 1780 to 100,000 PJ by 2010). There % three decades further on. Oil, first produced there
is particularly rapid growth as the economy in 1859, did not significantly replace coal until the
expanded in the 2 0 th century, albeit with evidence early 2 0 th century, when demand grew with the
of the impacts ofmajor events, including the Great spread of the internal combustion engine and new
Depression, world wars and the oil price shocks of and cheaper supplies of oil could satisfy it. Oil did
the 1970s. not exceed coal’s share until about 1950, peaking at
O’Connor and Cleveland discuss major US just under 50 % in the late 1970s, whereas natural
transitions, building on the assumption that a rea- gas overtook coal’s share by about 1960.
sonable benchmark for the start of a transition is O’Connor and Cleveland also examine the
when a new energy source captures 5 % of primary changing energy intensity of the American econ-
energy use (Smil ). Figure shows that, in contrast omy, in terms of its energy/GDP (E/GDP) ratio. It
with the dominance of coal early in the British is often thought that energy intensity rises with
Industrial Revolution (Fig. ), as the US developed, development, then falls in an inverted-U shape as
wood retained a 50 % share of total energy use even an economy matures. When traditional energy
through the mid-1880s. Although coal reached 5 % sources are included, however, the US graph shows
in the mid-1840s, it only gained a half share in the an overall declining trend, albeit with a 40-year
late 1880s, four decades later (through its use in period from around 1880 to 1920 when it was
steam engines, for transport and stationary power, constant or rose. They ascribe the changing
in iron production and
Energy Transitions, Fig. 5 South Korea: shares in total primary energy supply, 1961-83 (Source: Pearson ( ) and
the sources described there.)

slope of the E/GP ratio largely to the influence of the 20th century. They argue that these small
three factors: (a) changes in energy quality (which energy consumers had earlier and faster transitions
they define as the marginal increase in GDP flowing than leading nations. By outlining a whole series of
from the use of one additional heat unit of a fuel), energy transitions, they identify a number of
with higher quality fuels substituting for lower different transition processes. Factors such as
quality fuels over time, as in Fig. ; (b) domestic energy resources, the size of the internal
improvements in the efficiency of energy end-use, market for energy services, trade relations and
from incremental improvements in existing policy decisions were important in determining the
technologies and from the adoption of new nature and speed of the transitions experienced.
technologies (which they illustrate via the example They suggest that the lessons will be particularly
of changes in lighting technologies, but which have relevant for understanding the way in which non-
arisen in other main energy conversion processes pioneering countries might adopt low-carbon
and heat production); and (c) more efficient energy sources and technologies.
operational organisation and new manufacturing The experience of the Republic of Korea (South
systems. And, of course, aggregate energy Korea) since the beginning of the 1960s provides a
efficiency is influenced over time by the changing striking example of more recent and much more
sectoral mix of activities with different energy rapid and highly directed transitions, illustrated in
intensities across the sectors of an economy (for a Fig. .
discussion of the reasons for the declining trend in The figure shows that in less than 20 years,
aggregate energy intensity in Europe in the 20th Korea transited from nearly 60 % dependence on
century, see Gentilvaite et al. ). wood fuel (and serious deforestation problems) to
Just as Britain’s energy transitions were not 90 % dependence on modem commercial fuels
replicated in nature or timing by those of the USA, (Pearson ). Total energy supplies grew at an
Rubio and Folchi ( ) present evidence average of more than 8 % per year between 1962
on the energy transitions from coal to oil for 20 and 1979, at a time when Korea experienced
Latin American countries over the first half of remarkably rapid economic growth and structural
change. In less than two decades, the country was structural shifts that take time to achieve’ because
transformed, via an outward-oriented of a significant lag between early inventions and the
industrialisation strategy, from a poor developing widespread adoption of a technology. They argue
country into a semi-industrial middle income that transitions to higher quality energy carriers and
country, even though it was poorly endowed with rising thermal efficiencies in machines have led to
energy resources or a mineral base for heavy improvements in economic energy efficiency,
industry (Kim ). indicated by the ratio of GDP to Energy (GDP/E).
The first of three major transitions was from fuel In addition, technological shifts associated with
wood to anthracite coal during the first five- year development blocks and industrial revolutions have
plan (1962-66); the second saw the growing produced structural shifts (changes in the relative
replacement of coal by oil during the second plan importance of different activities) that have also
(1967-71); and the third saw transition away from significantly affected economic energy efficiency,
heavy dependence on oil towards a wider mix of making technologies more affordable, sometimes
fuels, after the first oil shock (1973—74 ), and more with concomitant r e b o u n d or t a k e -
strikingly, after the second shock (1979-80). These b a c k effects from increased demand (see
were highly directed transitions in which, until the Turner ( ) for a
second oil shock, the main aim of energy policy review of rebound concepts).
was to ensure that energy did not become an As with most analyses, Kander et al. ( )
obstacle to economic growth, with efforts directed emphasise and explore the interplay between
towards supplying cheap and often subsidised energy, economic growth and population. As part of
energy to critical sectors (electrical power and this, they examine the growth in total energy
industry). The increase in world oil prices and consumption (E) by decomposing it into the effects
import costs and other inflationary pressures after of three factors, energy intensity (E/GDP) - the
the second shock led the government to re-evaluate inverse of economic energy efficiency, per capita
the expansionist policies it had pursued until that income (GDP/P) and population (P) (these latter
point (Kim ). comprise the s c a l e e f f e c t ) :
Kander et al. ( ), in a major study of energy
and economic development in Europe, have E = (E/GDP) x (GDP/P) x P
recently analysed the unfolding of energy transi-
They show, for example, that for Western Europe
tions in several countries over five centuries. They
between 1820 and 1910, while energy grew on
do this through exploring first the pre-industrial
average at the rate of 2.04 % per year, population
economies and then the First, Second and Third
grew at 0.76 %, income per capita by 1.08 % and
Industrial Revolutions. In their analysis, they
employ the term ‘development blocks’ ‘to describe energy intensity by 0.19 %.
the series of systems of technology, infrastructure, Later they explore the evolution of carbon
energy sources and institutions by which economic emissions (C) and the key factors that have
growth proceeded’. Development blocks are influenced it by decomposing the widely used Kaya
constantly evolving systems centred on a generic Identity (Ogawa ) into carbon intensity
technology (Dahmen ; Enflo et al. ). For instance, (C/GDP), energy intensity, per capita income and
they say that it was the combination of coal, steam population, each of which can exert a significant
engine and iron, the raw material from which much influence:
of the new technology was made, that characterised
C = (C/E) x (E/GDP) x (GDP/P) x P
and drove the first Industrial Revolution in Britain
and then Western Europe. Kander et al. argue that For other examples of such decompositions, see
although the process of growth is fairly continuous, Pearson and Fouquet ( , ).
it has been ‘achieved through fundamentally Although coal and steam power are widely
discontinuous processes involving major acknowledged to be key elements in the first
Industrial Revolution, it has not proved easy to 130 years for the growth of steam power displacing
demonstrate formally their rapid impact on output pre-industrial renewable sources. He also observes
and productivity growth (Crafts ). It should be that while European late adopters of new
noted, however, that in a broader European context technologies achieved faster transitions through
Kander et al. ( , p. 368; also Appendix profiting from learning externalities that reduced the
A) argue strongly that ‘energy is more important to costs of later adoption, early adopters faced the
economic growth than generally believed among challenge of sunk costs associated with human,
economists’. They suggest that such economists’ technological and infrastructural capital.
focus on overall efficiency gains may miss the Wilson ( ) has also explored how and why
‘capital deepening’ effect (linked to the growing use energy supply and end-use technologies take time to
of machinery stimulated by cheap energy) that in mature. He studied processes of scaling-up,
their view has played an essential part in raising formative phases and learning in the historical
labour productivity (see also Kander and Stem ). diffusion of energy technologies from the early
They also argue that scepticism about energy’s role 1900s. He used logistic growth functions to help
in explaining economic growth is partly a reflection establish the time from initial commercialisation to
of economic growth models set up with low-or market saturation. He concluded that: (1) increases
zero-cost shares for energy. in unit size come after an often prolonged
experimentation with many smaller- scale units; and
(2) that the peak growth phase of an industry can lag
Energy Transitions and Time these increases in unit size by up to 20 years.
Correspondingly, for a low-carbon transition, he
As we have seen, economic historians have argued
suggested that it may be risky to use low-carbon
that the coming together of the elements that made
technology policies that push for big jumps in unit
up the transition from wood to coal in the UK not
size before a ‘formative phase’ of experimentation
only had deep historical roots but also took a
with smaller-scale units.
considerable time to develop. Pearson and Foxon ( Fouquet ( ) examined past energy transi
) note how evolutionary economists, tions and their drivers in the UK between 1500 and
drawing on some earlier economic ideas of 1920, by end-use energy service (for heat, power,
Kondratiev and Schumpeter, identified five Tong light and transport) and sector, to help find common
waves’ of economic development. In these waves, features relevant for future transitions. He gives
while the application of innovative technologies and greater weight to post-industrial Revolution
processes, such as the steam engine, electrification transitions and reminds us of the dangers of
and mass production, drove growth, the full societal aggregation: partly from a lack of detailed data,
benefits were only realised when wider institutions many historical studies have tended to analyse broad
and practices had time to adapt to them. It is argued transitions within an economy. However, as he
that structural crises of adjustment tend to arise in shows, a ‘single’ energy transition (say, from wood
the face of the widespread introduction of radical fuel to coal) may be composed of several different
new technologies because suitable new institutions transitions, some running in parallel and others at
and industrial structures have to be established to very different times.
accommodate them (Freeman and Perez ; Freeman Fouquet identified the opportunities to produce
and Louga )• cheaper and/or better energy services as the main
Grubler ( ), considers the speed at which economic drivers in the 14 cases he examined (and
transitions have taken place. He notes that at the in most cases he also identified catalysts for faster
global level, characteristic ‘change over times’ adoption). The new services began in niche markets
(Marchetti and Nakicenovic ) in primary energy or market segments. Here, despite their often initial
range from 80 years for the growth of higher costs, users might be willing to pay for their
oil/gas/electricity replacing steam power to extra service attributes (e.g. greater ease, cleanliness
or flexibility in use, or faster
speed oftransport). These new energy sources and significant behavioural changes by energy con-
energy-using technologies could be subsequently sumers on an unprecedented scale.
refined (e.g. leading to lower fuel costs or enhanced Numerous studies suggest that although energy
energy conversion efficiencies) until they could transitions have proceeded at different speeds in
compete successfully across the market with the different places and times, and some of the more
incumbent service provider (e.g. the switch from recent transitions have been faster, transitions do
horse to rail transport or from gas to electric light). not usually happen quickly (Sovacool ). When they
This process of refinement, performance or quality do, they seem likely to have built on a foundation of
improvement and cost reduction meant that on precursor activities in areas including infrastructure,
average the whole innovation chain took more than institutions, technology, niche experimentation and
100 years and the diffusion phase nearly 50 years. an openness to change. For example, although the
Fouquet also suggests that, based on past headline events of the UK’s transition from town
experiences, a complete transition to a low-carbon gas (produced from coal) to natural gas from the
economy could be very slow. This, he concludes, North Sea took 10 years between 1967 and 1977,
suggests that ‘early action and favourable the seeds were sown in the 1940s as the newly
conditions may be warranted to steer any transition nationalised industry accepted the need to respond
to a low-carbon economy’. to the challenge of rising costs and growing
The studies reported in Fouquet ( ) found competition from coal, oil and electricity. It not
remarkable increases over time in the efficiency of only experimented with alternative technologies and
converting energy flows into energy service flows, feed stocks but also made major institutional and
which were particularly striking in the case of organisational changes that enabled it to respond
lighting. Indeed, Gmbler ( ) states that past rapidly to the discovery of natural gas in the North
energy transitions were essentially driven by tech- Sea and to decide to strand its hundreds of town
nological and associated institutional and gas-producing assets (Arapostathis et al. ).
organisational transformations in energy end-use:
‘transitions in energy services, in which new
technological combinations enabled entirely new, or Lock-in, Path Dependence and the Role of
vastly improved traditional services, at greater Incumbents
energy efficiency and ever falling costs in a virtual,
self-re-enforcing positive feedback loop drove In energy transitions, the penetration of innovative
associated transitions in energy supply systems’. new fuels and technologies depends on their ability
While accepting that energy demand and supply to compete with and displace the incumbent fuels,
systems co-evolve, and that there have been technologies and their industries. This in turn is
transformative changes in supply systems and influenced by the strategies and reactions of those
technologies, he asserts that in the absence of incumbents. Long-term technological systems
energy service demand changes, we would not have change can be path-dependent, in that a system’s
seen the kinds of radical energy supply changes that future evolution depends on the past sequence of
have emerged so impressively from studies of the events that led to its current state,
past. This implies the particular importance for i. e. its ‘evolution is governed by its own
policy of acting on the end-use and demand side, as history’ (David ). So a system state may be locked
well as the supply side. For example, it is clear that in because of particular historical experiences, cre-
a successful low-carbon transition requires the ating barriers to moving to an alternative state,
decarbonisation of both heating and transport although the conditions leading to that lock-in may
systems, which currently often depend on liquid and no longer obtain (David ; Foxon ).
gaseous fossil fuels, with many consumers deeply Arthur ( ) showed that increasing returns
attached to their current cars and heating systems; relating to scale, learning, adaptation and network
moreover, many current policy strategies are
predicated on
effects can lead to technological lock-in, while engagement with low-carbon transitions, as well as
North ( ) and Pierson ( ) suggested that to limiting their ability to constrain them.
increasing returns can also apply to institutions,
including market or regulatory frameworks - such
that rule systems become hard to alter, enabling Sustainability Transitions Studies
incumbents to protect their interests (see also Foxon
). These processes have important implications for The growing interest in sustainable energy futures
future low carbon transitions. Thus Unruh ( , (c.g. GEA , ) is reflected in recent theoretical and
) and Unruh and empirical work in areas ranging from innovation to
Carrillo-Hermosilla ( ) suggest that low-carbon transition pathways and policies to
co-evolutionary processes and mutually reinforcing achieve them. We briefly explore an approach, often
positive feedbacks have led to the lock-in of current called ‘sustainability transitions’, that has attracted
fossil fuel energy systems, i.e. carbon lock-in, and recent academic and policy attention. In
hence to systemic barriers to investment in low- sustainability transition studies, researchers explore
carbon technology systems that can retard low- potential societal transformations in production and
carbon transitions. consumption that combine economic and social
Nevertheless, it has also been argued that if development with reduced pressures on the
increasing returns to new alternatives can be set off, environment.
this may lead to virtuous cycles of rapid change. In their review, on which this section draws,
Thus Garud and Kamoe ( ) have Markard et al. ( ) explain how this new field
suggested there can also be ‘path-creation’ by of studies has grown, as those in the policy arena
incumbents: entrepreneurs may choose to depart and social scientists have paid growing attention to
from the structures they have jointly created. how to promote and govern a low-carbon transition
Incumbents may also, of course, sometimes increase to sustainability. In transition studies, sectors like
their competitiveness. The sailing ship effect or last energy are viewed as socio-technical systems that
gasp effect of obsolescent technologies comprise interacting networks of actors (people,
(Rosenberg ) is postulated to occur where firms etc.), broadly defined institutions, material
competition from new technologies stimulates artefacts and knowledge. Thus an energy transition
improvements in incumbent technologies/ firms (but might unfold over several decades, and involve
see Mcndonca ). Analyses of energy industries many actors and lead to new products, services, user
threatened by technological discontinuities have, for practices, business models and organisations, as
example, offered insights into how the UK gaslight well as changes in technological and institutional
industry eventually responded to the threat from structures and impacts well beyond the energy
newly introduced incandescent electric light sector. Sustainability transitions are, therefore,
(Arapostathis et al. ) and why incumbent complex, long drawn-out processes, involving
automotive technologies might show a sudden governance and guidance (Smith et al. ), through
performance leap (Furr and Snow ); and, on the which systems shift towards more sustainable
other hand, how current analyses may overestimate modes of production, consumption and living.
new entrants’ ability to disrupt incumbent firms and The idea of the socio-technical regime brings
underestimate incumbents’ capacities to see the ideas from evolutionary economics together with
potential of new technologies and to integrate them insights from the history and sociology of tech-
with existing capabilities (Bergek nology. It emphasises how scientific knowledge,
et al. ). Given the urgency of climate change and the engineering practices and processes are socially
time taken for new entrants to scale up their embedded. The regime tends to persist unless
activities, growing attention is now being paid to the destabilised, leading to the emergence of a new
potential of encouraging large relatively high regime. Much of the interest in this area is in regime
carbon incumbents’ positive changes, transitions, and the factors that
might result in such destabilisations (e.g. Kemp et trying to ‘manage’ national level transitions through
al. ). For example, Tumheim and Geels ( ), such processes.
explored the factors that led to the decline Energy Innovation Systems approaches have
and ultimate demise of the UK’s coal mining constituted another key approach in transition
industry from its late 19th century dominance of the studies. Truffer et al. ( ), review the energy-
world coal market. related areas of the emerging socio-technical
Researchers in sustainability transitions have innovation systems literature, which has aimed to
carried out numerous empirical studies of historical address the interacting social and technical aspects
energy transitions. These studies drew on the notion of innovation processes. This literature ranges
of the multi-level perspective (MLP), an approach across four innovation system areas: those of
built on the researches of Kemp, Rip and Schot national (NIS), regional (RIS), sectoral (SIS) and
(Kemp et al. ; Rip and Kemp ). The MLP posited technological (TIS) innovation systems.
that transitions could arise from dynamic The NIS developed in the late 1980s, partly as a
interactions between the three interconnected levels riposte to what was seen by its proponents as the
of niche, regime and landscape. Pressures on the failure of neo-classical economics to explain the
regime from the landscape, such as higher world oil major economic challenges of that period: ‘The core
prices or concern over climate change, might help assumption was that nationally specific institutional
prise open windows of opportunity for innovations arrangements between science, policy and industry
in niches (i.e. ‘protected spaces’ in which explained differences in innovation success among
innovations can develop and that might be managed different countries (especially the technology
strategically); some innovations might then break leaders US, Germany and Japan)’ (Truffer et al. , p.
through, leading perhaps to fundamental regime 4). The other three innovation systems approaches
shifts (Geels , ; Raven et al. ). Different interac started from a criticism of the original NIS for
tions could then lead to several different types of limiting systems within their national boundaries
transition pathway, including pathways to future and ignoring wider influences and interactions, such
energy systems (Geels and Schot ). This approach as the role of multinational companies. However, of
has been used to help develop forward- looking these areas, Truffer et al. argue that the TIS
analyses of the challenge of developing low-carbon tradition has been much the most productive in the
energy transition trajectories, as in Hammond and energy field (see also Markard et al. ). TIS has its
Pearson ( ) and Trutnevyte roots in the seminal paper of Carlsson and
et al. ( ), which describe studies of pathways Stankiewicz ( ), which drew on Dahmen’s
to the UK’s legislated target of 80 % reductions in work on development blocks (Dahmen ; Enflo et
greenhouse gas emissions by 2050. al. ), mentioned earlier.
Notions of transition management brought Studies have gone from looking at selected
transition research together with insights from the energy innovations in particular countries, often
areas of complex systems theory and governance. focusing on the functions of the innovation system
From these ideas came procedures to try to guide necessary for it to operate well (Hekkert et al. ), to
ongoing transitions toward greater sustainability inter-country comparisons and to some regional and
(Kemp and Loorbach ). The guiding principles for global analyses of technological innovation
transition management were derived from thinking systems. Much of the focus is on Einope, but with
about existing sectors as complex, adaptive systems growing attention to emerging economies. The
and understanding management as a reflexive and work includes an analytical framework of an
evolutionary governance process (Voss et al. ). ‘energy technology innovation system’ that claims
Transition management has been attempted in the to produce innovation policy guidelines that
Netherlands but has proved challenging, while ‘diverge substantially from policies implied by
questions have been raised about the political partial perspectives on innovation’ (Gallagher et
feasibility of al. ). Despite the
progress in energy innovation systems research, Although the developing world has strong incen-
Truffer et al. ( ) rightly suggest that there is tives to avoid the damaging impacts of climate
room for further integration of the four systems change, to which many will struggle to adapt, there
approaches, and for further conceptual and empir- is tension between the urgency of development now
ical developments, including in the analysis of and the mitigation of greenhouse gases (GHGs),
longer term energy transitions and their dynamics. evident in the demands for financial transfers and
While much of the research on energy transition technology transfer from the richer countries. Few
pathways has been historical and qualitative, in the developing world need extra incentives to
belated but increasing attention is being given to the adopt new fuels and technologies, and might be
development of forward-looking quantitative pleased to leapfrog to the most modem technologies
approaches (Li et al. ) and with their consistent if they could access and afford them. But, as noted
integration with qualitative analyses (Trutnevyte et earlier, the private benefits of adopting currently
al. ; Tumheim et al. ). Such developments are more expensive low-carbon technologies and
essential if these approaches are to provide more practices are much less than the societal benefits of
effective insights into guidance and policy for low- doing so. This, along with the fact that many low-
carbon transitions. carbon technologies do not, as yet, possess
evidently superior bundles of performance
characteristics to the fuels that they replace, means
Energy Transition Pathways, Scenarios
that policymakers face an unprecedented challenge
and Policies
(Pearson and Foxon )•
While most past energy transitions were not pur- The desire for directed transitions to modem
posefully guided along particular trajectories or and/or low-carbon energy has led to a proliferation
pathways, modem transitions are different. Thus, of energy transition scenarios and pathways.
developing and emerging countries and their citi- Although many earlier low-carbon transition sce-
zens seek rapid economic growth, poverty reduction narios provided technological detail, they tended to
and higher living standards through wider access to over-rely on exogenous emission constraints and
modem fuels and energy-using technologies (IEA ; high-level trends, without paying sufficient
, ). For many, except in attention to how policy, technology and behaviour
niche applications, the most direct and cheapest might interact and how scenario trajectories and
route has been via the exploitation of fossil fuels end-points might be achieved (Hughes and Strachan
and fossil-generated electricity, often - as in China ). Recently, however, growing attention has been
and India - through particularly rapid growth in the paid to scenario or pathway construction that, in
use of carbon-intensive coal and oil (IEA , ; line with some of the thinking in the sustainability
National Bureau of Statistics of China ; Central transition studies area, acknowledges this
Statistics Office ). At the same time, as well as interaction, incorporates the roles of different
growing recognition of the need to tackle carbon system actors and, rather than focusing on their
emissions (e.g. Liu et al. ; Reddy ), there has been notional endpoints, explores the means whereby the
growing governmental concern and public disquiet trajectories of transition pathways might be realised
over energy-related pollution, particularly over the (e.g. GEA ; Foxon ; Hammond and Pearson ; ET1 ;
cumulative health impacts of air pollution in cities. RTP Engine Room ). Nevertheless, much remains
At the global level, the perceived urgency of to be done to make low-carbon scenarios and
addressing climate change was reflected in the 2015 pathways contribute more effectively to our
Paris Agreement under the auspices of the United understanding of the challenges and dynamics of
Nations Framework Convention on Climate Change the transition and how to address them.
(IPCC ; UNFCCC ). Any transition from fossil fuels poses significant
challenges for electricity generation (widely
dependent on coal, natural gas and oil), for all disposal strategies. Some countries, such as China,
forms of transport (widely dependent on petroleum- are proceeding with significant nuclear electricity
based fuels and natural gas), and for process heat programmes. In others, including Germany,
and domestic and commercial heating, ventilation however, nuclear power has met with considerable
and cooling (HVAC) (widely dependent on coal, political opposition, exacerbated by concerns raised
gas, oil and fossil-generated electricity). To respond by the 2011 Fukushima Daiichi events.
to these challenges will require significantly more Increasing interest has developed in various
(low-carbon) electrified provision of transport, heat forms of decentralised or distributed electricity
and HVAC, with corresponding implications for generation (and other forms of energy). As well as
infrastructure investment and management, such as the technical challenges of interfacing them with
electric vehicle charging and hydrogen refuelling larger transmission and distribution systems, they
stations for fuel cell vehicles. will also require regulatory, financial and business
The decarbonisation of electricity, for example, model innovation, which is likely to involve selling
raises technical, social, behavioural and financial energy services, such as illumination and comfort
issues. On the supply side, incorporating very large (RTP Engine Room ). Existing electricity (and other
proportions of renewable energy brings issues of energy) utilities face the challenge of adapting their
power density (the rate of flow of energy per unit of business models, which have been predicated on the
land area) (Smil ) and intermittent generation (e.g. expansion of demand via large-scale, centralised
from the variability of wind and sunlight). The technologies, and have often been associated with
latter requires compensating backup and/or storage limited consumer satisfaction and trust (Richter ).
capacity, while low utilisation of some of this Recent electricity utility reorganisations, such as
capacity might undermine its efficiency and those of the German-based companies
economic viability. Although any electrical system E. ON in 2014 and RWE in 2015, indicate
must balance supply and demand, greater use of attempts to respond to some of these issues and
renewables may place new short-run (e.g. hourly) opportunities (as well to as the 2011 government
and longer run (e.g. seasonal) challenges. These can decision to phase out and close Germany’s nuclear
be eased by better forms of storage and by managed power plants by 2022).
demand side responses across the whole system to Not least because of recent rapid and projected
enhance the efficiency of generation, transmission growth in coal-based generation in China (IEA )
and distribution network capacity and manage its and India (IEA ), emphasis has been placed on the
operational and economic performance (Aunedi et development of systems of carbon capture and
al. ; Pudjianto et al. ). sequestration (CCS), e.g. in depleted petroleum
While nuclear electricity is widely proposed as a reservoirs or salt caverns, at either pre-or post-
potentially valuable element in a low-carbon combustion stages. Moreover, some low-carbon
portfolio, its technologies tend to be relatively scenarios depend for their ultimate effectiveness on
capital-intensive (like many renewables), to be slow combinations of sustainable biomass with CCS that
to construct and not infrequently to meet with could yield negative carbon emissions. CCS faces
public distrust about operational safety, waste issues that are technical, economic (imposition of a
disposal or proliferation risks. Consequently, in cost penalty), financial and social (in terms of
many countries it remains too risky for private public acceptability) (Hammond and Spargo ;
investors, in the absence of the sustained comfort of Watson ). Similarly, ideas of geoengineering and
long-term financial support from the state (Joskow climate manipulation, from solar radiation
and Parsons ). Its economic prospects may depend management to carbon dioxide removal, to offset
on the development of more modular, flexible, the greenhouse effect or limit GHG concentrations,
rapidly construct- ible, publicly acceptable designs also raise analogous and perhaps more challenging
and waste
issues, as well as those of the international gover- low carbon technologies; and (3) measures to
nance and stability of such a global undertaking remove or address institutional and non-market
(Bellamy and Lezaun ). barriers to the uptake of energy-efficient and low-
On the demand side, many scenarios or path- carbon options.
ways incorporate significant restraint of the growth In orthodox economic terms, these three mea-
of energy demand. Such restraint comes partly from sures address three types of ‘market failure’ that
elements of behavioural change and acceptance of justify government intervention. The carbon price is
new ‘smarter’ technologies, ranging from there to ‘internalise’ the negative externality of
monitoring and control of the use of domestic climate change from CO2 . The innovation supports
devices, like dishwashers, washing machines and are there to harness the positive externalities or
refrigerators, to possible management and uses of spillovers available from RD&D, including
the storage and discharge capacities of automotive addressing the ‘valley of death’ between a techno-
batteries. A growing body of research suggests that logy’s demonstration and the commercialisation
while there is real interest in such developments, the phases. Following Kenneth Arrow, it is argued that
modification of energyusing social practices is far the private market will underinvest in invention and
from straightforward and will require much better research because such activities are risky, because
understanding of different groups’ knowledge, social value exceeds private value and because of
beliefs and habits if it is to occur. Long-run increasing returns in the use and scaling up of
scenarios also tend to include significant and innovations. The institutional and non-market
challenging modifications to and investment in the barriers are those that can delay or inhibit the
design, regulation and energy efficiency of the built commercialisation and growth of innovations; this
environment, from dwellings to neighbourhoods also connects with ideas of path dependence and
and cities, including the retrofitting of existing lock-in, mentioned earlier. Alternatively, and
structures (Dixon et al. ). drawing on ideas from the innovation literature, it
There has been some concern about possible has also been argued that broader ideas of ‘systems
rebound effects, i.e. whether, as energy services failures’ should be seen as complements to or
such as lighting, thermal comfort or transport superior substitutes for the market failure approach
become more efficiently delivered and hence (Bleda and del Rio ; Foxon ). This approach
cheaper, a significant amount of the efficiency is includes proposals that addressing large-scale
taken back in the form of increased consumption societal challenges, including climate change,
and energy use (Turner ). In this area, there are requires a long-term visionary and mission-oriented
likely to be significant differences between approach in which public investment should play a
situations of latent demand in rapidly growing significant part (Mazzucato and Penna ).
emerging or developing countries, in which con- There is continuing debate about the relative
sumer demands may be highly responsive to merits of carbon taxes (setting a ‘price’ to achieve a
increases in income and wealth and falling energy quantity reduction) and marketable permits (setting
service prices, and mature economies where a quantity that achieves a price) as one of the routes
responsiveness may be expected to be much less to controlling the climate externality. And it is clear
(Fouquet ). that there are significant practical challenges with
The Stem Review of the Economics of Climate both instruments, e.g. the problem of setting
Change (Stem ) argued that the innovation and politically acceptable tax levels and the governance
deployment of low-carbon technologies requires at issues of agreeing and running a permit system
least three types of government policy measure: (1) across multiple jurisdictions and sectors (as in the
a carbon price, through a carbon tax or tradable EU tradable permits scheme). Moreover,
permit scheme; (2) direct support for research, distributional issues arise, since expenditures on
development and demonstration (RD&D) and early energy normally form a larger proportion of lower
stage commercialisation of than of higher incomes and there can
be serious concerns over levels of ‘fuel poverty’. technologies, infrastructures and institutions. Fossil
These issues can be addressed by the use of other fuel incumbents use a variety of strategies to protect
policy instruments, such as income supports, pro- their interests (and in some cases even embrace the
vided that such instruments are available and new technologies). Their position may be, however,
workable. considerably bolstered by the effective inverse of a
Governments may provide financial and regula- carbon tax, namely a subsidy. Thus many countries
tory support for appropriate levels of low-carbon maintain very large subsidies to fossil fuels and
RD&D, via policy instruments such as renewable infrastructure investments, distorting relative prices
energy certificates (or ‘green certificates’), feed-in and creating significant barriers to low-carbon fuels
tariffs (FiTs) and auctions for electricity generating and developments. Estimates of such subsidies vary
capacity. This raises the question of how such widely but are big. According to the International
supports should be paid for. They are sometimes Energy Agency’s (IEA) estimates, worldwide fossil
paid for via energy consumers’ bills, as in the UK. fuel subsidies, measured as the gap between end-
However, Newbery ( ) argues that the user prices and reference prices, totalled $490
general principles of public finance imply that billion in 2014; this is almost four times the size of
societal public goods like climate change mitigation subsidies to help deploy renewable energy tech-
should b e financed from general taxation o f the nologies in the power sector of $112 billion, plus
population at large. Several jurisdictions have $23 billion for biofuels (IEA ). Coady et al. ( )
recently shown greater interest in electricity gener- offer a tentative but strikingly larger
ating capacity auctions, because a well-designed estimate, on the basis of post-tax subsidies, i.e. the
bidding process may reduce the cost of such sup- subsidy that arises when consumer prices are below
ports. Moreover, if a support instrument is set up supply costs plus a tax to reflect environmental
without appropriate exit strategies to phase it out damage, including non-climate damage, and a tax
when costs fall - because of learning, economies of applied to consumption goods to raise revenues;
scale or other sources of cost reduction - it may they estimate that in 2013 these subsidies amounted
either prove hard to change or sudden changes may to $4.9 trillion (6.5 % of global GDP) and were
disrupt investor confidence. continuing to rise.
Similarly, there are arguments for providing The International Energy Agency (IEA) suggest
public funds for investment in low-carbon infra- in a 2015 W o r l d E n e r g y
structure, as now happens in countries like Ger- O u t l o o k S p e c i c d R e p o r t
many, since the state may be able raise finance at (IEA ) that several targeted policy actions might be
lower cost than the private sector (Newbery ). done at zero net economic cost, leading to a peak in
Private sector investors may insist on risk premiums energy-related GHG emissions by 2020: increasing
that reflect the perceived risks of new technologies, energy efficiency in the industry, buildings and
whose prospects depend on uncertain future state transport sectors; progressively reducing the use of
commitments to climate change targets and their the least-efficient coal- fired power plants and
associated carbon price trajectories. More broadly, a forbidding their construction; raising investment in
key challenge for the low-carbon transition is for renewable energy technologies in the power sector
the state, and ultimately the global community, to from $270 billion in 2014 to $400 billion in 2030;
give sufficiently credible, consistent longer term phasing out remaining fossil fuel subsidies to end-
commitments and to help create the policy users by 2030; and reducing methane emissions in
structures and instruments to achieve them, while oil and gas production (since methane is a potent
also retaining a necessary flexibility in the face of GHG). Nevertheless, the achievement of such
changing conditions. policies would require significant political will and
Successful transitions to new fuels and tech- public acceptance.
nologies depend, as suggested earlier, not only on Since energy and climate policies and instru-
the cost and performance of low-carbon technol- ments are administered by regional, national and
ogies, but also on what is happening to incumbent
local governments, governance matters. This is not ► Energy Price Shocks
only in terms of the efficiency and transparency of ► Energy-GDP Relationship
the processes of government and their ► Industrial Revolution
implementation, but also in terms of the balance of ► Oil and The Macroeconomy
policy objectives and the means whereby they are ► Rebound Effects
achieved. For example, for many countries policy Acknowledgments Work on this article was supported by
has three overarching broad objectives, sometimes funding from the UK Engineering and Physical Sciences
called the ‘Energy Policy Trilemma’. They are: Research Council (EPSRC) [Grant EP/K005316/1] under the
climate and environment; energy security; and ‘Realising Transition Pathways’ project. The author is solely
responsible for the views expressed and any errors and
affordability and cost. The balance of these omissions. He thanks Roger Fouquet and two reviewers for
objectives and the trade-offs between them tend to helpful and perceptive criticisms and suggestions.
shift through both internal and external influences,
as for example when energy security became a key
objective in oil-importing countries after the oil
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Wilson, C. 2012. Up-scaling, formative phases, and learning Introduction
in the historical diffusion of energy technologies. Energy
Policy 50: 81-94. Figure shows that energy use per capita increases
Wrigley, E.A. 1988. Continuity, chance and change. The character
of the industrial revolution in England. Cambridge:
with GDP per capita, so that richer countries
Cambridge University Press. typically use more energy per person than poorer
Wrigley, E.A. 2010. Energy and the english industrial revolution. countries. In fact, this relationship has been very
Cambridge: Cambridge University Press. stable over the last several decades, and the graph
for 1971 looks very similar except that most
countries were poorer and therefore used less
energy. Van Benthem ( ) finds sim
Energy-GDP Relationship ilarly that energy intensity - energy used per dollar
of GDP - in today’s middle-income countries is
David I. Stem similar to that in today’s developed countries when
they were at the same income level.
The slope of the graph is a bit less than 1, so
that a 1 % increase in income per capita is associ-
Abstract ated with only a 0.7% increase in energy use per
Energy use and GDP are positively correlated, capita (Csereklyei et al. ). This means that energy
although energy intensity has declined over time intensity is on average lower in higher income
and is usually lower in richer countries. Numer- countries, but that this relationship is not so strong
ous factors affect the energy intensity of econo- (Fig. ).
mies, and energy efficiency is obviously one of Globally, total energy use has increased over
the most important. However, the rebound effect time and energy intensity has decreased (Fig. ).
might limit the possibilities for energy efficiency This is mostly due to countries decreasing in energy
improvements to reduce energy intensity. Natu- intensity as they get richer, as the cross- sectional
ral science suggests that energy is crucial to relationship in Fig. has been fairly stable over time.
economic production but mainstream economic Energy intensity has, however, become more
growth theory largely ignores the role of energy. similar over countries over time, so that countries
Ecological economists and some economic his- that were more energy intensive in the 1970s
torians argue that increasing energy supply has reduced their energy intensity by more than less
been a principal driver of growth. It is possible energy-intensive countries on the whole and the
that historically energy scarcity imposed con- least energy-intensive countries often increased in
straints on growth, but with the increased avail- energy intensity. This convergence relationship is
ability of modem energy sources energy’s shown in Fig. .
importance as a driver of growth has declined. Though data are limited to fewer and fewer
Empirical research on whether energy causes countries as we go back further in time, these
growth or vice versa is inconclusive, but meta- relationships also appear to hold over the last two
analysis finds that the role of energy prices is centuries - energy use has increased, eneigy inten-
central to understanding the relationship. sity has declined globally and countries have con-
verged in eneigy intensity (Csereklyei et al. ).
Of course, although energy intensity has
Keywords declined, per capita energy use has increased over
Ecological economics; Economic growth; time, and when we also take population growth into
Energy; Energy intensity; GDP; Granger account total energy use has risen strongly, though
causality at a slower pace than total world economic output.
Between 1971 and 2010 total world energy use
increased by about 140% and GDP by 270%.
JEL Classifications Population increased by 80%.
Q32; Q43; Q57; 040
 GDP per Capita (2005 PPP Dollars)

Energy-GDP Relationship, Fig. 1 Energy

consumption USA at upper right and China in the middle (Sources:
per capita by GDP per capita 2010. Bubbles are propor- International Energy Agency and Penn World Table 7.1)
tional to total energy use. The two largest circles are the

GDP per Capita (2005 PPP Dollars)

Energy-GDP Relationship, Fig. 2 Energy

intensity by right and China in the middle (Sources: International GDP per capita 2010.
Bubbles are proportional to total Energy Agency and Penn World Table 7.1) energy use. The two largest circles are the USA
at lower
 12

11

CL
CL
CL
in
10-

9-

8-
OJ
c
LU
7

6 -I---------------------------1----------------------------1------------------------------1--------------------------1—
1970 1980 1990 2000 2010

Energy-GDP Relationship, Fig. 3 Global energy intensity (Sources: International Energy Agency and Penn World Table
7.1)

Energy-GDP Relationship, Fig. 4 Convergence of energy intensity (Sources: International Energy Agency and Penn
World Table 7.1)

This article next examines the factors that might energy and economic growth. Third, it reviews
lead to lower energy intensity with higher GDP and estimates of the elasticity of energy use with respect
convergence in energy intensity, as seen in Figs. , , to GDP. The penultimate section looks at the
and . Then it reviews the literature on the empirical evidence on the question of whether
theoretical relationship between changes in energy use cause changes in
GDP or vice versa. Concluding remarks point to the efficiency, which is usually defined more narrowly
main gaps in our knowledge. (Ang ; Stem ).
The theoretical rationale for considering energy
as a factor of production is discussed later in this
Factors Affecting the Linkage Between article. Of course, if energy is an input to
Energy and GDP production, then there is also a derived demand
Introduction function for energy and the level of output or
We saw above that energy intensity is lower in income is one of the factors that determine demand.
richer countries and has declined globally over time. Estimates of the income elasticity of energy are also
What are the reasons for this change in the ratio of discussed below.
energy to GDP? We can use a production frontier Substitutability of Energy and Capital
approach to examine the factors that could weaken Koetse et al. ( ) conduct a meta-analysis of the
or strengthen the linkage between energy use and (Morishima) elasticity of substitution (MES)
economic activity over time. A general production between capital and energy for an increase in the
frontier, assuming separability between inputs and price of energy. Their base case finds that the MES
outputs, is given by: between energy and capital is 0.216, so that capital
and energy are poor substitutes. The MES estimated
(Gi> • • • <Qm)' =/(djaXit —AxnXn,AElEl................AEpEp)
using panel and cross-section data are greater: 0.592
(1) and 0.848, respectively. It is likely that these larger
where the Q t are various outputs, such as values reflect long-run elasticities and the lower
manufactured goods and services, the X j are var- values short-run elasticities (Stem ). Relatively little
ious non-energy inputs, such as capital and labour, research has looked at whether capital-energy
the E k are different energy inputs, such as coal substitution has driven part of the decline in energy
and oil, and the A X j and A E k are indices of the intensity. Stem ( ) found that capital deepening
state of factor-augmenting technology. The reduced
relationship between energy and an aggregate of energy intensity by 7% globally from 1971 to 2007.
output such as GDP is then affected by: On the other hand, Wang ( ) found
that capital accumulation was the main driver of
reduced energy intensity in China.

- substitution between energy and other inputs, Energy Efficiency and Technological
- technological change, Change
- shifts in the composition of the energy input, There are several ways of measuring changes in
and energy efficiency that take into account the shifts in
- shifts in the composition of output. other factors, such as the quantities of other inputs.
The distance function approach measures the
We discuss each of these below. Also, shifts in change in energy efficiency as the change in the
the mix ofthe other inputs - for example to a more minimum energy requirement to produce a given
capital-intensive economy from a more labour- level of output holding all other inputs constant.
intensive economy - could affect the relationship Equation ( ) compares the minimum energy
between energy and output, but this issue has not requirements given the technologies in two
been much discussed in the literature and so will different periods but the same levels of inputs and
not be pursued further here. An important factor
-£o(yo-
offsetting the effects of technological change is the (2)
*o)
rebound effect, so we discuss this separately.
E ,
Because all of these factors affect energy intensity,
energy intensity is a poor proxy for energy
periods and E ,() is a function indicating the min- and so was the most important driver of reduced
imum energy required in period i in order to energy intensity.
achieve the given outputs given the level of inputs. When there is endogenous technological
The functions in Equation ( ) can be estimated change, changes in prices may induce technological
econometrically (e.g. Stem ) or changes. Newell et al. ( ) provide some
non-parametrically. information on the degree to which energy price
A second approach is to use an index of energy increases induce improvements in the energy effi-
augmenting technical change. Based on equation ( ), ciency of consumer products. For room air condi-
the index of energy augmenting technical change tioners they found that only about one quarter of the
can be constructed as: gain in energy efficiency since 1973 was induced by
higher energy prices. Another quarter was found to
be due to raised government standards and
/'/•; = ]T.S'A„ (3) labelling. For gas water heaters the induced
ii improvements were close to one half of the total,
although much less cost-reducing technical change
where S , are the shares of each type of energy in occurred. Using US data, Popp ( ) similarly
the total cost of energy. Change over time in this finds that increased energy
index can be computed using an index method such prices have a significant though quantitatively small
as Divisia aggregation. The actual energy effect on the rate of patenting in the energy sector.
augmentation indices need to be estimated Dechezlepretre et al. ( ) broaden the
econometrically. analysis to cover patents from 84 national and
Bottom up, engineering-based measurements of international patent offices covering various climate
energy efficiency represent a third approach. For mitigation technologies, including renewable
example, Ayres et al. ( ) and Warr et al. energy and energy efficiency technologies. They
( ) estimate the useful work performed per find that until 1990 patenting in these fields closely
joule of energy by various fuels and uses of energy. followed oil prices. After 1990 patenting increased
With some exceptions, the general trend over the steadily, although oil prices remained stagnant until
20th century in the USA, UK, Japan and Austria has 2003. They argue that the increase in patenting
been to greater energy efficiency measured in this since 1990 was driven by environmental policies as
way. Over shorter periods energy efficiency has they occurred, especially in countries that ratified
declined in some countries, as it has in the long term the Kyoto Treaty.
for some fuels, especially food and feed. New energy-using technologies initially diffuse
Estimates of the trends in energy efficiency are slowly due to high costs of production that are
mixed (Stem ). The direction of change has not been typically lowered radically by a fairly predictable
constant and varies across different sectors of the process of learning by doing (Griibler et al. ).
economy. Judson et al. ( ) show Diffusion tends to follow a logistic curve, with the
that technical innovations tend to introduce more speed of diffusion depending, among other things,
energy-using appliances to households and energy- on how well the innovation fits into the existing
saving techniques to industry. Stem ( ) finds that infrastructure. Energysaving innovations such as
energy efficiency improved LED light bulbs would be expected to diffuse
from 1971 to 2007 in most developed economies, rapidly once their price becomes competitive, while
the former communist countries (including China ) more radical innovations that require new support
and in India. But there was no improvement or a infrastructures diffuse much more slowly due to
reduction in energy efficiency in many developing ‘network effects’.
economies. Globally, such technological change Research also investigates the factors that affect
resulted in a 40% reduction in energy use over the the adoption of energy efficiency policies or energy
period than would otherwise have been the case efficiency technology (Matisoff ;
Fredriksson et al. ; Gillingham et al. ; Linares and effects in the household sector in India and other
Labandeira ; Wei et al. ; Stem ). Differences developing countries can be expected to be larger
in the adoption of than in developed economies. Fouquet ( )
energy efficiency technologies across countries and confirms how the price elasticity of demand for
states, over time and among individuals might be energy services declines and how the direct rebound
optimal due to differences in endowments, effect decreased as Britain developed.
preferences or the state of technology. But the rate In the case of energy efficiency improvements
of adoption may also be inefficient due to market in industry, the rebound effect at the firm level
failures and behavioural factors. Market failures could be large as the firm could greatly increase its
include environmental externalities, information sales as a result of reduced costs. However, under
problems, liquidity constraints in capital markets, perfect competition for an industry supplying
failures of innovation markets and principal-agent domestic demand it is much harder for the industry
problems, such as between landlords and tenants as a whole to expand output, so the direct rebound
(Gillingham et al. ; Linares and Labandeira ). effect would be more limited. Rebound effects are
Fredriksson et al. likely to be larger for export industries that have
( ) find that the greater the corruptibility of more opportunity to expand production (Grepperud
policymakers the less stringent is energy policy, and and Rasmussen ; Allan et al.
that the greater lobby group coordination costs are ; Linares and Labandeira ).
the more stringent energy policy is. Matisoff ( ) As a result of the reduction in the cost of the
finds that the most significant energy service, consumers will demand less of
variable affecting the adoption of energy efficiency substitute goods and more of complementary goods.
programs across US states is citizen ideology. A These include other energy services. Firms will
broad band of states from Florida to Idaho had not make similar changes in their demands for inputs.
adopted any policies. There will also be additional repercussions
throughout the economy. Non-energy goods whose
The Rebound Effect demand has increased require energy in their
Energy-saving innovations reduce the cost of pro- production. The fall in energy demand may lower
viding energy services, such as heating, lighting and the price of energy (Gillingham et al. ; Borenstein ),
industrial power. This reduction in cost encourages increasing energy use again, and the efficiency
consumers and firms to use more of the service. As improvement is a contribution to an increase in total
a result, energy consumption usually does not factor productivity, which tends to increase capital
decline by as much as the increase in energy accumulation and economic growth, which again
efficiency implies. This difference between the results in greater energy usage (Saunders ). These
improvement in energy efficiency and the reduction additional effects are called indirect rebound
in energy consumption is known as the rebound effects, though the latter two may be treated
effect. Rebound effects can be defined for energy- separately as ‘macrolevel rebound effects’ (e.g.
saving innovations in consumption and production. Howarth ). Direct and indirect rebound effects
In both cases, the increase in energy use due to together sum to the economy-wide rebound effect.
increased use of the energy service where an Estimates of the economy-wide rebound effect
efficiency improvement has happened is called the are few in number (e.g. Turner ; Barker et al.
direct rebound effect. For consumer use of energy, ; Turner and Hanley ) and vary widely (Stem ;
the estimated rebound effects are usually small: in Saunders ; Turner ). At the economy-wide level,
the range of ‘backfire’, where energy use increases as a result of
10- 30% (Greening et al. ; Sorrell et al. an efficiency improvement, or even ‘super-
). Roy ( ) argues that because high- conservation’, where the rebound is negative, are
quality energy use is still small in households in both theoretically possible
India, demand is very elastic, and thus rebound
(Saunders ; Turner ). It is usually assumed that the Cleveland et al. ; Stem ). Some fuels, in particular
indirect rebound is positive and that the economy- electricity, require innovations to allow their use
wide rebound will be larger in the long run than in that must be embodied in capital equipment, which
the short run (Saunders ). Turner ( ) argues, can transform the workplace entirely and change
instead, that because the work processes, thus contributing to productivity
energy used to produce a dollar’s worth of energy is gains (Schurr and Netschert ; Toman and Jemelkova
higher than the embodied energy in most other ; Enflo et al. ).
goods, the effect of consumers shifting spending to In the least developed economies, as in today’s
goods other than energy will mean that the indirect developed economies before the Industrial Revo-
rebound could be negative and the economy-wide lution, the use of biomass and muscle power dom-
rebound may also be negative in the long run. inates. The evolution of the energy mix over the
Borenstein ( ) presents further course of economic development and over history
arguments for negative rebounds. in the technologically leading countries depends on
All evidence on the size of the economy-wide each country’s endowments of fossil energy and
rebound effect to date depends on theory-driven potential for renewables, such as hydroelectricity,
models, which have limited empirical validation. but some regularities apply. The share of electricity
Turner ( ) finds that, depending on the in total energy use tends to rise. Low-income coun-
assumed tries tend to generate electricity from hydropower
values of the parameters in a simulation model, the and oil, while high-income countries have more
rebound effect for the UK can range from negative diverse power sources, including nuclear power.
to more than 100%. Barker et al ( ) provide the Direct use of coal tends to rise and then fall over
only estimate of the global rebound effect, estimat- time and with income. Natural gas use has increased
ing the rebound from a set of IEA recommended significantly in recent decades, mostly in more
energy efficiency policies at 50%. developed economies. Finally, electricity generated
However, these are rebounds in energy use from solar and wind power is only now beginning
rather than energy intensity. As the economywide to take off in more developed economies. Figure
rebound effect is largely due to an increase in illustrates this pattern for the USA.
output, the rebound effect probably has small Surprisingly, relatively few studies evaluate the
effects on energy intensity. role of the change in energy mix on energy
intensity. Schurr and Netschert ( ) were
among the first to recognise the economic impor-
Energy Quality and Shifts in Mix of tance of energy quality in understanding trends in
Energy Inputs energy and output. Noting that the composition of
energy use has changed significantly over time,
In the course of economic development, countries’ Schurr and Netschert argued that the general shift to
fuel mix tends to evolve as the mix of energy higher quality fuels reduces the amount of energy
sources used shifts to higher quality fuels (Burke ). required to produce a dollar’s worth of GDR Bemdt
Energy quality is the relative economic usefulness ( ) also noted the key role played
per heat equivalent unit of different fuels and by the shifting composition of energy use towards
electricity. Fuels have a number of physical higher quality energy inputs.
attributes that affect their relative qualities, Cleveland et al. ( ) and Kaufmann ( ,
including energy density (heat units per mass unit); ) presented analyses that explain much of the
power density (rate of heat units produced per unit decline in the US energy/GDP ratio in terms of
or per unit time); ease of distribution; the need for a structural shifts in the economy and shifts from
transfer medium; controllability (the ability to lower to higher quality fuels. Kaufmann ( )
direct the position, direction and intensity of energy found that shifting away from coal use and, in
use); amenability to storage; safety; and particular, shifting towards the use of oil reduced
environmental impacts (Bemdt ; Schurr ;
 o O
LT s
Energy-GDP Relationship, Fig. 5 Composition of US primary energy input 1850-2013 (Source: US Energy Information Administration)

energy intensity in the USA. This shift away from Shifts in the Composition of Output
coal more than explained the decline energy inten- Output mix also typically changes over the course
sity over the entire 1929-99 time period. Other of economic development. In the earlier phases of
studies find, however, a much larger role for tech- development there is a shift away from agriculture
nological change than for changes in the compo- towards heavy industry, while in the later stages of
sition of energy in the reductions in energy intensity development there is a shift from the more
seen around the world. For example, Ma and Stem ( resource-intensive extractive and heavy industrial
) find that interfuel substitu sectors towards services and lighter manufacturing.
tion had negligible effects on the decline in energy Different industries have different energy
intensity in China between 1994 and 2003. Tech- intensities. It is often argued that this will result in
nological change reduced energy intensity by more an increase in energy used per unit of output in the
than the actual reduction in energy intensity due to early stages of economic development and a
the intensity increasing effects of structural change. reduction in energy used per unit output in the later
Stem ( ) finds that between 1971 stages of economic development (Stem )•
and 2007, changes in fuel mix within individual However, there is reason to believe that the
countries increased world energy use by 4%, while energy-saving effects of structural changes are
global energy intensity declined by 40%. Shifts in overstated (Henriques and Kander ). When the
the distribution of economic activity towards indirect energy use embodied in manufactured
countries with lower quality energy mixes, such as products and services is taken into account, the
China and India, contributed further to increasing service and household sectors are more energy
energy intensity globally.
intensive than they first appear. Service industries to obtain a given production output, greater or equal
still need large energy and resource inputs. The quantities of materials must be used as inputs, and
service being sold may be intangible, but the office the production process results in residuals or waste
towers, shopping malls, warehouses, rental (Ayres 1969). Additionally, production requires
apartment complexes etc. where the activity is energy to carry out work to convert materials into
conducted are very tangible and energy is used in desired products and to transport raw materials,
their construction, operation and maintenance. goods and people. The second law of
Furthermore, consumers use large amounts of thermodynamics (the entropy law) implies that
energy and resources in commuting to work, going energy cannot be reused and there are limits to how
shopping etc. much energy efficiency can be improved. As a
Furthermore, on a global scale there may be result, energy is always an essential factor of
limits to the extent to which developing countries production (Stem ) and continuous supplies of
can replicate the structural shift that has occurred in energy are needed to maintain existing levels of
the developed economies, to the degree that this is economic activity as well as to grow and develop
due to outsourcing manufacturing overseas rather the economy. Before being used in the production
than simply from an expansion in service activities. of goods and services, energy and matter must be
However, the evidence shows that trade does not captured from the environment, and energy must be
result in reductions in energy use and pollution in invested in order to extract useful energy (Hall et al.
developed countries through the offshoring of ).
pollution-intensive industries (Levinson ; Aguayo
and Gallagher ; Kander and Lindmark ). The Mainstream Theory of Growth
Additionally, if the service sector does require Despite these facts, the core mainstream economic
growth models disregard energy or other resources.
substantial material support, it is not clear whether
the developed world can continue to shift in the Aghion and Howitt’s ( ) textbook
direction of a growing service share of GDP on economic growth does discuss growth and the
indefinitely. In fact, as manufacturing prices have environment, but only in a chapter near the end of
fallen relative to the prices of services, even the the book. Acemoglu’s ( ) textbook does not
relative decline of manufacturing in developed cover the topic at all. There has been some analysis
countries is exaggerated when the relative sizes of of the potential for resources to constrain growth in
the sectors are computed in current prices the journal literature, but it has mostly been
(Kander ). contained within the sub-field of environmental and
Kander ( ) and Stem ( resource economics, and the main focus has been on
) find a rela
tively small role for structural change in reducing the implications of nonrenewable resources for
energy intensity in Sweden (1800-2000) and the economic growth.
world (1971-2007), respectively. But, using a much Solow ( ) introduced non-renewable
finer disaggregation of industries, Sue Wing ( ) resources - which could represent fossil or nuclear
finds that structural change fuels - into neoclassical growth models and showed
explained most of the decline in energy intensity inthat sustainability - or the ability of a nation to
the USA (1958-2000), especially before 1980. support a constant level of economic production
indefinitely - is achievable under certain
institutional and technical conditions. Assuming
The Theory of Energy in Economic that there is no population growth or technological
Production and Growth progress, Solow shows that technology must allow
the use of natural resources and manufactured
Energy as a Factor of Production capital - machines and buildings - to be sufficiently
Physical laws describe the operating constraints of responsive to changes in prices. As the price of
economic systems (Boulding ; Ayres and Kneese ). natural resources relative to that of capital rises,
Conservation of mass means that, capital is substituted for resources in
production. In Solow’s ( ) model the elasticity exogenous technical progress will allow con-
of substitution is 1 , as implied by the Cobb-Douglas sumption to grow over time if the rate of techno-
production function. This means that resources are logical change divided by the discount rate is
essential, but that a constant level of production greater than the output elasticity of resources.
could be maintained even with infinitesimally small Technological change might enable sustainability,
resource inputs. An elasticity of substitution greater even with an elasticity of substitution of less than 1 .
than unity means that resources are not essential and Once again, technical feasibility does not guar-
so achieving sustainability is much easier. These are antee sustainability. Depending on preferences for
all conditions concerning the technology available current versus future consumption, technological
to society. But the institutional framework - for change might instead result in faster depletion of the
example, whether an economy is a free market resource (Smulders ).
economy or whether it follows a particular planning
rule - is just as important. From an institutional The Ecological Economics Approach
perspective, sustainability can be achieved only if A prominent tradition in ecological economics,
the welfare of future generations is given equal known as the biophysical economics approach (Hall
weight to that of the present generation. This et al. ), is based on thermodynamics (Georgescu-
implies that the discount rate used to aggregate Roegen ; Costanza ;
costs and benefits over time must be zero. Cleveland et al. ; Hall et al. , ;
If instead the economy is a free market economy Ayres and Warr , ; Murphy and Hall
with perfect competition, but has the same ). Ecological economists usually argue that
technology as Solow’s ( ) model, the substitution between capital and resources can only
resources are exhausted and consumption and social play a limited role in mitigating the scarcity of
welfare eventually fall to zero (Stiglitz ). Dasgupta resources (Stem ). Furthermore, some ecological
and Heal ( ) showed that economists downplay the role of technological
with any constant discount rate the efficient growth change in productivity growth, arguing that growth
path also leads to eventual depletion of the natural is a result of either increased energy use or
resource endowment and the collapse of the innovations allowing the more productive use of
economy. Hartwick ( , ) has energy (Hall et al. , ; Cleveland
shown that, if sustainability is technologically et al. ; Ayres and Warr ). Therefore, in this view,
feasible, a constant level of consumption can be increased energy use is the main or only cause of
achieved by investing the rents from exhaustible economic growth.
resources in other forms of capital, which in turn In this approach, value is derived from the
can substitute for exhausted resources. It is difficult action of energy that is directed by capital and
to apply this rule in practice, as the rents and capital labour. Energy flows into the economy from fossil
must be valued at prices that are compatible with fuels and the Sun.
sustainability (Asheim ; Asheim et al. ; Pezzey ). In some biophysical economic models, geolog-
Such prices are unknowable given that we have ical constraints fix the rate of energy extraction so
poor understanding of the costs of current that the flow rather than the stock can be considered
environmental damage and resource depletion or of as the primary input to production (Gever et al. ).
the future development of technology. Capital and labour are considered as intermediate
In addition to the substitution of capital for inputs that are created and maintained by the
resources, technological change might permit primary input of energy and flows of matter. The
continued growth or at least constant consumption level of the flows is computed in terms of the
in the face of a finite resource base. Stiglitz ( ) embodied energy use associated with them. Prices
showed that, when the elasticity of sub of goods should then ideally be determined by their
stitution between capital and resources is 1 , embodied energy cost (Hannon ) - a normative
energy theory of
value - or are seen as actually being correlated with economists argue that the more energy that is
energy cost (Costanza ) - a positive energy theory of required to extract energy, the less energy is avail-
value (Common ). This theory - like the Marxian able for other uses and the poorer an economy will
paradigm - must then explain how labour, capital be. In this view, the increase in EROI allowed by
etc. end up receiving part of the surplus the switch from biomass to fossil fuels enabled the
(Kaufmann ; Burkett ; Homborg ). Industrial Revolution and the period of modem
However, because the quality of resources and economic growth that followed it (Hall et al. ).
the level of technology do affect the amount of Thus, declining EROI would threaten not just
energy needed to produce goods and services, it is growth but overall economic output and, therefore,
difficult to argue for a model where energy is the sustainability. Murphy and Hall ( ) doc
sole factor of production (Stem ). For exam ument EROI for many energy sources, arguing that
ple, the quality of resources such as oil reservoirs is it is declining over time despite the extensive
critical in determining the energy required to extract innovation in the industry. Wind and direct solar
and process fuels. As an oil reservoir is depleted, energy have more favourable EROIs than biomass
the energy needed to extract oil increases. On the fuels, but worse than most fossil fuels. However,
positive side, improved geophysical knowledge and unlike fossil fuels, the EROI of these energy
techniques can increase the extent to which oil can sources tends to improve over time due to inno-
be extracted for a given energy cost. Odum’s energy vation (Kubiszewski et al. ). Declining EROI
approach (Brown and Herendeen ) and the could be mitigated by substituting other inputs for
framework developed by Costanza ( ) address the energy or by improving the efficiency with which
resource quality energy is used. However, biophysical economists
issue by including the solar and geological energy argue that both these processes have limits.
embodied in natural resource inputs in indicators of Substitution can occur w i t h i n a category
total embodied energy. An alternative approach is to of similar production inputs - for example between
measure material and energy inputs on the common different fuels - and b e t w e e n different
basis of their exergy (Ayres et al. ; Ukidwe and categories of inputs - for example between energy
Bakshi ). and machines. There is also a distinction to be made
However, both approaches seem too reduction- between substitution at the micro level - for
ist. For example, other services provided by nature, example within a single engineering process or at a
such as nutrient recycling, the provision of clean air single firm - and at the macro level - in the
and water, pollination and the climate system, that economy as a whole.
make economic production - and life itself- possible As shown in Fig. for the USA, the long-mn
should also then be accounted for. Models that pattern of energy use in industrial economies has
allow a number of different factors of production been dominated by substitutions from wood and
while complying with the physical laws of the animal power to coal, oil, natural gas and primary
conservation of mass and thermodynamics to electricity (Griibler et al. ). Meta-analysis of
varying degrees were developed by Georgescu- existing studies of interfuel substitution suggests
Roegen ( ), Perrings ( ), and that the long-run substitution possibilities at the
O’Connor ( ) among others. The ecological level of the industrial sector as a whole are good.
economics approach does not have to reduce to an But there seems to be less substitutability at the
energy-only model of the economy. macro-economic level (Stem ).
A key concept in biophysical economics is Ecological economists emphasise the impor-
energy return on investment (EROI), which is the tance of limits to inter-category substitution - in
ratio of useful energy produced by an energy supply particular, the substitution of manufactured capital
system to the amount of energy invested in for resources including energy (Costanza and
extracting that energy. Lower quality energy Daly ). Thermodynamic limits on substitution can
resoinces have lower EROIs. Biophysical be approximated by a production function with an
elasticity of substitution significantly below one
(Stem ). As discussed above, a
meta-analysis of the existing empirical literature discussed in the previous section. Stem and Kander
finds that the elasticity of substitution between ignore the issue of whether the energy resource is
capital and energy is less than 1 but much greater non-renewable, as depletion of fossil fuels does not
than 0 (Koetse et al. ). seem to have been a very important factor in
In addition to this micro-economic limit to constraining economic growth to date.
substitution, there may also be macroeconomic Assuming that the elasticity of substitution
limits to substitution. The construction, operation between energy and capital is less than 1 allows the
and maintenance of tools, machines and factories share of energy in production costs to fall over time.
require a flow of materials and energy. Similarly, When the elasticity of substitution is unity, cost
the humans that direct manufactured capital con- shares must be constant in the long mn. The cost
sume energy and materials. Thus, producing more share of energy has fallen in the long run in both
of the ‘substitute’ for energy - manufactured capital Britain and Sweden, countries for which we have
- requires more of the thing that it is supposed to data from 1800 till the present (Fig. ). An elasticity
substitute for. This again limits potential of substitution of less than unity also allows us to
substitutability (Cleveland et al. ). distinguish between labour- augmenting innovations
The mainstream economic argument that tech- and energy-augmenting innovations, which again is
nological change can overcome limited substitut- not possible using a Cobb-Douglas production
ability would be more convincing if technological function.
change were really something different from sub- The production function is given by:
stitution. Changes in technology occur when new
techniques are developed. However, these new
{\-y)(AlL^K^)\y{AEEf
techniques represent the substitution of knowledge Y= (4)
for other factors of production. The knowledge is
embodied in improved capital goods and more Equation ( ) embeds a Cobb-Douglas function of
skilled workers and managers. But there are still capital, K , and labour, L , i f K ] in a
thermodynamic restrictions on the extent to which constant elasticity of substitution production
energy and material flows can be reduced in this function of this combined input and energy, E , to
way. Although knowledge is non-rival in use, it produce gross output, Y . <|) = (CT — l)/cr, where
must be used in conjunction with the other inputs, CT is the elasticity of substitution between energy
such as energy, and the productivity of knowledge and the capital-labour aggregate. A L and A E are
is limited by the available quantities of those inputs. the augmentation indices of labour and energy,
Synthesis: Unified Model of Energy and which can be interpreted as reflecting both changes
Growth in technology that augment the effective supply of
As a first step to integrating the ecological eco- the factor in question and changes in the quality of
nomic and mainstream approaches and explaining the respective factors. A e E and A l L are called
historical economic growth, Stem and Kander ( ) effective energy and effective labour, respectively.
add an energy input that has low substitutability In Solow’s ( ) model, as long as there is
with capital and labour to Solow’s ( ) technological change the economy can grow. In
growth model. As discussed above, low substitut- Stem and Kander’s model, depending on the avail-
ability between capital and energy is one of the key ability of energy and the nature of technological
assumptions of ecological economists. Using 200 change, eneigy can be either a constraint on growth
years of Swedish data Stem and Kander estimate or an enabler of growth. When effective energy,
that the elasticity of substitution between energy A,.E, is very abundant, the model behaves very
and the other two inputs is 0.65. This figure is similarly to Solow’s original model and energy
similar to the other estimates of the elasticity also neither constrains nor drives growth. The more
eneigy there is, the less important energy appears to
be. But when effective energy is relatively scarce,
 50%

Great Britain
45% Sweden

40%

35%

30%

25%

20%

15%

10%

5%

0%
1800 1825 1850 1875 1900 1925 1950 1975 2000

Energy-GDP Relationship, Fig. 6 Share of energy in total production costs: Britain and Sweden 1800-2009 (Source:
Gentvilaite et al. ( ))

the level of output depends on the level of energy The Elasticity of Energy with Respect to
supply and the level of energy-augmenting technol-
GDP
ogy. Labour-augmenting technological change
alone no longer results in economic growth. How much does eneigy use increase with economic
Before the Industrial Revolution most energy growth? Various studies have estimated by how
was in the form of wood and animal and human much eneigy use tends to be higher as income
muscle power - wind- and water-power contrib- increases without controlling for other factors,
uted relatively little energy (Kander et al. ). while other studies attempt to estimate the macro-
The supply of this renewable energy was level elasticity of demand for energy, controlling
constrained by the availability of land, so energy for energy prices and changes in technology. I
was scarce (Wrigley ). Therefore, as the data summarise some recent econometric results. As
show (Maddison ), until the Industrial Rev- mentioned in the introduction, Csereklyei et al. (
olution, output per capita was generally low and ) find that there has been a remarkably stable
economic growth was not sustained. Stem and relationship between energy and GDP over the last
Kander ( ) find that increases in energy use four decades in a sample of 99 countries. The
and energy-augmenting technological change elasticity, which does not control for eneigy prices
were the main contributors to economic growth or technological change, is 0.7. Similarly, using
in the 19th and early 2 0 th centuries, but in the panel data for middle-income countries, including
second half of the 2 0 th century labour- today’s developed countries in earlier decades, Van
augmenting technological change became the Benthem ( ) finds an elasticity of 0.9 or 0.97
main driver of growth in income per capita, as it controlling for energy prices and time effects. He
is in the Solow growth model. finds lower elasticities for higher and lower income
bands. Similarly, Fouquet ( ) finds that energy causality findings. The most common additional
income elasticities first rose and then fell over the variables used are capital and labour or energy
course of economic development in Britain. Using a prices. A third way to differentiate among models is
cointegration approach, Joyeux and Ripple ( ) whether energy is measured in standard heat units
estimate that the long-run income elasticity or whether a method is used to account for
is 1.08 forOECD countries and 0.853 for 19devel- differences in quality among fuels.
oping countries between 1973 and 2007. These The results of early studies that tested for
estimates do not control for energy prices or time Granger causality using a bivariate model were
effects. Thus energy is a normal good and most generally inconclusive (Stem ). Stem tested for
estimates of the elasticity are between 0.5 and unity. Granger causality in the USA in a multivariate
However, there does not seem to be a consensus on setting using a vector autoregression (VAR) model
whether the income elasticity declines or not with of GDP, capital and labour inputs, and a Divisia
increasing income. index of quahty-adjusted energy use in place of the
usual heat equivalent of energy use. When both the
multivariate approach and quahty-adjusted energy
Testing for Causality Between Energy and index were employed, energy use was found to
GDP Granger cause GDP.
Yu and Jin ( ) conducted the first
Two methods for testing for causality among time cointegration study of the cncrgy-GDP relationship
series variables are Granger causality tests and using the bivariate approach. Stem ( )
cointegration analysis (Granger ; Engle and Granger estimated a dynamic cointegration model for GDP,
). Hendry and Juselius ( ) dis quahty weighted energy, labour and capital. The
cuss the application of these methods to energy analysis showed that there is a cointegrating relation
economics, where they have been applied exten- between the four variables and, depending on the
sively to test for causality and cointegration version of the model used, found that energy
between energy, GDP and other variables from the Granger causes GDP or that there is mutual causa-
late 1970s on (Kraft and Kraft ; Ozturk ). There are tion between energy and GDP. Some subsequent
now hundreds of journal articles on this topic research appeared to confirm these findings using
(Bruns et al. ). other measures of energy quahty (Warr and Ayres )
Early studies relied on Granger causality tests on or data for other countries (Oh and Lee ; Ghah and
unrestricted vector autoregressions (VARs) in levels El-Sakka ) and panels of many countries (Lee and
of the variables, while more recent studies use Chang ; Lee et al. ).
cointegration methods. A vector autoregression Bruns et al. ( ) carry out a meta-analysis
model consists of one regression equation for each of 75 single-country Granger causality and
variable of interest in a system. Each variable is cointegration studies comprising more than 500
regressed on lagged values of itself and all other tests of causality in each direction. They find that
variables in the system. If the coefficients of the most seemingly statistically significant results in the
lagged values of variable X in the equation for literature are probably the result of statistical biases
dependent variable Y are jointly statistically that occur in models that use short time series of
significant, then X is said to Granger cause Y . data - ‘overfitting bias’ - or the result of the
Cointegration analysis tests whether variables that selection for publication of statistically significant
have stochastic trends - their trend is a random walk results - ‘publication bias’. The most robust findings
- share a common trend. If so, then at least one in the literature are that growth causes energy use
variable must Granger cause the other. when energy prices are controlled for in the
Early studies also used bivariate models of underlying studies. Using a panel cointegration
energy and output, while more recent research tends model of GDP, energy use and energy prices for 26
to employ multivariate models. Ignoring other OECD countries (1978-2005), Costanhni and
relevant variables can generate spurious Martini ( ) also
find that in the long run GDP growth drives energy Research is also hampered by inadequate data.
use and energy prices, though in the short run With the exception of traditional biomass, energy
energy prices cause GDP and energy use, and use data are normally of good quality. But data on
energy use and GDP are mutually causative. prices is much more fragmentary. Most economic
However, Bruns et al. ( ) find that studies research is based on understanding the linkages
that control for capital do not find a genuine effect between prices and quantities. So this is an impor-
of energy on growth or vice versa. But they had too tant area where international comparable datasets
small a number of studies that used quality- could be very useful.
adjusted energy to test whether there was a genuine
relationship between energy and growth when this
measure of energy use was employed. So their
findings do not necessarily contradict the previous See Also
research by Stem and others reviewed above.
► Cau
► ;3C
Gaps in Knowledge ► :<
► :<
As this article has shown, the relationship between ► inerg]
energy and GDP is one where there is remarkably ► }
little consensus, and large gaps in knowledge
remain. The field of energy economics has
expanded rapidly in the last decade, but much
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150. 122.
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 To examine enforcement procedures in greater
Enforcement detail, first consider the monitoring mechanism. If
monitoring is impossible then agents will abide with
Kevin Roberts a rule only if it is self-enforceable. If monitoring is
costly then there may be a decision to be taken with
regard to the best monitoring mechanism. Two
dimensions of choice seem natural. First, there is
Enforcement, with its usual connotations of agents the quality of the monitoring mechanism. After
being compelled to behave in ways that are at monitoring, an inference will be made with regard
variance with how they would like to act, seems a to whether a rale has been broken. The better the
long way removed from the conventional quality of the monitoring mechanism, the more
neoclassical approach of laissez-faire inherent in a accurate will be this inference. Accuracy will
decentralized economic system. If an enforcement involve both a low probability of inferring rale-
mechanism is viewed as a method by which rule- breaking when it has not occurred and a low
breaking may be discouraged then laissez-faire probability of inferring rale- compliance when rale-
attempts to be a set of rules that are self- breaking has occurred.
enforceable so that no formal enforcement mech- The second component of the monitoring mech-
anism is required (see Stigler for a useful discussion anism is the intensity with which it is applied. The
of enforcement). But it is clear that same agent may be monitored several times to
decentralizability is not, in itself, enough. For improve the accuracy of the test; agents may be
instance, the fact that tax evasion is kept in check monitored on a random basis so that any one agent
only by legal pressure shows how the addition of a will be monitored with a probability of less than
tax system to a decentralized competitive structure unity. The overall mechanism is likely to be more
may destroy self-enforceability. The possibility of effective if agents must decide upon their behaviour
gain by the exercise of monopoly power shows how with regard to rale-compliance before they know
the rule of price-taking behaviour is not immune to file intensity with which they will be monitored.
the problems of enforcement. A high punishment level will deter ralebreaking
Except when self-enforceability holds, so that more than a low punishment level. To see what an
agents wish to follow the given set of rules - the optimal enforcement mechanism may look like,
rules are incentive compatible - an enforcement consider a planner who wishes to deter rale-
mechanism will be necessary to prevent rule- breaking (which, for instance, imposes significant
breaking. A formal enforcement mechanism has negative externalities on other agents). Assume that
two components. First, there must be a method of the planner wishes to maximize the expected utility
monitoring agents so that it is possible to observe, of agents whilst deterring ralebreaking - rale-
perhaps imperfectly, rule-breaking. Second, there breaking is assumed to be privately optimal. If a is
must exist a sanction or punishment which can be the accuracy of the test used then let p ( a ) be the
imposed on rule-breakers. If perfect observability is probability of a ralebreaking inference if rale-
costless and there is no limit to the disutility that a breaking has not occurred. Similarly, let q ( a )
punishment can impose then there is no difficulty in be the probability of such an inference if rale-
enforcing a rale and, importantly, the enforcement breaking has occurred.
procedure never needs to be exercised. Thus, the Thus, p ( a ) < q ( a ) , p ( a ) is falling
existence of an enforcement procedure alters the in a and q U t ) is rising in a . Let U be the
incentives to obey rales and can be used as a utility that an agent gets from rale-compliance
component of the incentive structure within an before the introduction of an enforcement
economic system. It is clear that this is in part the mechanism and V be the utility that would result
role of a legal system. from rale-breaking. Then if m is the probability of
being monitored and / is the punishment cost then,
taking the
simplest specification of linear utility, the expected result in a richer setting than that of the above
utility of an agent who complies with the rule is model. For a model where finite levels of punish-
given by ment are optimal because of the risk aversion of
agents, see Polinsky and Shavell ( ).
U — mp{a)f — am (1) The structure outlined above has the property
that the enforcement mechanism is operated by a
where a m is taken to be the cost of operating the planner. One reason for assuming this is that it is
enforcement mechanism, the money being raised unnecessary to consider the planner’s incentives to
through taxation, say. The punishment / is assumed operate the mechanism. In some situations, it is
to be a deadweight loss rather than a monetary fine necessary for a group of agents to operate an
which could be used to finance the monitoring enforcement mechanism that will be imposed upon
mechanism. An agent compares ( ) with the themselves. The classic example of this is the oper-
expected utility from rale-breaking: ation of a cartel (Stigler ). A major problem
introduced by not having an external agency is that
V — mq{a)f — am (2) costs may be imposed on firms if they choose to
punish a firm that breaks the cartel’s rales. An
so that rale-breaking can be deterred if example of this is when a firm is punished by all
mf[q{a) - p(a)] > V - U . (3) firms entering into a price-cutting war. To provide
an incentive to punish, it may be necessary to have
If the planner wishes to maximize ( ) subject to (
a mechanism to enforce the operation of the original
) then die first point to notice is that ( ) can always
enforcement mechanism, and so on. For an insight-
be increased while still satisfying ( ) i f m f
fill analysis of this problem, see Abreu ( ). Con
i s held constant but m is reduced. Thus, it is
siderations of this sort show the potential richness
desirable to increase the punishment whilst reducing
of the structure of enforcement mechanisms in
the rate of monitoring and it is optimal to punish as
general.
severely as possible (this argument is credited to
Becker ). Once the worst punishment is chosen, the
optimal monitoring mechanism satisfies See Also

U±1 <Lz£
= (4) ►
fp + a q - p ► Cooperative Equilibrium
► c Games
which gives rise to the comparative statics results
► . • e C’lec:: /
that would be expected. I f f can be chosen
► Industrial Organization
without limit (punishment can reduce utility to
minus infinity) then i n will be set arbitrarily small
and, keeping m f f t x e d , ( ) can be increased References
by increasing a ifp ' ( a ) is strictly negative. If
Abreu, D. 1986. Extremal equilibria of oligopolistic super-
perfect accuracy is attainable ( p ( a ) = 0 for games. Journal of Economic Theory 39(1): 191-225.
some a ) then the expected utility of the agent will Becker, G. 1968. Crime and punishment: an economic
be U — the first-best is achievable - and the approach, vol March-April, 169-217. Journal of Political
enforcement mechanism will take the form of an Economy.
Nalebuff, B. and Scharfstein, D. 1985. Self-selection and
infinitesimally small amount of monitoring using a testing. Forthcoming in Review of Economic Studies.
very accurate procedure and infinitely large punish- Polinsky, A., and S. Shavell. 1979. The optimal tradeoff
ments being imposed on rale-breakers. This strong between the probability and magnitude of fines. American
Economic Review 69(5): 880-891.
result depends upon the strong assumptions that
Stigler, G. 1964. A theory of oligopoly. Journal of Political Economy
have been imposed on the model. However, 72(1): 44-61.
Nalebuff and Scharfstein ( ) obtain a similar Stigler, G. 1970. The optimum enforcement of laws. Journal of
Political Economy 78(3): 526-535.
 w j = /;,[log(v), z] where vv, is the fraction of v
Engel Curve that is spent buying good i . The goods are
typically aggregate commodities such as total food,
Arthur Lewbel and H. S. Houthakker clothing or transportation, consumed over some
weeks or months, rather than discrete purchases.
Engel curves can be defined as Marshallian demand
functions, with the prices of all goods fixed.
Abstract The term ‘Engel curve’ is also used to describe
An Engel curve describes how a consumer’s the empirical dependence of q , on y , z in a
purchases of a good like food varies as the population of consumers sampled in one time and
consumer’s total resources such as income or place. This empirical or statistical Engel curve
total expenditures vary. Engel curves may also coincides with the above theoretical Engel curve
depend on demographic variables and other definition if the law of one price holds (all sampled
consumer characteristics. A good’s Engel curve consumers paying the same prices for all goods),
determines its income elasticity, and hence and if all consumers have the same preferences
whether the good is an inferior, normal, or after conditioning on z and possibly on some well-
luxury good. Empirical Engel curves are close to behaved error terms. Since these conditions rarely
linear for some goods, and highly nonlinear for hold, it is important in practice to distinguish
others. Engel curves are used for equivalence between these two definitions.
scale calculations and related welfare Using data from Belgian surveys of working
comparisons, and determine properties of class families, Ernst Engel ( , ) studied
demand systems such as aggregability and rank. how households’ expenditures on food vary with
income. He found that food expenditures are an
increasing function of income and of family size,
Keywords
but that food budget shares decrease with income.
Aggregation; Consumers’ expenditure; Con-
This relationship of food consumption to income,
sumer demand; Demand equations; Engel
known as Engel’s law, has since been found to hold
curves; Engel equivalence scales; Engel’s law;
in most economies and time periods, often with the
Law of one price; Nonparametric methods;
function h t for food i close to linear in log(y).
Rothbarth scales; Separability; Utility theory;
Engel curves can be used to calculate a good’s
Working, H.; Working-Leser model
income elasticity, which is roughly the percentage
change in q t that results from a one per cent
change in y , or formally d log g f y , z ) ! d
JEL Classifications
D12 log ( y ) . Goods with income elasticities below
zero, between zero and 1 , and above 1 are called
An Engel curve is the function describing how a inferior goods, necessities and luxuries
consumer’s expenditures on some good or service respectively, so by these definitions what Engel
relate to the consumer’s total resources, with prices found is that food is a necessity. Elasticities can
fixed, so q t = g j ( y , z), where q t is die themselves vary with income, so a good that is a
quantity consumed of good i , y is income, necessity for the rich can be a luxury for the poor.
wealth, or total expenditures on goods and services, Some empirical studies followed Engel ( ),
and z is a vector of other characteristics of the such as Ogbiun ( ), but Allen and Bowley
consumer, such as age and household composition. ( ) firmly connected their work to utility the
Usually y is taken to be total expenditures, to ory. They estimated linear Engel curves q , =
separate the problem of allocating total consumption a t + b y on data-sets from a range of
to various goods from the decision of how much to countries, and found that the resulting errors in
save or dissave out of current income. Engel curves these models were sometimes quite large, which
are frequently expressed in the budget share form they interpreted as indicating considerable
heterogeneity in tastes across consumers. Working ( shares or equal expenditures on adult goods such as
) proposed the linear budget share spec alcohol. The ratio of total expenditures needed to
ification W j = c i j + b j log (v), which equate food budget shares across households are
is known as the Working-Leser model, since Leser ( known as Engel equivalence scales, while the ratio
) that equates expenditures on adult goods are called
found this functional form to fit better than some Rothbarth scales (Rothbarth ).
alternatives. However, Leser obtained still better fits Shape invariance assumes that budget share
with what would now be called a rank-three model, Engel curves for one type of consumer, such as a
namely, W j = «,• + b t log (y) + and in a household with children, is a linear transformation
similar, earlier, comparative statistical analysis of the budget-share Engel curves for other types of
Prais and Houthakker ( ) found consumers, such as households without children.
q t = c i j + b j log (y) to fit best. More Shape invariance is necessary for constructing what
recent work documents sometimes considerable are known as exact or independent of base
nonlinearity in Engel curves. Motivated by this equivalence scales, and has been found to at least
nonlinearity, one of the earlier empirical approximately hold in some data-sets. See Lewbel (
applications of non- parametric regression methods ), Blackorby and Donaldson ( ), Gozalo
in econometrics was kernel estimation of Engel ( ), Pendakurf ), and Blundell et al. ( ).
curves. Examples include Bierens and Pott-Buter ( The level of aggregation across goods affects
), Lewbel Engel curve estimates. Demand for a narrowly
( ), and Hardle and Jerison ( ). More defined good like apples varies erratically across
recent studies that control for complications like consumers and over time, while Engel curves based
measurement error and other covariates Z, including on broad aggregates like food are affected by
Hausman et al. ( ) and Banks et al. ( ), variation in the mix of goods purchased. The
find Engel curves for some goods are close to aggregate necessity food could include inferior
Working-Leser, while others display considerable goods like cabbage and luxuries like caviar, which
curvature, including quadratics or S shapes. Even may have very different Engel curve shapes.
Allen and Bowley ( , p. 123) noted ‘there is a Other empirical Engel curve complications
good fit, allowance being made for observation and include unobserved variations in the quality of
sampling errors,..., to a linear expenditure relation goods purchased, and violations of the law of one
and occasionally to a parabolic relation’. price. When price or quality variation is unobserved,
Other variables z also help explain cross- section their effects may correlate with, and so be errone-
variation in demand. Commonly used covariates ously attributed to, y or z. Examples of such corre-
include the number, ages and gender of family lations could include the wealthy systematically
members, location measures, race and ethnicity, favouring higher quality goods, and the poor facing
seasonal effects, and labour market status. Variables higher prices than other consumers because they
indicating ownership of a home, a car or other large cannot afford to travel to discount stores.
durables can also have considerable explanatory Assume a consumer (household) h determines
power, though these are themselves consumption demands q h i facing prices p t for each good i
decisions. by maximizing a well-behaved utility function over
Engel’s original work showed die relevance of goods (which could depend on z h ) , subject to a
family size, and later studies confirm that larger budget constraint Y . p p h i < This yields
families typically have larger budget shares of Marshallian demand functions q h i =
necessities than smaller families at the same income G h i ( P , y , „ z/(), with Engel curves given
level. Adult equivalence scales model the by these functions with the price vector p fixed.
dependence of utility functions on family size, and Utility functions that yield Engel curves of the form
use this dependence to compare welfare across q h j = b j ( z ) y h are called homothetic,
households, assuming that a large family with a and q h i = a , ( z ) + b j ( z ) y h are
high income is as well off as a smaller family with a quasihomothetic. Many theoretical results
lower income if both families have demands that are
similar in some way, such as equal food budget
regarding two-stage budgeting and aggregation and for aggregation across goods and across con-
across goods require homotheticity or quasi- sumers. Many empirical studies find demands have
homotheticity, most notably Gorman ( ). rank three.
The shape of Engel curves plays an important One area of current research concerns the
role in the determination of macroeconomic demand observable implications of collective models, that is,
relationships. For example, if we ignore z for now, households that determine expenditures based on
suppose individual consumers h each have Engel bargaining among members. For example, the Engel
curves of the quasihomothetic form q h i = a curves of such households could violate Gorman’s
h i + b ( y h . Then, letting Q t and Tbe rank theorem, even if each member had exactly
aggregate per capita quantities and total aggregable preferences. Another topic attracting
expenditures in the population, we get Q t = A t current attention is the role of errors in demand
+ b t Y by averaging q h i across consumers models, particularly their interpretation as
h . This is a representative consumer model, in the unobserved preference heterogeneity, random utility
sense that the distribution of y affects aggregate model parameters. This matters in part because
demand Q , only through its mean E ( y ) Y . another of Allen and Bowley’s ( ) findings
Gorman ( ) remains true today,
showed that only linear Engel curves have this namely, Engel curve and demand function models
property, though linear Engel curve aggregation still fail to explain most of the observed variation in
dates back at least to Antonelli ( ). Gorman’s individual consumption behaviour.
linearity requirement, which does not usually hold
empirically, can be relaxed given restrictions on the See Also
distribution of y ; for example, Lewbel ( )
shows that E ( y log y ) / Y - log(F) is very
► Aggrc
close to constant in US data, and if it is constant ► Const
then Working-Leser household Engel curves yield
Working-Leser aggregate, representative consumer
demands.
Exactly aggregable demands are defined by q l
= Y j i A j i ( p ) c j ( y , z ), and so have
Engel curves q t = Y j i a j i c j O', z)that
are linear in the functions c j ( y , z). These
models have the property that aggregate demands
Q t depend only on the means of C j i y , z ) . Bibliography
Utility theory imposes constraints on the functional
Allen, R., and A. Bowley. 1935. Family expenditure: A study
forms of c f y , z). Properties of exactly of its variation. London: P.S. King and Son.
aggregable demands and associated Engel curves Antonelli, G. 1886. Sulla teoria metematica della economia
are derived in Muellbauer ( ), politica. Pisa: Nella Tipografia del Fochetto. Translated
Jorgenson et al. ( ), and Lewbel ( ), but as ‘On the mathematical theory of political economy’. In
Preferences, utility and demand, ed. J. Chipman et al.
primarily by Gorman ( ), who proved the New York: Harcourt Brace Jovanovich, 1971.
surprising result that utility maximization forces the Banks, J., R. Blundell, and A. Lewbel. 1997. Quadratic Engel
matrix of Engel curve coefficients to have rank curves and consumer demand. The Review of Economics
and Statistics 79: 527-539.
three or less.
Bierens, H., and H. Pott-Buter. 1990. Specification of
Lewbel ( ) extends Gorman’s rank idea to household expenditure functions and equivalence scales
arbitrary demands, not just those in the exactly by nonparametric regression. Econometric Reviews9: 123-
aggregable class, by defining the rank of a demand 210.
Blackorby, C., and D. Donaldson. 1991. Adult-equivalence
system as the dimension of the space spanned by its scales, interpersonal comparisons of well-being, and
Engel curves. Engel curve rank can be non- applied welfare economics. In Interpersonal
parametrically tested, and has implications for
 comparisons of well-being, ed. J. Elster and J. Roeraer.
Cambridge: Cambridge University Press. Engel, Ernst (1821-1896)
Blundell, R., M. Browning, and I. Crawford. 2003. Non-
parametric Engel curves and revealed preference.
Econometrica 71: 205-240.
H.S. Houthakker
Engel, E. 1857. Die Productions- und Consumption-
sverhaeltnisse des Koenigsreichs Sachsen. Zeitschrift des
Statistischen Bureaus des Koniglich Sachsischen
Ministeriums des Inneren, No. 8 und 9. Reprinted in the
Appendix ofEngel (1895). Keywords
Engel, E. 1895. Die Lebenskosten Belgischer Arbeiter- Agricultural economics; Engel curve; Engel, E.;
Familien Fruher and jetzt. International Statistical
Engel’s Law; Household surveys; International
Institute Bulletin 9: 1-74.
Gorman, W. 1953. Community preference fields. Statistical Institute
Econometrica 2 1: 63-80.
Gorman, W. 1981. Some Engel curves. In Essays in the
theory and measurement of consumer behaviour in honor
of Sir Richard Stone, ed. A. Deaton. Cambridge: JEL Classifications
Cambridge University Press. B31
Gozalo, P. 1997. Nonparametric bootstrap analysis with
applications lo demographic effects in demand functions. Horn in Dresden, Engel was a German statistician
Journal of Econometrics 81: 357 393.
best known for the discovery of the Engel curve and
Hardle, W., and .VI. Jerison. 1991. Cross section Engel
curves overtime. Recherches Economiques de Louvain of Engel’s Law. In his early years he was associated
57: 391-431. with the French sociologist Frederic Lc Play, whose
Hausman, J.. W. Newey, and .1. Powell. 1995. Nonlinear interest in the family led him to conduct household
errors in variables: Estimation of some Engel curves. surveys. The expenditure data collected in these
Journal of Econometrics 65: 205 253.
Jorgenson, D., L. Lau, and T. Stoker. 1982. The trans- surveys convinced Engel that there was a relation
cendental logarithmic model of aggregate consumer between a household’s income and the allocation of
behavior. In Advances in econometrics. ed. R. Busman its expendhures between food and other items. This
and G. Rhodes. Greenwich: JAI Press. was one of the first functional relations ever
Leser, C. 1963. Forms ofEngel functions. Econometrica
31:694-703. established quantitatively in economics.
Lewbel, A. 1 989. I [ousehold equivalence scales and welfare Furthermore, he observed that households with
comparisons. Journal of Public Economics 39: 377-391. higher incomes tended to spend more on food than
Lewbel, A. 1990. Full rank demand systems. International poorer households, but that the share of food
Economic Review 31: 289-300.
Lewbel, A. 1991. The rank of demand systems: Theory and
expenditures in the total budget tended to vary
nonparametric estimation. Econometrica 59: 711-730. inversely with income. From this empirical
Muellbauer, .1. ll>75. Aggregation, income distribution, and regularity he went on to infer that in the course of
consumer demand. Review of Economic Studies 62: 269 economic development agriculture would decline
283.
Ogbum, W. 1919. Analysis of the standard of living in the
relative to other sectors of the economy (Engel,
District of Columbia in 1916. Journal of the American 1857). From 1860 to 1882 Engel was director of the
Statistical Association 16: 374-389. Prussian statistical bureau in Berlin, in which
Pendakur, Is.. ll>99. Estimates and tests of base- independent capacity he did much to expand and strengthen
equivalence scales. Journal of Econometrics 88: I 40.
Prais, S., and 11. I louthakker. 1955. The analysis of family
official statistics. His resignation resulted from his
budgets. 2nd ed. Cambridge: Cambridge University opposition to Bismarck’s protectionist policies. In
Press. 1971. his own research he dealt particularly with the value
Rothbarth, E. ll>4.3. Note on a method of determining of human life (Engel, 1877), which he approached
equivalent income for families of different composition.
from the cost side. He also investigated the influ-
In Appendix 4 in War-time pattern of saving and
spending, ed. C. Madge. Cambridge: Cambridge ence of price on demand. His influence on official
University Press. statistics extended well beyond Germany, and in
Working, H. ll>43. Statistical laws of family expenditures. 1885 he was among the founders of the
Journal of the. Imerican Statistical Association 38:43 56.
International Statistical Institute. He died in everywhere so that it is intrinsically of interest.
Radebeul in 1896. Second, the finding suggests that over the long run
countries experiencing significant growth will find
that agriculture provides an increasingly
Selected Works unimportant part of national income. This argues
against balanced growth in long- ran development.
1857. Die Productions- und Consumptionsver- Third, we do not observe such a consistent pattern
haeltnisse des Koenigsreichs Sachsen. Reprinted for any other wide commodity grouping such as
with Engel (1895), Anlage I: 1-54. 1877. Der Kostenwerth clothing or durables. Finally, the fact that the food
des Menschen. Berlin. 1895. Die Lebenskosten budget share is a decreasing function of the material
E
Belgisher Arbeiter- Familien fruether und jetzt. standard of living (if other factors are held constant)
Reprinted in International Statistical Institute Bulletin 9: 1-124. suggested at one time that it can be used as an
indicator of the latter. In particular, isoprop (‘same
proportion’) methods have been used to compute
adult equivalence scales by finding the level of
income that would equate the food budget share
across different demographic groups. The
Engel's Law conditions under which the iso-prop method is valid
are very strong - essentially, extra people in the
Martin Browning household have to make the household behave as
though it is poorer and should not cause any change
in the structure of demands above this - and such
methods have fallen out of favour (see Deaton and
Muellbauer , for discussion and references).
Keywords
Despite the venerability of the literature on
Agriculture and economic development;
Engel’s law, the inferences that can be drawn from
Equivalence scales; Engel’s law
it are limited. For example, the cross-section finding
is consistent with all households having a
decreasing relationship so that increasing the
JEL Classifications
D12 income of a household will lead to a decrease in the
food budget share. On the other hand, the
Engel’s law states that food is not a luxury. This is correlation might be completely spurious if it is due
one of the earliest empirical regularities in eco- to poorer households having a higher ‘taste’ for
nomics and also one of the most robust. The food. In this case the apparent dependence is simply
widespread finding is that regressions of food due to heterogeneity in tastes, which is correlated
expenditures, quantities or budget shares on income with income. The fact that studies using aggregate
or total expenditure and other variables such as time series-data find different elasticities from those
prices, demographics and regional dummies found in cross-section data from the same country
uniformly imply that the income elasticity of food and time period suggests that the empirical finding
is less than 1 (and greater than zero). For example, is a combination of both causes. The paucity of
time series from individual countries, cross-sections panel data with full expenditure information makes
within countries and crosscountry analyses all find any inference hazardous. Thus Engel’s law remains
the same qualitative empirical finding. what it has always been: a very robust but
This conelation seems to have been highlighted unsurprising partial correlation with many
for a number of reasons. First, food is an important alternative interpretations.
component of household budgets
See Also Returning home via Paris in 1844, Engels had
his first serious meeting with Marx. Their lifelong
► ingel Curve collaboration dated from this point with an agree-
► ingel, Ernst (1821-:.:; ment to produce a joint work ( T h e H o l y
► quru l.e ■ ■ les F a m i l y ), setting out their positions against
other tendencies within Young Hegelianism. This
Bibliography was followed by a second unfinished joint enterprise
( T h e G e r m a n I d e o l o g y > ,
Deaton, A., and J. Muellbauer. 1986. On measuring child 1845-6), where their materialist conception of
costs: With applications to poor countries. Journal of
history was expounded systematically for the first
Political Economy 94: 720-744.
time.
Between 1845 and 1848, Engels was engaged in
political work among German communist groups in
Paris and Brussels. In the 1848 revolution itself, he
Engels, Friedrich (1820-1895) took a full part, first as a collaborator of Marx on the
N e u e R h e i n i s c h e Z e i t u n g
Gareth Stedman Jones and subsequently in the last phase of armed
resistance to counter-revolution in the summer of
1849.
In 1850, Engels returned once more to Man-
chester to work for his father’s firm and remained
Keywords
there until he retired in 1870. During this period, in
Cost of production theory of value; Engels, E;
addition to numerous journalistic contributions,
Kautsky, K.; Labour theory of value; Marx, K.
including attempts to publicize Marx’s
H.; Marxian transformation problem; Peasants;
C r i t i q u e o f P o l i t i c a l
Rent; Subjective theory of value
E c o n o m y ( ) and C a p i t a l ,
vol
ume 1 (1867, second edition 1873), he first devel-
JEL Classifications
B31 oped his interest in the relationship between
historical materialism and the natural sciences.
Bom in Barmen, the eldest son of a textile manu- These writings were posthumously published as
facturer in Westphalia, Engels was trained for a T h e D i a l e c t i c s o f N a t u r e
merchant’s profession. From school onwards, (1925). In 1870 Engels moved to London.
however, he developed radical literary ambitions As Marx’s health declined, Engels took over
which eventually brought him into contact with the most of his political work in the last years of the
Young Hegelian circle in Berlin in 1841. In 1842, First International (1864-72) and took increasing
Engels left for England to work in his father’s responsibility for corresponding with the newly
Manchester firm. Already converted by Moses Hess founded German Social Democratic Party and other
to a belief in ‘communism’ and the imminence of an infant socialist parties. Engels’s most important
English social revolution, he used his two-year stay work during this period was his polemic against the
to study the conditions which would bring it about. positivist German socialist, Eugen Duhring. The
From this visit came two works which were to make A n t i - D u h r i n g (1877) was the first
an important contribution to the formation of comprehensive exposition of a Marxian socialism in
Marxian socialism: O u t l i n e s o f a the realms of philosophy, history and political
C r i t i q u e o f P o l i t i c a l economy. The success of this work, and in particular
E c o n o m y (generally called the of extracts from it like S o c i a l i s m ,
U m r i s s e ) published in 1844, and T h e U t o p i a n a n d S c i e n t i f i c ,
C o n d i t i o n o f t h e represented the decisive turning point in the
W o r k i n g C l a s s i n international diffusion of Marxism and shaped its
understanding as a theory in the period before 1914.
publishing of the remaining volumes of ‘objective’ conception as cost of production
C a p i t a l from Marx’s manuscripts, volume attributed to Ricardo and McCulloch. Reconciling
2 appeared in 1885, volume 3 in 1894, a year before these two definitions in Hegelian fashion, Engels
his death. Engels had also hoped to prepare the final defined value as the relation of production costs to
volume dealing with the history of political utility. This was the equitable basis of exchange, but
economy. But the difficulty of deciphering Marx’s one impossible to implement on the basis of
handwriting, his own failing eyesight and the competition which was responsive to market
formidable editorial problems encountered in demand rather than social need. (Engels still
constructing Volumes 2 and 3, induced him to hand adhered to this definition of value 30 years later in
over this task to Karl Kautsky, who subsequently the A n t i - D i i h r i n g . Discussing the
E
published it under the title T h e o r i e s o f disappearance of the Taw of value’ with the end of
S u r p l u s V a l u e . commodity production, he wrote:
Engels’s work was of importance, both in the
As long ago as 1844, I stated that the above men-
constmction and interpretation of Marxian economic tioned balancing of usefid effects and expenditure of
theory and in the laying down of important labour would be all that would be left, in a
guidelines in the subsequent development of communist society, of the concept of value as it
Marxist economic policy. appears in politicaleconomy ... The scientific jus-
tification for this statement, however,... was only
In the realm of theory, his contribution is of made possible by Marx’s Capital (Engels 1877, pp.
particular significance in three respects. 367-8)
First, and of real importance in the formation of
a distinctively Marxian stance towards political This shows how much greater continuity of thought
economy was Engels’s O u t l i n e s o f a there was between the young and the old Engels
C r i t i q u e o f P o l i t i c a l than is normally imagined.)
E c o n o m y (the U m r i s s e ) , He next analysed rent, counterposing a
published in 1844. In 1859 in his own Ricardian notion of differential productivity to one
C r i t i q u e o f P o l i t i c a l attributed to Smith and T.R Thompson based upon
E c o n o m y , Marx acknowledged this sketch competition. Interestingly, in this analysis Engels
as ‘brilliant’, and its impact is discernible in Marx’s differed both from Watts and Proudhon, in denying
1844 writings. The U m r i s s e represented the the radical form of the labour theory - the right to
first systematic confrontation between the the whole product of labour - both by citing the case
‘communist’ strand of Young Hegelianism and of the need to support children and in querying the
political economy. The communist aspiration was possibility of calculating the share of labour in the
expressed in Feuerbachian language, while the product.
mode of analysis was Hegelian. But, as has recently Finally, after an attack on the Malthusian pop-
been demonstrated (Claeys ), the content of Engels’s ulation theory, which closely followed Alison and
critique was first and foremost a product of his early Watts, Engels attacked competition itself, both
stay in Manchester. For, apart from some because it provided no mechanism of reconciling
indebtedness to Proudhon’s W h a t i s general and individual interest, and because it was
P r o p e r t y ? (1841), the main source of argued to be self-contradictory. Competition based
Engels’s essay was John Watts, T h e F a c t s on self-interest bred monopoly. Competition as an
a n d F i c t i o n s o f immanent law of private property led to polarization
P o l i t i c a l E c o n o m y (1842 ), a and the centralization of property. Thus private
resume of the Owenite case against the propositions property under competition is selfconsuming.
of political economy. At this stage, Engels’s own What particularly impressed Marx was the
acquaintance with the work of political economists argument that all the categories of political econ-
seems to have been mainly at second-hand. omy were tied to the assumption of competition
The U m r i s s e was an attempt to based on private property. This, for him,
demonstrate that all the categories of political
economy presupposed competition which in turn
presupposed private property. He began with an
represented an important advance over Proudhon ‘transformation’ debate by his dramatization of
whose notion of equal wage would lead to a society Marx’s switch from value to production price in his
conceived as ‘abstract capitalist’ and whose introductions to Volumes 2 and 3 of
conception of labour right presupposed private C a p i t a l . Engels’s own contribution to
property. Proudhon had not seen that labour was the this debate in his last published article in N e u e
essence of private property. His critique was of Z e i t in 1895 (now published as ‘Supplement
‘political economy from the standpoint of political and Addendum’ to volume 3 of C a p i t a l )
economy’. He had not ‘considered the further was to argue that the shift from value to production
creations of private property, e.g. wages, trade, price was not merely a logical development entailed
value, price, money etc. as forms of private property by the enlargement of the scope of investigation to
in themselves’ (Engels and Marx 1844b). The include circulation and the ‘process of capitalist
U m r i s s e suggested a new means of production as a whole’, but also reflected a real
underpinning the Marxian ambition to transcend the historical transition from the stage of simple
categorical world of political economy and private commodity production to that of capitalism proper.
property altogether. Moreover, by representing ‘The Marxian law of value has a universal
competition as a law which would produce its economic validity for an era lasting from the
opposite, monopoly, the elimination of private beginning of the exchange that transforms products
property and revolution, Engels preceded Marx in into commodities down to the fifteenth century of
positing the ‘free trade system’ as a process moving our epoch’ (Marx , p. 1037).
towards self-destruction through the operation of Leaving aside the empirical question whether
laws immanent within it. during the pre-capitalist era commodities were
These conclusions were amplified in Engels’s exchanged in accordance with the amount of labour
other major work of this period, T h e embodied in them, commentators as diverse as
C o n d i t i o n o f t h e Bernstein and Rubin have objected that this makes
W o r k i n g C l a s s i n no sense in terms of Marx’s theory, since during
E n g l a n d . Here, the law of competition by this epoch there existed ‘no mechanism of the
engendering ‘the industrial revolution’ had created a general equalisation of different individual labour
revolutionary new force, the working class. The expenditures in separate economic units on the
single thread underlying the development of the market’ and that consequently it was not appropriate
working class movement had been the attempt to to speak of ‘abstract and socially necessary labour
overcome competition. Such an analysis prefigured which is the basis of the theory of value’ (Rubin , p.
the famous statement in the C o m m u n i s t 254). They have further objected, appealing to
M a n i f e s t o that the capitalists were Marx’s 1857 ‘Introduction to the Critique of
begetting their own gravediggers (Stedman Jones ). Political Economy’, that there is no necessary
Between the mid-1840s and the mid-1870s, connection between the logical and historical
Engels played no discernible part in the elaboration sequence of concepts, and that the order of
of C a p i t a l beyond supplying Marx with appearance of concepts in C a p i t a l is deter-
practical business information. His vital mined simply by the logical place they occupy in an
contributions to the prehistory of the theory were exposition of the theory of the capitalist mode of
forgotten and it was only in his better-known role as production.
interpreter and publicist of Marx’s work that his Engels could certainly claim explicit textual
writings received widespread attention. During the support from volume 3 for his historical interpre-
Second International period, these writings attained tation of value (‘It is also quite apposite to view the
almost canonical status, but in the 2 0 th century they value of commodities not only as theoretically prior
generally provided a polemical target for all those to the prices of production, but also as historically
attempting to re-theorize Marx in the light of the prior to them. This applies to those conditions in
publication of his early writings. which the means of production belong to the
In the realm of political economy more narrowly worker...’; Marx , p. 277). It should also be stressed
conceived, Engels helped to set up the that there was nothing new in
Engels’s representation of the character of Marx’s the manuscripts, from which Engels worked, it is
theory. Back in 1859, in a review of Marx’s C r i - impossible to assess whether the emphasis and
t i q u e o f P o l i t i c a l meaning of the published volumes differ in any
E c o n o m y , Engels stated, ‘Marx was, and significant way from the original. What seems clear,
is, the only one who could undertake the work of is that in his cautious desire to reproduce as much of
extracting from the Hegelian Logic the kernel the original material as possible, Engels produced a
which comprised Hegel’s real discoveries ... and to much bulkier and more repetitive version than Marx
construct the dialectical method divested of its originally intended. Marx, it seems, always hoped
idealistic trappings’; and in characterizing that that C a p i t a l should consist of two volumes
method as a form of identity between logical and and a further volume on the history of political
historical progression, he continued, ‘the chain of economy (Rubel ; Levine ). From a detailed
thought must begin with the same thing that this comparison of volume 2, Part 1, with the original
history begins with, and its further course will be manuscripts, it appears that Engels also occasionally
nothing but the mirror image of the historical course committed inaccuracies in the citation of the
in abstract and theoretically consistent form ... ’ manuscripts he had used (Levine ). Much more
(Engels 1859). It is implausible to suppose that doubtful, given all we know of Engels’s caution as
Marx at this time should have sanctioned a an editor, is the further suggestion that Engels’s
fundamental distortion of his method and it is editing procedures may have shifted the meaning of
suggestive that he himself, describing his the text in ways that lent support to a ‘collapse
relationship to Hegel, should have endorsed the theory’ of capitalism
metaphor of discovering ‘the rational kernel in the ( Z u s a m m e n b r u c h s t h e o r i e
mystical shell’ in his 1873 Postface to the second ) (Levine ). Apart from the smallness of the sample
edition of C a p i t a l , volume 1 (Marx , p. and Engels’s own reservations about such a theory,
103 ). Perhaps the real difficulty lies not in Engels the fact is that proponents of such a position already
but in Marx himself. It may be, as Louis Althusser had sufficient ammunition from C a p i t a l ,
has claimed, that Marx did not find a suitable lan- volume 1. Moreover, it simply begs the question
guage in which to characterize the distinctiveness of whether Marx’s attitude to the collapse of capital-
his approach, or it may be more simply that Marx ism was any more or less apocalyptic than that of
remained ambivalent about how to characterize the Engels.
theory. In any event, it is not difficult to establish This discussion by no means exhausts Engels’s
disjunctions between the way he proceeds and the importance in the history of economic theory or
descriptions he gives of his procedures. Engels policy. A fuller treatment would have to discuss his
stuck fairly closely to Marx’s descriptions of his analysis of the ‘peasant question’ which included
procedures and can hardly be reproached for taking the important prescription that collectivization must
Marx at his word. be by example rather than force, his definition of
The problem of Engels’s role as an interpreter of political economy in the A n t i -
Marx’s theory debouches onto a third and D i i h r i n g , his interpolations in
potentially yet more contentious aspect of Engels’s C a p i t a l , volume 3, on banks, the stock
legacy, his role as editor of C a p i t a l , exchange and cartels which set the agenda for the
Volumes 2 and 3. Engels’s work was not confined early 2 0 th-century discussion of finance capital, his
to the transcription of Marx’s illegible handwriting. various writings on the relationship between the
He had to make active editorial choices. The state and economic forces and his later surveys of
published versions of these volumes contain over English developments since 1844 which prepared
1300 pages, but the original manuscripts amount to the way for later Marxist theories of labour
almost twice as many. For volume 2, for instance, aristocracy. These are only some of the more salient
Marx had composed eight versions of his treatment examples.
of the process of circulation, from which Engels Finally, at a time when it seems that the tech-
made a collation. In the absence of an independent nical debate on value seems to have reached a
transcription and publication of moment of exhaustion, it is perhaps worth going
back to Engels if only to remind us of the anti- Stedman Jones. G. 1977. Engels and the history of Marxism.
economic purpose underlying Marx's attempt to In The history of Marxism, ed. E.J. Hobsbawm.
Hassocks: Harvester, 1983.
construct a theory of value in the first place.

Bibliographic Addendum
Carver, T. 1990. Friedrich Engels: His life and thought.
Selected Works London: Palgrave Macmillan.
Hunley. J.D. 1991. The life and thought of Friedrich Engels:
1844a. Outlines of a critique of political economy. A reinterpretation of his life and thought. New Haven:
In Karl Marx and Frederick Engels, Yale University Press, are useful in understanding Engels
C o l l e c t e d w o r t s [MECW], vol. as an original thinker in his own right.
3. London: Lawrence & Wishart, 1975.
1844b. (With K. Marx). T h e h o l y
f a m i l y . In MECW, vol. 4.
1845. The condition of the working class in
England. In MECW, vol. 4. Engle, Robert F. (Born 1942)
1845-6. (With K. Marx). T h e G e r m a n
i d e o l o g y . London: Lawrence & Tim Bollerslev
Wishart, 1987.
1859. Karl Marx. A contribution to the critique of
political economy. D a s V o l k . . Nos.
14 and 16, 6 and 20 August. Abstract
1877. A n t i - D u h r i n g . Moscow: Robert Engle has published widely on topics
Foreign Languages Publishing House, 1954. ranging from urban economics to band spectrum
1894. T h e p e a s a n t q u e s t i o n regression, electricity demand, state- space
i n F r a n c e a n d G e r - modelling, testing, exogeneity', seasonality,
m a n y . in Karl Marx and Frederick Engels, option pricing, and market micro structure
S e l e c t e d w o r k s , vol. 3. finance. Most notable, however, are his seminal
Moscow: Progress Publishers, 1970. contributions on cointegration and Auto-
1925. T h e d i a l e c t i c s o f Regressive Conditional Heteroskedasticity
n a t u r e . Moscow: Foreign Languages (ARCH), which have revolutionized the field of
Publishing House, 1954. time series econometrics and the practice of
1938. E n g e l s o n c a p i t a l . empirical macroeconomics and asset pricing
London: Lawrence & Wishart. finance, respectively. The research field of
financial econometrics and corresponding
Bibliography developments in practical risk management and
measurement also derive largely from the
Claeys, G. 1984. Engels' outlines of a critique of political insights afforded by the ARCH class ofmodels
economy (1843) and the origins of the Marxist critique of and Engle’s many other research contributions
capitalism. History of Political Economy 16: 207-232.
Levine, N. 1984. Dialogue within dialectics. London: Allen
since the 1980s.
& Unwin.
Marx, K. 1859. A contribution to the critique of political
economy. In MECW, vol. 16. New York: International Keywords
Publishers. ARCH models; Asset pricing finance;
Marx, K. 1873. Capital. Vol. 1, 2nd ed. Harmondsworth:
Penguin, 1976. Cointegration; Engle, R.; Financial economet-
Marx, K. 1894. Capital. Vol. 3. Ilarmondsworth: Penguin, rics; Fischer, F.; Friedman, M.; Granger Rep-
1981. resentation Theorem; Phillips curve; Risk
Rubel, M., ed. 1968. Karl Marx, Oeuvres. Vol. 2. Paris: management; Risk measurement; Rothenberg,
Gallimard.
Rubin, I. 1928. Essays on Marx's theory of value, 1972. J.; So low, R.; Time series econometrics
Detroit: Black & Red.
 JEL Classifications econometrics and the practice of empirical mac-
B31; Cl; C32; G1 roeconomics and asset pricing finance, respectively.
The blossoming new research field of financial
econometrics and corresponding developments in
Robert F. Engle was bom in Syracuse, upstate New practical risk management and measurement may
York, on 10 November 1942. Shortly thereafter his also in large part be attributed to the insights
family moved to Philadelphia, and Engle graduated afforded by the ARCH class of models and some of
from high school there in 1960. He majored in Engle’s many other pioneering research
physics as an undergraduate at Williams College, contributions.
and went on to enrol as a Ph.D. student in physics at Encouraged by his senior colleagues Franklin
Cornell University. However, after one year he E
M. Fisher, Robert Solow and Jerome Rothenberg,
decided to switch to the Ph.D. programme in eco- much of Engle’s work as an assistant professor at
nomics, where he wrote his thesis on temporal MIT was in the area of urban economics. In fact,
aggregation and the relationship between macro- Engle was hired by UCSD as an urban economist,
economic models estimated at different frequencies, and he continued to teach, and occasionally publish
under the direction of T.C. Liu. After graduating in, urban economics almost up until he left San
from Cornell in 1969, Engle was hired as an Diego in 2000. It was Clive Granger, whom Engle
assistant professor at MIT. He moved on to had first met at the 1970 World Congress of the
University College at San Diego (UCSD) in 1975, Econometric Society in Cambridge, who persuaded
where he was promoted to full professor in 1977 Engle to move to the West Coast. Granger had
and a Chancellors’ Associates Chair in 1993. He himself just accepted a permanent position at UCSD
also chaired the UCSD Economics Department in 1974 and, only a few years after Engle’s arrival
from 1990 to 1994. In 2000 his growing interest in in 1975, Halbert White also joined the department.
financial markets prompted him to accept the The ensuing two decades may rightfully be referred
Michael Armellino Professorship in Finance at the to as the golden age of modem time series
Stem School of Business at New York University, econometrics, and UCSD, along with Yale, home of
and he now lives on Manhattan with his wife of the group led by Peter Phillips, was t h e place to
many years, Marianne, for most of the year. be. The list of visitors to the UCSD Economics
Together they have two grown children. Department over this period reads like a who’s who
Engle has written and published extensively on a in time series econometrics. Engle’s hospitality and
wide array of topics, ranging from urban economics generosity with his time, as well as the many
to band spectrum regression, electricity demand, successful conferences he organized in San Diego,
state-space modelling, testing, exogeneity, played a cmcial role in fostering this nexus. The
seasonality, option pricing, and market micro group was further strengthened by the arrival of
structure finance. However, he is particularly well- James Hamilton, Graham Elliott and Allan
known for his contributions to time series Timmermann as additional faculty members in the
econometrics and his path-breaking work on early 1990s, and the Engle-Granger UCSD
cointegration and AutoRegressive Conditional econometrics tradition continues to this day. Many
Heteroskedasticity (ARCH). The 2003 Bank of of Engle’s former Ph.D. students from that period
Sweden Prize in Economic Sciences in Memory of have also gone on to successful academic careers,
Alfred Nobel was explicitly awarded to Engle for continuing the UCSD legacy.
‘methods of analyzing economic time series with Albert Einstein’s famous maxim ‘Everything
time-varying volatility (ARCH)’, a prize he shared should be made as simple as possible, but not
with Clive W. J. Granger for his seminal simpler’ succinctly characterizes Engle’s approach
contributions to the theory of cointegration. It is to econometric modelling. Consider his early
hardly an exaggeration to say that since the 1980s research on band spectrum regression. The static
the concepts of cointegration and ARCH have OLS regression approach routinely employed
completely revolutionized the field of time series throughout economics implicitly
assumes that the identical linear relationship holds Theorem. Intuitively, while both y , and x , are
across all frequencies. Yet in many simations this is stochastically trending, they trend together, so that
obviously a gross oversimplification. For instance, in the long run they do not stray too far apart. The
the relation between interest rates and housing starts inclusion of the stationary z , term as an additional
arguably differs between the short run and the long explanatory variable ensures this condition. On the
run. Similarly, the Phillips-curve trade-off between other hand, if the two variables are not cointegrated
unemployment and inflation may be primarily a will be non-stationary, resulting in an unbalanced
business cycle phenomenon. Rather than building a regression. Hence, empirically the null hypothesis
fully fledged complicated dynamic model for of no cointegration may be assessed on the basis of
analysing these types of temporal dependencies, the the popular Engle-Granger cointegration test for a
band spectrum regression approach offers a simple unit root in or, if /i is not known, a least-squares
way of estimating separate regression coefficients, estimate thereof. The cointegration concept has had
and therefore different relationships, for different a profound impact on practical macroeconomic time
frequencies. The idea of estimating different short- series modelling in government and private
run and long- run regressions may also be seen as a institutions around the world. The academic
precursor to Engle’s later work on cointegration and literature also abounds with hundreds, if not
error correction models. thousands, of papers expanding upon the basic
The original idea of cointegration came from testing and modelling approach first developed by
Granger. Nonetheless, it was the seminal joint paper Engle and Granger. Engle's subsequent work on
by Engle and Granger (1987a) that devised the first common features may also be seen as a natural
empirical test for cointegration and formally extension of the cointegration concept.
established the link between cointegration and the Another more technical theme brought to the
error-correction type models popularized by Denis fore by Engle’s research entails the powerful use of
Sargan and David Hendry at the LSE during the one-step-ahead prediction error decompositions and
1960s and 1970s. More specifically, suppose that conditional Gaussian likelihoods. For instance, the
the two univariate time series y t and A', are both beauty of his influential work on testing, including
non-stationary, or 1 (1 ), so that their first differences, the simple-to-implement Lagrange Multiplier (LM)
Ay, = y t - y t - i and Ax> = x, - x, _ b are chi-square type test statistics constructed by
stationary, or 1(0). Most nominal macroeconomic multiplying the number of time series observations
and financial time series may be characterized in with the R2 from an auxiliary regression of either
this way. Any linear combination of the two series, unity on the vector of scores evaluated under the
say z t = y , — fix,, will then generally also null hypothesis, or, alternatively, a regression of the
be non-stationary. However, it is possible that z t squared residuals on the derivatives of the
may actually be stationary, or 1 (0 ), in which case conditional mean, hinges directly on recursively
y , and xt are said to be cointegrated, with expressing the likelihood function in terms of
cointegrating vector (1, — / > ) . Indeed, many conditional one-step-ahead densities. Engle’s
of the ‘classical ratios’ in macroeconomics and pioneering contributions on dynamic factor models
finance (such as consumption/ineome and divi- and Kalman filtering are similarly based on the
dends/prices) are naturally thought of as powerfiil idea of representing the likelihood
cointegrating relationships when expressed in logs. function in terms of successive conditional
Engle and Granger showed that in this situation a densities. Most important, however, the seminal
satisfactoiy vector autoregression for the stationary ARCH class of models is also formulated directly in
bivariate process of first differences, [Ay„ AA', }, must terms of one-step- ahead conditional expectations
necessarily include the z , ‘error-correction’ term and densities.
in at least one of the two equations, the so-called The ARCH model (aptly named so by David
Granger Representation Hendry) was conceived during Engle’s sabbatical
visit to the LSE in 1979. Engle’s interest in function maximized with respect to all of the model
modelling variance dynamics was spurred by the parameters, in turn resulting in a time series of
assertion in Milton Friedman’s 1976 Nobel Lecture positively serially correlated conditional variance
on a trade-off between unemployment and estimates, h,, / 1 , 2 , ... , T (that is, esti
inflationary uncertainty rather than a tradeoff mates of inflationary uncertainty in Engle’s original
between unemployment and the level of inflation as application).
stipulated by the conventional Phillips curve. The While Engle’s initial work and empirical appli-
actual formulation of the first ARCH model was cations of the ARCH model were rooted in mac-
also influenced by Granger’s ongoing work on roeconomics, the model has shone most brightly in
bilinear models. At the time Granger had noted that the area of finance. Since Mandelbrot’s work in the
early 1960s on the behaviour of speculative prices,
E
in a non-Gaussian setting white noise series need
not necessarily be unpredictable, and, in particular, it had been recognized that, even though most
when the squared residuals from otherwise well- returns are approximately serially
specified linear models were regressed on their own uncorrelated (at least over shorter daily or weekly
lagged squared values, the regression coefficients horizons), Targe changes tend to be followed by
often turned out to be highly significant. Engle large changes - of either sign - and small changes
realized that this was not actually a test for tend to be followed by small changes’
bilinearity but rather the optimal LM test for some (Mandelbrot ). However, the empirical finance
other nonlinear model. Putting this together, Engle literature up until the mid-1980s had largely ignored
brought forth the ARCH model. this fact, focusing instead on best characterizing the
The particular ARCH(p) model first analysed unconditional return distributions. Meanwhile,
and estimated by Engle (1982) may be succinctly Engle soon realized that the ARCH model was
expressed as ideally suited to this type of data: little, or no, serial
correlation in the mean, but strong serial correlation
y , = m , + E , , e,|I,_i~N(0, h , ) ,
and h , in the second moments. Moreover, the ability to
directly quantify the risk through a parametric
= a0 + ai£t2_! + ... + ap£t2_p,
model for the conditional variance, or more
where It _ i refers to the set of information available generally the conditional covariance matrix, for the
at time t — 1 , m t denotes the conditional mean returns strikes directly at the heart of the risk-return
ofthe y, time series, and all ofthe z(l, ... , xp trade-off central to asset pricing finance.
parameters are restricted to be non-negative. The Consequently, Engle quickly shifted the focus of his
first equation for the conditional mean is, of course, research agenda to finance. Over the next 20 years,
completely standard (in his original application to along with his many students and other
UK consumer prices Engle used an error correction collaborators, he developed numerous refinements
model for the mean). However, the key difference - to the basic ARCH model described above designed
Engle’s brilliant new insight - comes from to account better for specific features of the data
recognizing that even though the residuals, a,, must and/or questions of economic import: richer
be serially uncorrelated, their conditional variance, ARMA-type representations for the variance,
and therefore the conditional variance of v„ need including unit-root and long-memory type depen-
not be constant but may in fact be predictable. dencies, models in which the variance directly
Moreover, by explicit parameterizing h t as a func- influences the conditional mean, asymmetries or
tion of the past squared residuals and by assuming leverage effects in the variance, alternative para-
conditional normality, the joint density for all ofthe metric and non-parametric conditional distributions
observations, say y„ t = 1 , 2 , ... , T, may easily in place of the normal, multivariate factor models
be evaluated through a prediction error decom- and cointegration in variance, to mention but a few.
position type argument, and the log likelihood The corresponding long list of new
acronyms is also legendary: ARCH-M, GARCH, has a long list of invited talks and keynote addresses
IGARCH, EGARCH, TARCH, GJR-GARCH, to his name, including the prestigious A. W. Philips
NARCH, QARCH, STARCH, VGARCH, and Fisher-Schultz lectures sponsored by the
SWARCH, FIGARCH - the list goes on. Empirical Econometric Society. (For a more in-depth
applications of these models have in turn resulted in discussion of Engle’s work along with some
many important new insights into the pricing and personal reflections, see Diebold •)
hedging of financial instruments and functioning of In conclusion, it is simply impossible to imagine
financial markets, and it is no exaggeration to say what the field of time series econometrics, let alone
that the day-to-day risk management and the new field of financial econometrics, would have
monitoring in financial institutions have been looked like today had it not been for Engle’s
completely altered by the advent of the ARCH class seminal contributions, both direct and indirect,
of models. through the substantial subsequent research
Not one to rest on his laurels, Engle continues to programmes his work has helped stimulate. But
push forward the research frontier in financial Engle isn’t merely one of the greatest
econometrics. Most recently he has worked exten- econometricians of his time. He has a wide range of
sively on new methods for analysing ultra high- other interests and talents. For example, he is an
frequency, or tick-by-tick, financial data. In partic- outstanding ice skater, having competed at the US
ular, whereas most procedures in time series econo- national level, finishing second in the 1996 and
metrics, including most of Engle’s own earlier 1999 ice dancing championship competition.
work, are explicitly designed for modelling dis-
cretely sampled equidistant observations, high-
frequency financial data are typically not observed
at fixed time intervals. Engle’s recent Auto-
regressive Conditional Duration (ACD) model,
which derives many of its statistical properties from See Also
the ARCH class of models, provides a particularly
convenient way of accommodating this feature by
explicitly modelling the times between observations
as a serially correlated process. His Dynamic
Conditional Correlation (DCC) model, which
allows for the estimation of large-scale dynamic
covariance matrices, represents another recent ►(►I
noteworthy advance. In keeping with his trademark, ►::
this latest research represents the perfect blend
between sophisticated yet simple-to- implement
econometric techniques explicitly designed for
Selected Works
answering genuinely interesting economic
questions. Like most of his research since the 1972. (With F. Fisher, J. Harris and J.
1970s, his latest work has already found widespread Rothenberg.) An econometric simulation model
use both inside and outside academia, and spurred a of intra-metropolitan housing location: housing,
number of ongoing new developments by other business, transportation and local government.
researchers in the field. A m e r i c a n E c o n o m i c
In addition to the much-deserved recognition R e v i e w 62: 87-97.
bestowed on him by the Nobel Prize Committee, 1973. Band spectrum regression.
Engle is a long-standing fellow of the Econometric I n t e r n a t i o n a l
Society, of the American Statistical Association, E c o n o m i c R e v i e w 15: 1-11.
and of the American Academy of Arts and 1976. Interpreting spectral analysis in terms of time
Sciences. He is also an excellent speaker, and he domain models. A n n a l s o f
E c o n o m i c a n d S o c i a l
1979. (With C. Granger, R. Ramanathan and A. 1990b. Asset pricing with a factor ARCH covari-
Andersen.) Residential load curves and time-of- ance structure: Empirical estimates for Treasury
day pricing: An econometric analysis. bills (with V. Ng and M. Rothschild).
J o u r n a l o f J o u r n a l o f
E c o n o m e t r i c s 9 : 13-32. E c o n o m e t r i c s 45: 213-237.
1981. (With M. Watson.) A one-factor multivariate 1990c. Seasonal integration and cointegration (with
time series model of metropolitan wage rates. S. Hylleberg, C.W.J. Granger and B.S. Yoo).
J o u r n a l o f t h e J o u r n a l o f
A m e r i c a n S t a t i s t i c a l E c o n o m e t r i c s 40:45-62.
A s s o c i a t i o n 76: 774-781. 1991a. (With C. Granger.) L o n g r u n
1982. Autoregressive conditional hetero- e c o n o m i c r e l a t i o n s :
skedasticity with estimates of the variance of UK R e a d i n g s i n
inflation. E c o n o m e t r i c a 50: 987- c o i n t e g r a t i o n . Oxford: Oxford
1008. University Press.
1983a. (With D. Hendry and J. Richard.) Exo- 1991b. (With G. Gonzales.) Semi-parametric
geneity. E c o n o m e t r i c a 51: 277- ARCH models. J o u r n a l o f
304. B u s i n e s s a n d E c o n o m i c
1983b. (With M. Watson). Alternative algorithms S t a t i s t i c s 9: 345—359.
for the estimation of dynamic factor, MIMIC, 1992. (With C. Mustafa.) Implied ARCH models
and varying coefficient regression models. from options prices. J o u r n a l o f
J o u r n a l o f E c o n o m e t r i c s 52:289-311.
E c o n o m e t r i c s 23: 385-400. 1993a. (With T. Bollerslev.) Common persistence
1984. Wald, likelihood ratio, and Lagrange mul- in conditional variances.
tiplier tests in econometrics. In E c o n o m e t r i c a 61: 167-186.
H a n d b o o k o f 1993b. (With S. Kozicki). Testing for common
e c o n o m e t r i c s , Vol. 3, ed. Z. features. J o u r n a l o f
Griliches and M. Intrilligator. Amsterdam: B u s i n e s s a n d E c o n o m i c
North-Holland. S t a t i s t i c s 11: 369-380.
1986a. (With C. Granger, J. Rice and A. Weiss.) 1994a. H a n d b o o k o f
Semi-parametric estimation of the relation e c o n o m e t r i c s , Vol. 4, ed. with
between weather and electricity demand. D. McFadden. Amsterdam: North- Holland.
J o u r n a l o f t h e 1994b. (With T. Bollerslev and D. Nelson.) ARCH
A m e r i c a n S t a t i s t i c a l models. In H a n d b o o k o f
A s s o c i a t i o n 81: 310-320. e c o n o m e t r i c s , Vol. 4, ed. R.
1986b. (With T. Bollerslev.) Modeling the persis- Engle and D. McFadden. Amsterdam: North-
tence in conditional variances. Holland.
E c o n o m e t r i c R e v i e w s 5: 1995a. A R C H : S e l e c t e d
1-50. r e a d i n g s . Oxford: Oxford University
1987a. (With C. Granger.) Co-integration and error Press.
correction: Representation estimation and 1995b. (With K. Kroner.) Multivariate simulta-
testing. E c o n o m e t r i c a 55: 251- neous ARCH. E c o n o m e t r i c
276. T h e o r y 11: 122-150.
1987b. (With D. Lilien and R. Robins.) Estimation 1998. (With J. Russell). Autoregressive condi-
of time varying risk premia in the term structure: tional duration: A new model for irregularly
The ARCH-M model. spaced transaction data.
E c o n o m e t r i c a 55: 391-407. E c o n o m e t r i c a 6 6 , 1127-62.
1987c. (With S. Yoo.) Forecasting and testing in co- 1999. (With G. Lee). A permanent and transitory
integrated systems. J o u r n a l o f component model of stock return volatility. In
E c o n o m e t r i c s 35: 143-159. Cointegration, causality, and forecasting: A
1988. (With T. Bollerslev and J. Wooldridge.) A festschrift in honor of Clive W. J. Granger, ed.
 of Business and Economic Statistics 20: 339- Chadwick, E.; Chalmers, T.; Christian political
350. economy; Clark, J. B.; Classical economics;
2002b. (With J. Rosenberg.) Empirical pricing Cliffe Leslie, T. E.; Comparative advantage;
kernels. J o u r n a l o f Condillac, E. B. de; Diminishing returns;
F i n a n c i a l E c o n o m i c s 64: Edgeworth, F. Y.; English school of political
341-372. economy; Factor substitution; Fawcett, H.;
2004. Risk and volatility: Econometric models and Fawcett, M. G.; Fisher, L; Foxwell, H. S.; Free
financial practice. A m e r i c a n trade; Harrod, R. F.; Homer, F.; Hume, D.;
E c o n o m i c R e v i e w 94: 405- Increasing returns to scale; Jeffrey, F.; Jevons,
420. W. S.; Jones, R.; Keynes, J. N.; Labour theory
of value; Lauderdale, eighth earl of; Lloyd, W.
F.; Longfield, M.; Malthus, T. R.; Mandeville,
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Engle. Econometric Theory 19: 1159-1193. economics; Mayeme- Turquet, L. de;
Diebold, F. 2004. The Nobel memorial for Robert F. Engle. McCulloch, J. R.; Menger, C.; Mercantilism;
Scandinavian Journal of Economics 106: 165-185.
Mandelbrot, B. 1963. The variation in certain speculative
Mill, J.; Mill, J. S.; Montchretien, A. de; Natural
price; Neutrality of money; Nicholson, J. S.;
Norman, G. W.; Pareto, V.; Pigou, A. C.;
Political economy; Political economy club; Poor
English School of Political Economy law; Productive and unproductive labour;
Quesnay, F.; Ricardo, D.; Robbins, L. C.; Say,
A. M. C. Waterman J.-B.; Say’s identity; Say’s law; Scrape, G. P.;
Senior, N. W.; Sidgwick, H.; Smith, A.; Smith,
S.; Sraffa, P.; Stationary state; Steuart, J.;
Stewart, D.; Sumner, J. B.; Surplus; Thornton,
H.; Thornton, W. T.; Thiinen, J. H. von; Tooke,
Abstract
T.; Torrens, R.; Turgot, A. R. J.; Utilitarianism;
The ‘English School’ of political economy
Walker, F. A.; Walras, L.; Wayland, F.; Weiser;
describes the tradition of economic thought that
West, E.; Whately, R.; Whewell, W.; Wicksell,
began with Malthus, and included Henry
J. G. K.; Wicksteed, P. H.; Young, A. A.
Thornton, Chalmers, James Mill, Torrens, West,
Ricardo, and Thomas Tooke in the first
generation; Whately, Senior, McCulloch and
J.S. Mill in the second; and the Fawcetts,
Caimes, Jevons, Bagehot, Foxwell, Sidgwick, JEL Classifications
J.N. Keynes and Nicholson in the third. J.-B. B1
Say was an honorary member. Karl Marx iden-
tified his own work with that school. Its most The ‘English School’ of political economy com-
important production was J.S. Mill’s prises all major British economists of the 19th
P r i n c i p l e s o f P o l i t i c a l century, together with J.-B. Say and perhaps Karl
E c o n o m y , which continued to be used Marx.
as a textbook until the mid-2 0 th century. ‘Important changes have taken place in the
meaning of the term “political economy,” as used
by leading writers, since it was first employed’,
Keywords
wrote Henry Sidgwick in Palgrave’s original
American economic association; Anderson, J.;
D i c t i o n a r y o f P o l i t i c a l
Bagehot, W.; Bentham, J.; Bohm- Bawerk, E.
E c o n o m y (Palgrave , pp. 128-9). As first
von; Boisguilbert, R de; Brougham, H.; Bullion
used by Mayeme-Turquet and Montchretien,
committee; Caimes, J. E.; Cassel, G.;
‘ c e c o n o m i e
p o l i t i q u e ’ signified an attempt to to disagree with hostile critics of their enterprise,
extend the art of estate management to the entire such as the Lake Poets (from whom they were all
kingdom of Louis XIII and his successors indeed markedly ‘dissimilar’), because the latter
(Waterman , p. 225). This usage, generalized to chose not to acquire the viewpoint and vocabulary
mean a ‘system’ of policy designed to ‘increase the of the new, political-economy conversation, but
riches and power’ of a country (Smith , I.xi.n.l; resorted rather to the idioms of a very different
II.5.31; IV. 1.3) remained current until the end of the conversation: that of Romantic aesthetics and non-
18th century and was so employed by Steuart. utilitarian ethics.
Adam Smith disliked the usage because of its In attending to the conversation of the English
implicit mercantilism. He recognized it, but pro- School it is necessary first to establish its identity,
posed a better definition. ‘What is properly called secondly to consider its members and its literature,
Political (Economy’ is ‘a branch of the science of a and thirdly to distinguish its chief analytical
statesman or legislator’: namely ‘ a n features, especially as these differ both from the
i n q u i r y ’ , which is in principle economic thought that preceded it and from eco-
disinterested and open- ended, into ‘ t h e nomics of the present day. Finally, since the
n a t u r e a n d c a u s e s o f t h e boundary between the political economy of the
w e a l t h o f n a t i o n s ’ (Smith , IV. English School and what is generally thought of as
intro; IV.ix.38; emphasis added). The prestige that ‘modem’ economics is vague and permeable, some
W e a l t h o f N a t i o n s quickly attention should be paid to continuity and
acquired, amplified by Dugald Stewart’s widely ‘revolution’, if any.
influential Edinburgh lectures in the new science,
redefined ‘political economy’ as a ‘part of the
science of human society’ (Palgrave , p. 129; cf. Identity of the English School
Winch , who appears to disagree with this of Political Economy
interpretation) and created a circle of younger
thinkers committed both to criticizing and refining Writing of ‘the English School of Political Econ-
Smith’s ideas and to propagating them among the omy’ in the original Palgrave dictionary, James
governing classes. Though the E d i n b u r g h Bonar (Palgrave , p. 730) observed that ‘The
R e v i e w , founded in 1802, was at first the English writers on political economy before Adam
principal means of propagation, most of the prime Smith do not at any time present the marks of a
movers soon migrated to London, which from the “school” properly so called.’ What Bonar called
second or third decade of the 19th century became ‘Modem Economics’ - meaning ‘political economy’
the home of what was soon called the ‘English in the new, Smithian sense - he then divided into
School’. four periods headed respectively: Adam Smith,
It is important to recognize that to describe the Malthus and Ricardo, John Stuart Mill, and W.S.
small community of anglophone political econo- Jevons; with all other authors subsumed under these
mists in the 1820s and after as a ‘school’ is to imply canonical names.
neither a quasi- apostolic succession of doctrine in Adam Smith was not an Englishman and he died
some leading university nor a closed shop of experts before Malthus and Ricardo had begun to write.
defined by their adherence to any orthodoxy. It is Though the E d i n b u r g h R e v i e w
rather the fact, as T.S. Eliot observed of all such (Anon , p. 73) referred to the English School as ‘the
intellectual circles in general, that ‘they are driven to school of which Adam Smith was the founder’, this
each other’s company by their common dissimilarity is Caledonian hyperbole. Smith founded no
from everybody else, and by the fact that they find ‘school’. His most influential disciple, Dugald
each other the most profitable people to disagree Stewart, was the intermediary between Smith and
with’ (Kojecky , p. 244). Members of the English those the E d i n b u r g h R e v i e w
School, like all subsequent economists, were more accurately described later in the article as the
notorious for their disagreements, both with Adam ‘followers of Dr Smith’ practising ‘Political
Smith and with each other. But they did not find it Economy, using
profitable
the word in the sense of Ricardo and Malthus’ advice’. His business is ‘neither to recommend nor
(Anon , pp. 77, 79). Subject to this important to dissuade, but to state general principles which it
qualification, Bonar’s chronology is helpful. is fatal to neglect’ (Senior ). McCulloch for one
Roughly speaking the English School lasted for strongly disagreed with Senior on this point: the
about three generations. The first generation, from general principles, he thought, had already been
1798 to the 1830s is that of which Malthus, Henry completely enounced by Ricardo. What remained
Thornton, Chalmers, James Mill, Torrens, West, was ‘to exhibit some of their more important
Ricardo, and Thomas Tooke are now the best applications’ (McCulloch , p. vi). Though Senior’s
remembered. A second generation, whose members view of the scope of political economy was tidied
were active in some cases before 1830, but who up and assimilated by the end of the 19th century
flourished for the most part until the 1860s or even (J.N. Keynes ), all members of the ‘school’ were
later, included Whately, Senior, McCulloch and J.S. agreed at the outset on at least one most important
Mill. Political economy of the English School never ‘application’. The ‘great principles of free exchange
really died out. It changed, very gradually and and natural distribution’ that Smith had developed
almost imperceptibly, into the international, from ‘the philosophers of the Continent’ (that is,
professionalized ‘economics’ of the mid-20th Quesnay, Turgot and so on) showed it to be eco-
century. Yet a third and last generation can be nomically unprofitable ‘for the legislature to inter-
detected - and was in fact detected in the 1890s - meddle’ with trade and income distribution (Anon ,
which included W.T. Thornton, the Fawcetts, pp. 80, 78). Though Caimes later averred that
Cairnes, Jevons, Bagehot, Foxwell, Sidgwick, J.N. ‘political economy has nothing to do with laisser
Keynes and Nicholson. The positions of Marshall, faire’, Sidgwick thought this ‘too daring a paradox’.
Edgeworth and Wicksteed are problematic and will There can be no doubt that the interest of Adam
be considered below. Smith’s book for ordinary readers is largely due to
The English School was recognized by its dif- the decisiveness with which he offers to statesmen
the kind of practical counsels which, according to
ference from ‘the foreign school’ (Anon p. 77)
Senior and Caimes, he ought caretully to have
which included Sismondi, Cherbuliez and abstained from giving. (Palgrave , pp. 130-1)
Villeneuve, but not J.-B. Say who from the first was
Rightly or wrongly, the political economy of the
deemed an honorary Englishman. The English
English School was associated in the popular mind
writers distinguished ‘the art of government’ from
with free trade and attacks on corporate privilege,
the ‘science’ of political economy. With respect to
and was denounced for these disturbing ideas by a
the former, the latter is ‘only one of many
wide variety of hostile critics.
subservient sciences; which involves the
Both the methodological tendencies of the new
consideration only of motives, of which the desire
science and its ‘more important applications’ owed
for wealth is only one among many, and aims at
much to Dugald Stewart: the former to his
objects to which the possession of wealth is only a
influential P h i l o s o p h y o f t h e
subordinate means’ (Senior , pp. 129-30). The
H u m a n M i n d ( ,
foreign writers rejected this minimalist con- strual,
1814,1827) the latter to his annual public lectures at
labelled it ‘chrematistics’ or ‘chrysology’, and
the University of Edinburgh, beginning in the
continued to maintain that political economy
winter of 1800/1.
embraces both the art and the science of
Though preferring a broader definition of
government.
‘political economy’ than that of either Smith or his
The incipient distinction between ‘art’ and
English followers, and emphasizing the historical
‘science’ seemed to imply that any practitioner of
character of economic knowledge, Stewart argued
the latter must abstain - qua political economist -
in H u m a n M i n d that the hypothetical
from political judgements. His analytical
and a priori reasoning so characteristic of what he
conclusions, being strictly positive and abstracted
called the ‘new science’ - and which became
from ethical considerations, ‘do not authorize him
in adding a single syllable of
one of the hallmarks of the English School - was outset Ricardo, George Warde Norman and Thomas
perfectly legitimate, and compatible with the testing Tooke. J.-B. Say was elected as an Honorary
of theories against experience (Fontana pp. 99-102; Foreign Member in 1822, the only such member
Waterman , eh. 8 ). until 1919. McCulloch was elected in 1829, shortly
Stewart’s Edinburgh lectures were crucial in after his migration from Scotland; Senior (in ),
what a recent author has aptly called ‘the process of Pryme (1828) and Whately ( ) were elected
Anglicisation of Scottish thought after 1790’ as Honorary Members by
(Fontana , p. 9). Not only were they attended by virtue of their professorships in political economy.
Jeffrey, Homer, Brougham, Chalmers and the newly Cairnes (1862), Cliffe Leslie (1862), Fawcett
arrived Englishman, Sydney Smith, all of whom (1862), Jevons (1873), Foxwell (1882), Marshall
were influential in propagating political economy; (1886), Nicholson (1888) and Edgeworth (1891)
Pryme ( , p. vii) were all subsequently elected under this rule.
records that they ‘attracted so much attention that Among those political economists now remembered
several members of our own university [namely, as influential authors of the English School, only
Cambridge] went from the South of England to pass Henry Thornton, Sir Edward West, Archbishop J.
the Winter at Edinburgh, for the purpose of B. Sumner, Thomas Chalmers, Poulett Scrope, and
attending them’: one of these seems to have been Richard Jones were never members of the Club:
John Bird Sumner (Waterman , pp. 159-60). Thornton because he died in 1815, West because he
According to a later account, ‘a wave of young went to India, Chalmers because he stayed in
Scotland, and Sumner because he announced in
Englishmen ... went North in lieu of the grand tour
1818 - to Ricardo’s regret - that he intended to give
made impossible by the renewal of war’ (Checkland
up political economy for the study of theology
, p. 43). Though the lectures were diffuse and
(Waterman , p. 157). Scrope and Jones were on the
circumspect, their underlying message was that
outer edge of the ‘School’.
contained in an early paper that Adam Smith had
It has been suggested that the English School
entrusted to Stewart before his death:
was a ‘scientific community’ of which the Political
Little else is required to carry a state to the highest Economy Club was a ‘vital hub’ (O’Brien , pp. 12-
degree of opulence from the lowest barbarism, but
peace, easy taxes and a tolerable administration of
13). There is merit in this suggestion, but it should
justice; all the rest being brought about by the natural be recognized that the original purpose of the club,
course of things (Smith 1755). (Winch , p. 90) though including the ‘mutual instruction’ of
Leading members of Stewart’s circle - Jeffrey, members, was chiefly propagandist: ‘the diffusion
Homer, Brougham, and Sydney Smith - founded the amongst others of the just principles of Political
E d i n b u r g h R e v i e w to urge this Economy’ and
message upon the Holland House Whigs from to watch carefully the proceedings of the Press, and
whom they hoped to receive patronage. First Smith, to ascertain if any doctrines hostile to sound views
on Political Economy have been propagated ... to
then Jeffrey, served as editor until 1829, when
refute such erroneous doctrines, and counteract their
replaced by McVey Napier. By that date its influence ... and to limit the influence of hurtful
contributors on political economy had included all publications. (Political Economy Club , p. 375)
the leading members of the English School save
Many members were Whig or liberal statesmen
Ricardo (who declined out of modesty, and who
who knew a ‘hurtful publication’ when they saw
died in 1823): Malthus, James Mill, Chalmers,
one: 52 of the 115 elected between 1821 and 1870
Torrens and McCulloch (Fontana , p. 8 ).
sat in either the upper or lower House of Parlia-
Of these authors, all save Chalmers were mem-
ment; and included Lord Althorp, the Marquis of
bers of the Political Economy Club, a London
Landsdown (a descendent of Sir William Petty),
dining club founded in 1821 which, in addition to
Earl Grey and W. E. Gladstone. Fetter ( ) has
Malthus, Mill and Torrens, included from the
documented the activities of ‘the economists in Samuelson’s influential interpretation, land scarcity
Parliament’. plays little or no analytical part in W e a l t h
Almost from the first there was a desire by the o f N a t i o n s (Samuelson ; cf. Hollander ;
Club to recognize and foster the academic study of Waterman ). When Malthus ( ), West
political economy. Though there had been high- ( ), Torrens ( ) and Ricardo ( )
level economic analysis at British universities worked out the implications of Malthus ( )
before the end of the 18th century, it was but a they believed that they were correcting Smith and
small ingredient of ‘moral and political philosophy’ saying something new and important (McCulloch ,
(for example, see Waterman ) and never known as p. 6 8 ). Diminishing returns immediately became
‘political economy’. But in the decade of the 1820s part of the hard core of the so-called classical
chairs in political economy were established in political economy of the English School.
Oxford, London and Cambridge and their Ricardo made diminishing returns in agriculture
incumbents immediately co-opted (Checkland ). the cornerstone of his P r i n c i p l e s (1817),
We may therefore identify the English School combined it with ‘Malthusian’ population theory,
roughly speaking as that subset of Political Econ- Smith’s account of accumulation and growth, and
omy Club members in the 19th century who an ad hoc ‘93 % Labor Theory of Value’ (Stigler )
published and disputed with each other on the to produce a complete account of value, distribution
subject, together with half a dozen or so other major and growth in a two- sector market economy. The
authors who at some time or other were part of their labour theory of value (LTV) was also the key
conversation. Despite its name, several leading concept in Ricardo’s rigorous and elegant analysis
members were Scotch immigrants, and it included of comparative advantage in international trade.
one Frenchman. Though Karl Marx lived in London Looking back 30 years later, McCulloch ( p. 16)
from 1848 and thoroughly digested the literature of called the LTV ‘the fundamental theorem of the
anglophone political economy over the next two science of value’. An authoritative and exhaustive
decades, he was not known or recognized by the account of Ricardo’s contribution - which it treats, a
Club. But in the ‘Afterword’ to the second German la McCulloch, as virtually identical with ‘classical
edition of C a p i t a l (Marx , vol. 1, p. 26) he economics’ - appeared in the first edition of T h e
explicitly identified his own work, in method at N e w ’ P a l g r a v e
least, with that of the English School. D i c t i o n a r y o f E c o n o m i c s
(Blaug ).
In addition to the above works, the ‘English’
Literature of the English School literature that already existed by the time the
Political Economy Club was founded in 1821
Literature of the English School begins with
included Malthus’s ( ) H i g h P r i c e
Malthus’s first E s s a y o n
o f P r o v i
P o p u l a t i o n ( ). For
s i o n s , which formally specified a demand
as an unintended consequence of his Whiggish
function of price and inaugurated the supply-and-
polemic against Godwin’s ( ) romantic anar
demand value theory that eventually ‘won out’ over
chism, Malthus analysed the effect of population
the Ricardo-Marx LTV (Smith ; Schumpeter , p. 48)
growth under land scarcity to show what was later
which it generalizes, Thornton’s ( ) P a p e r
called ‘diminishing returns’ (Stigler ). Though
C u r r e n c y , which
diminishing returns in agriculture had been
analysed the macroeconomic relations between
identified by Steuart ( ) and Turgot
monetary and real variables in a manner reinvented
( ), and had actually been used by Anderson
by Wicksell a century later, and numerous
( ) to adumbrate the ‘Ricardian’ theory of
pamphlets by many authors on monetary questions
rent, the concept was not integrated into 18th-
provoked by the Parliamentary Bullion Committee
century economic thought. Notwithstanding
of 1810. It was this controversy that brought
Malthus and Ricardo together, and which seems to
have been a catalyst for the nascent
‘scientific community’. The pre-1821 literature also essay of 1933, has gradually restored the true
includes J.-B. Say’s ( ) picture (Waterman ). Donald Winch’s ( )
T r a i t e R i c h e s a n d P o v e r t y is the latest
d ’ e c o n o m i e p o l i t i q u e ' , and most
Lauderdale and Maitland ( ) authoritative intellectual history of political econ-
I n q u i r y , dismissed by McCulloch ( , omy, covering the period 1750-1834. Nearly half his
p. 15) as without value; Chalmers’s ( ) strik book is concerned with Malthus. Ricardo, ‘treated
ingly original but completely neglected largely as a foil to Malthus’ (Winch , p. 15) gets a
N a t u r e a n d S t a b i l i t y o f few scattered references. Samuel Hollander’s ( )
N a t i o n a l R e s o u r c e s (see magisterial E c o n o m i c s o f
Waterman ); Malthus’s ( ) heretical pam T h o m a s R o b e r t M a l t h u s
phlet, ‘Restricting the Importation of Foreign Com’, shows that the analytical differences between
which led to his excommunication by the Malthus and Ricardo have been exaggerated, and
E d i n b u r g h R e v i e w (Fontana , p. that the former was a theoretician of the same order,
75); J. B. Sumner’s ( ) R e c o r d s o f and of at least as much historical importance as the
t h e C r e a t i o n latter.
that Ricardo ( -73, vol. 7, pp. 247-8) deemed Malthus was central because the first E s s a y
a ‘clever book’ and which McCulloch ( , began a century-long transformation of ‘political
p. 261 described as ‘an excellent work’; the fifth economy’ (the science of wealth) into ‘economics’
edition of Malthus’s Essay on Population ( ) (the science of scarcity). The theological
substantially modified as a result of Sumner’s implications of this, totally ignored by most his-
arguments; Mrs Marcet’s ( ) influential work torians, are a vital part of the intellectual context of
of popularization, C o n v e r s a t i o n s the English School. Economic thought of the 18th
o n P o l i t i c a l E c o n o m y ; and century was believed by all to be wholly compatible
Copleston’s ( , ) two bril with Christianity. But the seeming inevitability of
liant and penetrating L e t t e r s t o ‘misery’ or ‘vice’ produced by human fecundity and
P e e l that grasped more clearly than Malthus resource scarcity challenges the goodness of God;
himself the connection between population and and the political economy of Malthus and Ricardo
poverty, and between the latter and inflation of the was therefore condemned as ‘hostile to religion’.
currency - and which Ricardo so admired that he For most of the 19th century, England was both
made a detailed paragraph-by-paragraph summary officially and actually a Christian society. In such a
(Waterman , pp. 186-95; Hollander , p. 135—45). society it is part of the duty of a scientist - essential
Finally, shortly before or just after the first meeting if his work is to receive serious attention - to
of the Club there appeared important monographs reconcile his findings with Christian theology.
by three of the founding fathers: Malthus’s ( ) Malthus attempted this in 1798 and failed. His
P r i n c i p l e s , which quarrelled with failure stimulated an important branch of the
Ricardo literature of the English School now known as
over value theory and put forward a heterodox ‘Christian Political Economy’ (Waterman ).
macroeconomics of ‘general gluts’ that Keynes was Works by William Paley
later to find so appealing, James Mill’s ( ) ( ), by Malthus himself ( , ), and by
E l e m e n t s o f P o l i t i c a l J. B. Sumner ( ) who eventually became
E c o n o m y , and Archbishop of Canterbury, demonstrated that the
Torrens’s ( ) long undervalued E s s a y new science could be co-opted as theodicy; and
o n t h e even better, be used to demonstrate the benevolent
Production of Wealth. ‘design’ of the Creator. The approval that Ricardo
It is apparent that during the first two decades of and McCulloch evinced for Sumner’s ‘clever book’
the 19th century, and for a further ten years or had less to do with their own religious convictions
more, Malthus was at the centre of the political- than with their relief that political economy had
economy conversation of the English School. This been convincingly defended against the damaging
fact has been obscured by the excessive attention charge of irreligion.
 Quite different circumstances in the 1820s and Malthusian Whigs. Elections to the Political
revived the need to defend political economy Economy Club in the 1820s and 1830s included
against religion, and created a new need: to defend both Whigs and radicals and even the liberal Tory,
religion against political economy. Jeremy Ben- Lord Althorp. When McVey Napier edited the 1824
tham, James Mill and other Benthamites, who were S u p p l e m e n t t o t h e
later called the ‘Philosophic Radicals’, founded the E n c y c l o p a e d i a
W e s t m i n s t e r R e v i e w in 1824 to B r i t a n n i c a he commissioned articles on
propagate a ‘radical’ reformism as against the political economy from Malthus and Sumner on the
Whig- gish reformism of the E d i n b u r g h . one hand, and from Mill and McCulloch on the
Anticlerical and at times anti-religious, the radicals other. (Ricardo’s contribution, on the Funding
hijacked political economy to mount a strictly System, was posthumous.) The Royal Commission
utilitarian attack on the Establishment in Church on the Poor Laws (1832) which included Sumner,
and State. Animated by James Mill’s puritanical then Bishop of Chester, united all in the common
hatred of the Arts, the W e s t m i n s t e r cause once again. Malthus was the most important
compounded the injury by gratuitous attacks on the witness. The report, which led to the Poor Law
Lake Poets and other romantic authors. Influential Amendment Act (1834), was jointly written by the
Tories at the two universities (then exclusively Benthamite Chadwick and the Whatelian Senior,
Anglican) were alarmed, and opposition was made and was based on Copleston’s ( p. 28) crucial
to the teaching of, and the establishment of chairs distinction between ‘propagation’ and
in, political economy. In this crisis, both political ‘preservation’ of human life.
economy and Christian theology were authenticated One of the most interesting, certainly the most
and insulated against mutual encroachment by two revealing, contributions to literature of the English
Oxford men, Richard Whately, a former pupil and School is McCulloch’s compendious L i t -
friend of Copleston, and Nassau Senior, Whately’s e r a t u r e o f P o l i t i c a l
former pupil and friend (Waterman ,pp. 196-215). E c o n o m y ( ) which
Whately engineered the election of Senior as appeared about halfway through the life of the
first Drummond Professor of Political Economy in ‘school’. The usual English and Scotch authors
1826, and accepted the chair himself when it fell from Mun and Petty are listed, and many of their
vacant in 1830. His seminal Introductory Lectures ( works praised or censured in light of McCulloch’s
) argued for an epistemological demar doctrinal preconceptions. Malthus is predictably
cation between ‘religious and ‘scientific’ belittled. All the leading French authors of the 18th
knowledge; and explained how, like all scientific and early 19th centuries appear save Boisguilbert
knowledge, political economy depends upon both a and Cournot. Condillac’s pathbreaking L e
priori deduction and the possibility of falsification. C o m m e r c e e t l e
Whately thus established the methodological g o u v e r n e m e n t (1776) is dismissed
tradition of the English School that runs through with a patronizing comment of J.-B. Say
Senior, J.S. Mill, J.N. Keynes and Lionel Robbins. (McCulloch , p. 63; cf. Eltis and Eltis , pp. 30—4).
Pietro Corsi ( ) has shown that Considerable respect is paid to Italian authors
Whately’s philosophical apparatus was based on (McCulloch , pp. 28-31, 8 6 ), but the Spanish are
Dugald Stewart’s P h i l o s o p h y o f written off as intellectually impotent until
t h e H u m a n M i n d , transmitted to Napoleon’s invasion ( ,
Oxford through the friendship between Stewart and pp. 31-2, 326). McCulloch seems never to have
Copleston created by the migration from Edinburgh heard of Thiinen, and no other German author is
to Oxford in 1799 of J.W. Ward, 1st Earl of Dudley. mentioned. Omissions of anglophone authors are
Whately’s decisive intervention healed a equally telling. Whewell’s pioneering mathematical
potentially disastrous schism in the young ‘scien- economics is ignored, presumably for the same
tific community’ between Benthamite radicals reason as the omission of Cournot and Thiinen.
Dugald Stewart is cited merely as a biographer of
Adam Smith and Robertson ( , pp. 8 , 104,
162). McCulloch seems not have read or understood
(1818), nor to have grasped the analytical signif- textbook in many parts of the British Empire in the
icance of Malthus ( ). Everything is viewed early 20th century. Nicholson’s appears to be the
through the powerful but slightly distorting lenses last widely read work of political economy to
of Adam Smith and Ricardo. consider explicitly the relation between that science
Three years later there appeared the single most and Christian theology ( -1901, vol.
important production of the School: J.S. Mill’s 3, eh. 20).
P r i n c i p l e s o f P o l i t i c a l Stanley Jevons ( , p. 275) went out of his
E c o n o m y (1848), perceptively reviewed by way to challenge ‘the noxious influence of author-
Bagehot ( ) among many others. Mill’s ity’ in the English School, above that of Mill.
P r i n c i p l e s is Though elected to the Political Economy Club as a
the definitive statement of the English School of professor in 1873 and as an Ordinary Member in
political economy. It went through seven editions in 1882 (the year of his death), he was therefore
the author’s lifetime; the 1909 scholarly edition by handled with caution by his fellow- economists -
Ashley was based on the seventh ( ), and including the powerfully influential Marshall.
may be taken as the terminus ad quem of the Whilst crediting him with the intellectual defeat of
English School. For though Mill continued to be the Ricardian and Marxian value theory, Bonar
principal textbook in political economy until the (Palgrave , p. 735) thought that ‘the ideas of Jevons
1930s at many universities throughout the English- have had greater power since his death than during
speaking world, Anglophone economic literature of his life’. Jevons and his two most creative English
the 2 0 th century gradually became less insular followers, Edgeworth and Wicksteed, were ‘often
(Palgrave , p. 735) and was formed in the cautiously spoken of as a school by itself, the mathematical
new idiom of Marshall and Pigou, with at least school’ (Palgrave ). The original Palgrave article on
some peripheral awareness of Jevons and ‘Recent Developments of Political Economy’
Edgeworth, Walras and Pareto, Weiser and Bohm- (Palgrave , p. 148) alludes to Jevons’s S t a t e
Bawerk, Cassel and Wicksell, J.B. Clark and Fisher. i n R e l a t i o n t o L a b o u r (
Though Mill dominated, there were many other ) but ignores his T h e o i y o f
significant contributions to the literature in the last P o l i t i c a l
third of the 19th century. Henry Fawcett’s Economy ( ).
M a n u a l o f P o l i t i c a l Literature of the English School was augmented
E c o n o m y ( ) encapsu and popularized by T h e E c o n o m i s t
lated Mill’s P r i n c i p l e s for faint-hearted newspaper, founded in 1843 and edited by Walter
undergraduates; his wife’s even more elementary Bagehot from 1860 to 1877, which, like the Polit-
P o l i t i c a l E c o n o m y f o r ical Economy Club, sought to relate economic
B e g i n n e r s (1870) went through ten analysis to public policy in the spirit of Adam
editions over the next 41 years. W.T. Thornton’s Smith. That literature may be said to have culmi-
O n L a b o u r ( ) introduced nated in the three-volume D i c t i o n a r y
the concept of multiple equilibria, as Mill ( p. 637) o f P o l i t i c a l E c o n o m y (1894-
admitted. Caimes’s L e a d i n g 1899) edited by R.H. Inglis Palgrave.
P r i n c i p l e s first appeared in , Cliffe
Leslie’s E s s a y s in , Bagehot’s posthumous
E c o n o m i c S t u d i e s in , and Henry Some Analytical Features of the
Sidgwick’s P o l i t i c a l E c o n o m y English School
in . Sidgwick’s importance in the incipient
‘Cambridge’ mutation of the English School has Political economists of the English School inherited
lately been documented (Backhouse ). J.N Keynes’s much of their economic analysis from their 18th-
classic S c o p e a n d M e t h o d first century predecessors, especially Cantillon, Hume,
appeared in . Perhaps the last major production of Quesnay, Smith and Turgot. However, some
the English School was J. Shield Nicholson’s three- features of their analysis were as ‘novel’ as any idea
volume P r i n c i p l e s o f ever is in the social sciences.
P o l i t i c a l E c o n o m y ( -
And despite loose talk about a ‘marginal revolu- Cantillon-Hume price-specie- flow mechanism of
tion’, much of their analysis, both what they international monetary adjustment which follows
inherited and what they originated, has become part from that relation. Most accepted Smith’s account of
of the stock-in-trade of present-day economics. The natural prices that correspond, more or less, to
standard account by D.P. O’Brien ( ) Marshall’s long-period equilibrium prices, but
should be supplemented by S.J. Peart’s and D. O’Brien ( , ch. 4) has shown in detail how
Levy’s ( ) review of the period much variation there was in this matter. Perhaps the
1830-1870, which considers catallactics, method- most important 18th-century idea, certainly that
ological egalitarianism and the new ideological which gave the English School its ideological
alliance - a mutation of the old Whig-Liberal momentum, was Boisguilbert’s vision - derived
orthodoxy - between political economists and from the Jansenist theology of Pierre Nicole and
reformist Evangelicals in the Church of England. Jean Domat - of a self-regulating market economy
The central conception of 18th-century eco- driven by ‘self-love’ and producing some kind of
nomic thought was that of a surplus of production in social optimum at competitive equilibrium
one period over and above what is necessary (as (Faccarello ). This powerful conception was
inputs into production) to sustain that level of transmitted by Mandeville, Cantillon and Quesnay
production in the next. The agricultural sector is an and canonized by Smith in W e a l t h o f
obvious source of the surplus since land normally N a t i o n s .
produces more than the (food) cost of necessary As we have seen, the English School made at
labour and capital inputs. But Smith generalized the least one sharp analytical break with 18th-century
concept to include all produced goods capable of thought. The explicit incorporation of diminishing
use as inputs. Masters inciu production costs in returns (though as yet in agricultural production
advance, hence control the entire output at the end only) created a fundamentally different view of the
of the process. Some of this they consume either economic universe. Though all recognized
directly, or in the employment of unproductive increasing returns to scale (IRS) resulting from the
labour. The remainder is used to feed and equip division of labour, IRS plays a small or negligible
productive labour. This unconsumed portion of part in the implicit growth models of Malthus and
output is the (circulating) capital stock of a master, his successors (Eltis ). The salient feature of the new
firm or community, the growth, stationarity or growth theory was rather a tendency for the rate of
decay of which depends on a psychological profit to fall: either because of rising costs in
propensity of masters: the extent of their ‘frugality’ agriculture as in Malthus and Ricardo, or because of
or parsimony (Eltis , pp. 75-100). These ideas, and increasing capital intensity in manufactures as in
the necessarily dynamic analytical framework they Marx. In the former case, falling real factor
imply, were taken for granted by most the English payments retarded the growth of capital and labour,
School despite its seeming incompatibility with leading to a stationary state in the absence of
such other conceptions as comparative advantage in technical progress. Samuelson ( ) has
trade (Blaug , vol. shown that the variable factor in agriculture was
1, pp. 439-42). Other characteristically 18th- conceived as a single Tabor-cum-capital’ unit, and
century ideas accepted by ‘the followers of Dr though all ‘classical’ economists recognized the
Smith’ included that of a labour supply perfectly possibility of factor substitution especially in
elastic in the (Malthusian) long period at a socially manufacturing, the capital-labour ratio was gener-
determined zero-population-growth real wage; ally taken as a parameter. The same was true of
enough factor mobility to produce uniform rates of technique. Improvements were seen to occur from
wages and profit throughout the economy; a time to time, and their effect upon wages, profits
negative relation between the real wage and the rate and employment analysed. Malthus, and perhaps
of profit; a positive relation between the general some others, recognized that technical progress
price level and the stock of money, and the could become endogenous (Eltis ,
pp. 150 ff.) and few if any of the English School
regarded it, as some do today, as ‘manna from created perhaps the most significant analytical
Heaven’. Two other new, or somewhat new, ana- difference between political economists of the
lytical features of the English School deserve note. English School and the new professionalized
The first is the LTV theory of comparative advan- economists of the early 2 0 th century: an almost
tage, later improved by Mill’s analysis of reciprocal complete lack of interest among the latter in mac-
demand. The second is Say’s Law of Markets, roeconomics and growth theory. Not until Keynes’s
which in its strong form (Say’s identity) implies the rediscovery of Malthus (Kates ) and Harrod’s ( )
neutrality of money (Blaug , pp. 143-60). Whether critique of Keynesian ‘equi
Samuel Hollander (for example, , pp. 6-7) is correct librium’ did these return to the theoretical agenda.
in maintaining that Ricardo and his contemporaries As for Adam Smith’s IRS, quietly forgotten by
and successors, including Marx, recognized ‘a most of the English School - save Marshall - for
fundamentally important core of general- most of the time and ignored by their successors, its
equilibrium economics accounting for resource reintroduction by Sraffa ( ) and Young
allocation in terms of the rationing function of ( ) has remained a thorn in the flesh for gen
relative prices’ is still a matter of debate (Blaug , eral equilibrium theorists.
vol. 1, pp. 442-3).
It is evident that most of these analytical char-
acteristics, both those inherited from the 18th Revolution and Continuity
century and those that were new, have been trans-
mitted to present-day economic thought. The Present-day ‘economics’ looks quite different from
obvious exception is the concept of a surplus with ‘political economy’ of the English School. Yet
its concomitant distinction between ‘productive’ despite Samuelson’s remarks about Marshall in
and ‘unproductive’ labour; though in the spirit of F o u n d a t i o n s ( , pp. 6 , 142, 311-12)
Feyerabend’s ( ) methodological and
anarchism this venerable doctrine has lately been despite his focus on Walrasian general equilibrium
brought back to useful life (Bacon and Eltis ). For in that work, the microeconomic part of his
the most part however, present-day economists immensely influential E c o n o m i c s ( ) is
prefer to rely on a putatively constant- retums-to- unmistakeably Marshallian, at any rate as mediated
scale (CRS) general equilibrium model that by Chamberlin ( ) and Joan Robinson
abstracts from time, and in which each factor-owner ( ). And though Marshall had digested
is paid the value of his factor’s marginal product. Thiinen and Cournot, knew the work of Menger and
The surplus is therefore regarded as a museum the Austrian School, and admitted that ‘there are
piece and left to heterodox Marxists and Sraffians few writers of modem times who have approached
(Walsh and Gram ; cf. Blaug , vol. 1, pp. 440-2). It as near to the brilliant originality of Ricardo as
is important to recognize, however, that the Jevons has done’ (Marshall p. 673), yet he
eventual disappearance of the surplus in a ‘consistently discounted the “Jevonian revolution’”
neoclassical theory of distribution was brought (Schumpeter p. 826) and used all his influence,
about by an ever wider application of the marginal which was great, to insist that in science, as in the
analysis originally applied by Steuart, Turgot, and world it contemplates, N a t u r a n o n
Anderson, and then by Malthus, Ricardo and their f a c i t s a l t u m . There are few
contemporaries to agricultural production costs references to Jevons in his famous
alone (Blaug , vol. 1, p. 441). Authors of the next P r i n c i p l e s , and in the most extended
generation such as Longfield and Lloyd began the of these (Appendix I) Marshall went out of his way
analysis of marginal utility (O’Brien , pp. 119-22). to counter the former’s ‘antagonism to Ricardo and
Replacement of the dynamic surplus Mill’ and to defend their value theory against his
macroeconomics by a static general-equilibrium intemperate exaggerations’ (Marshall , pp. 673-6;
microeconomics dependent on universal CRS see also O’Brien , vol. 2, pp. 325-61).
Upon the evidence of Palgrave’s original dictionary
it appears that by the last decade of the
19th century the effect of Marshall’s efforts had For that author at any rate, nothing had changed
been to co-opt Jevons and his ‘marginalist’ fol- since Malthus.
lowers into the mainstream of English political In summary, it would appear that the English
economy with a minimum of fuss, and with a School was alive and well in the first decade of the
minimum of attention to the continental 20th century. Elections to the Political Economy
marginalists. Jevons’s ‘final utility’ became ‘mar- Club included Pigou (in 1906) and J.M. Keynes
ginal utility’ in Marshall’s P r i n c i p l e s (1912), along with the Bishop of Stepney (1904),
( pp. 78-85), and there was used with deceptive the Rt Hon. Herbert Samuel MP, the Viscount
innocence (see Blaug , p. 322—37) to generate a Ridley (1907) and John Buchan (1909). Mill’s
market demand function of price. Though P r i n c i p l e s was still perhaps the most
Edgeworth himself contributed 17 articles to the widely used textbook. Questions on Adam Smith
dictionary, including ‘Cournot’, ‘Curves’ and still appeared in university examinations in political
‘Demand Curve’ in volume 1, ‘Mathematical economy (for example, at Edinburgh, 21 November
Methods’ in volume 2 and ‘Pareto’, ‘Pareto’s Law’, 1898, 17 March 1899). Mathematics was still an
‘Supply Curve’ and ‘Utility’ in volume 3, his own unwelcome eccentricity. Jevons ( , p. vii)
work was ignored in the general surveys of had asserted that economics ‘must be a mathemat-
‘Political Economy’ and ‘The English School’ and ical science in matter if not in language’. Marshall
his name omitted from the index of volume 1, along (for example, , p. ix) threw all his influence against
with those of Menger and J.B. Clark. Walras this doctrine and locked up his own sophisticated
received three short references in that volume. Not mathematics in well-guarded appendices (Keynes ,
until volume 3 (1899, pp. 652-5) was his work pp. 182-8). Despite his dependence upon
recognized, and then only for its use of marginal mathematical reasoning and his prominence in the
utility. There is no awareness of general equilibrium emerging profession of economics, Edgeworth’s
in that article, and the term appears nowhere else in deference for Marshall deterred him from
the original D i c t i o n a r y . challenging a Cambridge, anti- mathematical
It would appear from the foregoing that if there orthodoxy that persisted until the 1950s.
really was any such thing as a marginal revolution Edgeworth was unusual, too, in his ability and
in Anglophone political economy, it began as early willingness to read foreign authors and to recognize
as 1767 with Steuart’s P o l i t i c a l their contributions (Keynes ,
( E c o n o m y and still had some way to go pp. 263-5). In general, the insularity of the English
by the time volume 3 of the Palgrave dictionary School persisted until well into the 20th century.
appeared in 1899. Thiinen’s ( ) When Harrod was about to begin his studies in
generalization of economics, Keynes advised him not to waste his
diminishing returns to all factors of production time on the Continent ‘where they knew nothing at
remained unnoticed by any save Marshall. Though all of economics’ (Harrod , pp. 317-19). The
Wicksteed ( ) and Flux ( ) ‘market socialists’ of the 1930s, none of whom was
reinvented this wheel, Wicksteed’s (Palgrave , pp. English, were the first to specify the complete set of
140-2) own contribution to the Palgrave article on marginal conditions required for a welfare optimum
‘Political Economy’ only hints at what later became in general competitive equilibrium. J.R. Hicks (
known as the neoclassical theory of distribution. In , p. 6 )
1895 Edgeworth rejected Barone’s submission to believed himself to be the first English author to
the E c o n o m i c J o u r n a l showing ‘free the Lausanne School from the reproach of
that product exhaustion is implied by Walras’s ( ) sterility brought against it by the Marshallians’.
cost-minimization equations. A companion article It might have been expected that political econ-
to Wicksteed’s baldly states that ‘the law of omists in the United States, at any rate, would have
DIMINISHING RETURNS points to an increase in identified with the English School. In the early 19th
the cost of agricultural produce accompanying century authors such as Wayland
increase of population’ (Palgrave , p. 140).
( ) had assimilated Malthus and Ricardo, and Copleston, E. 1819a. A letter to the Right Hon. Robert Peel,
as late as 1888 Amasa Walker regarded Jevons and MP for the University of Oxford, on the pernicious effect
of a variable standard of value, especially as it regards
Marshall as ‘an extension of the English School’ the condition of the lower orders and the poor laws ....
(Goodwin , p. 562). But throughout much of the Oxford: Murray.
century protectionist sentiment in the USA was at Copleston, E. 1819b. A second letter to the Right Hon.
variance with the ideology of free trade promoted Robert Peel, MP for the University of Oxford, on the
causes of the increase in pauperism, and on the poor
by the English School. And towards the end of that laws .... Oxford: Murray.
century there was ‘an estrangement from British Corsi, P. 1987. The heritage of Dugald Stewart: Oxford
scholarly life’ created by a ‘growing attachment to philosophy and the method of political economy.
German thought’ (Goodwin , p. 563). The Nuncius 2: 89-143.
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rapid by the last quarter of the century. The
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293-334. Keywords
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Individual liberty; Innovation; Invisible hand;
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Boston: Gould and Lincoln. deville, B.; Melon, J.-F.; Millar, J.; Natural
jurisprudence; Physiocracy; Political economy;
Private property; Protectionism;
 Pufendorf, S.; Quesnay, F.; Reid, T.; Robertson, conditions and consequences was as urgent, for
W.; Rule of law; Scottish Enlightenment; instance, in the distant Kingdom of Naples as in
Shaftesbury, Lord; Smith, A.; Specialization; Scotland; and political economy was equally
Stages theory of development; Steuart, Sir J.; absorbing to the Neapolitan philosophers Antonio
Stewart, D.; Subsistence; T a b l e a u Genovesi and Ferdinando Galiani.
e c o n o m i q u e At the same time, the experience of Scotland in
the 18th century was distinctive in a number of
JEL Classifications respects, which offered a particular stimulus to
B1 Scottish thinkers. First of all, there was the actual
achievement of economic growth. The late 17th-
Between 1740 and 1790 Scotland provided one of century Scottish economy supported an uneasy
the most distinguished branches of the European balance between population and food supply; bad
Enlightenment. David Hume and Adam Smith were harvests, which occurred in a sequence in the
the pre-eminent figures in this burst of intellectual 1690s, could cause severe shortages and even
activity; and around them clustered a galaxy of localized famine. Overseas trade was likewise
major thinkers, including Francis Hutcheson, Lord vulnerable. Nevertheless the elites, both landed and
Karnes, Adam Ferguson, William Robertson, urban, were committed to economic development,
Thomas Reid, Sir James Steuart and John Millar. and showed a marked propensity to invest.
The interests of individual thinkers ranged from Agriculture gradually became commercialized, and
metaphysics to the natural sciences; but the landowners joined merchants to invest in
distinctive achievements of the Scottish manufactures, and, most spectacularly, in the
Enlightenment as a whole lay in those fields ‘Darien venture’, intended to establish a Scottish
associated with the enquiry into ‘the progress of trading colony in Panama. The failure of the latter
society’ - history, moral and political philosophy persuaded many of the elite that economic
and, not least, political economy. development could only come through closer union
‘Enlightenment’ and ‘Scottish Enlightenment’ with England. In the event, the economic fruits of
were usages unknown in the 18th century: the term the Union were disappointingly slow in coming; but
‘Scottish Enlightenment’ was first coined in the by the third quarter of the 18th century it was clear
early 2 0 th century, and began to be generally used to contemporaries that agriculture, trade and
by historians in the 1960s. ( L u m i e r e s and manufactures were all on an upward curve. The
A u j k l a n m g were in 18th-century use, but thinkers of the Scottish Enlightenment thus enjoyed
not to denote a European Enlightenment as a an unusually direct acquaintance with the
whole.) As a historian’s construction, however, the phenomena of economic development.
term ‘Scottish Enlightenment’ is supported by the Scotland’s political position was also unusual.
consciousness of those named above that they Many of Europe’s monarchies sought to bring their
shared common intellectual interests (which did not constituent kingdoms into closer union over the
preclude disagreement between them) and a 18th century, for economic as well as administrative
common standing as men of letters in 18th-century reasons. But none did so as successfully as the
Scottish society. This awareness of belonging to a British monarchy. The Union of 1707 with England
broad intellectual movement extended to the was in no simple or direct sense the cause of
continent of Europe: led by Hume, the Scottish Scotland’s economic growth (or of its Enlight-
thinkers cultivated connections with Paris, the enment). But it secured a common framework of
Enlightenment’s acknowledged metropolitan centre. law and a common market, and it also established
But the Scottish Enlightenment is perhaps best that the Scottish Presbyterian and the English
understood when it is compared with the Anglican Churches should coexist in peace. These
Enlightenment in Italy or in Germany. The concern gains were important to the great majority of the
with economic improvement and its moral and Scottish elites, and it was never in their
political
interest to back the Jacobite challenge to the Han- Mandeville to offer in his T r e a t i s e o f
overian monarchy. H u m a n N a t u r e (1739—40) and his
Culturally and intellectually, the position of two later E n q u i r i e s (1748; 1751) an
Scotland looked impropitious before 1700. There account of justice and morals which had no need of
were pockets of interest in the new science, Newton divine support. Most of those now associated with
having a group of Scottish adherents; but the latest the Scottish Enlightenment found Hutcheson’s
developments in French philosophy were shunned philosophy more congenial; but it was Hume’s
for their Epicurean, materialist and sceptical challenge which galvanized them. It was Hume,
tendencies. After the Revolution of 1688, however, moreover, who turned their attention back to
change gradually got under way in the institutions economic matters. Recognizing that philosophy
most important for intellectual life, making possible alone would never make the Scots into virtuous
the infiltration of new ideas. The fierce, atheists, Hume decided instead to educate them in
covenanting Presbyterianism of the 17th century political economy, the subject of the leading essays
was dissipated, as the ‘Moderate’ group of clergy in his P o l i t i c a l D i s c o u r s e s
rose to power in the Kirk. The universities of of 1752.
Edinburgh, Glasgow, Aberdeen and St Andrews For Hume as for all the Scottish thinkers, polit-
were reformed, allowing professorial specialization; ical economy was not a science apart. It belonged
and around the universities there developed a within a wider enquiry into the ‘progress of society’.
vigorous informal culture of voluntary clubs, most There were three principal dimensions to this
famous of which was the Select Society of enquiry: the historical, the moral and the political.
Edinburgh, founded by David Hume and his friends The historical theory of the Scottish Enlighten-
in 1754. Together these changes secured for ment developed a line of argument from later 17th-
Scottish thinkers unprecedented intellectual century natural jurisprudence, a tradition made
freedom and social support; and they provided an familiar to the Scots by its incorporation in the
object lesson in the importance of the moral and moral philosophy curriculum of the reformed
cultural as well as the material dimensions of universities. Discarding the older jurisprudential
progress. thesis of the contractual foundations of society and
The intellectual interests which distinguished the government, the Scots focused on the new insights
Scottish Enlightenment had two more specific of Pufendorf and Locke into the origin and
sources. One was the explicit preoccupation with development of property. According to Pufendorf,
the conditions and means of economic development there had never been an original state of common
which was fostered by the debate which preceded ownership of land and goods; from the first,
the Union of 1707. The preoccupation was by no property was the result of individual appropriation.
means unique to the Scots, but the contributions of As increasing numbers made goods scarce,
John Law (the future author of the French individual property became the norm, and systems
Mississippi Scheme) and others ensured a high of justice and government were established to
quality of discussion. The other, two decades later, secure it. What the Scots added to this argument was
was the initiative taken by two very different a scheme of specific stages of social development,
philosophers, Francis Hutcheson and David Hume, the hunting, the pastoral, the agricultural and the
to transform the agenda by which philosophy was commercial. At each of the four stages the extent of
taught and discussed in Scotland. Drawing on the property ownership was related to the society’s
moral philosophy of Shaftesbury and the natural means of subsistence, and these shaped the nature
jurisprudence of Pufendorf, Hutcheson taught his and sophistication of the society’s government. Dif-
Glasgow students, who included Adam Smith, a ferent versions of the theory were offered by Adam
moderate, benevolent, providential Stoicism. More Ferguson in his E s s a y o n t h e
disturbingly, Hume drew on the scepticism of Pierre H i s t o r y o f C i v i l S o c i e t y
Bayle and the Epicurean morals of Bernard (1767) and by John Millar in his O r i g i n o f
t h e D i s t i n c t i o n o f R a n k s
(1770), and it underlay both Lord Karnes’s
legal history and William Robertson's historical that the distribution of goods was a matter for
narratives. The locus classicus of the theory, how- justice, and the classical or civic humanist view that
ever, was Adam Smith's Lectures on Jurisprudence, luxury led to corruption and the loss of moral virtue.
delivered to his smdents in Glasgow in the early The Scots answered the first more confidently (but
1760s. perhaps less satisfactorily) than the second.
As Smith's exposition makes particularly clear, Following Grotius, Hobbes and Pufendorf, they
the stages theory of social development provided defined justice in exclusively corrective terns,
the historical premises for political economy. An setting aside questions of distribution. On the issue
explicitly conjectural theory - a model of society’s of corruption, they were divided. Hume, who
‘natural’ progress - it provided a framework for a ridiculed fears of luxury, was the most confident;
comparably theoretical treatment of economic Ferguson, who defiantly reasserted the ancient ideal
development as 'the natural progress of opulence'. of virtue, was the most pessimistic. Smith was
By positing the systematic interrelation of economic closer to Hume in preferring propriety to virtue, at
activity', property and government, with least for the great majority; but he showed that he
consequences which could be neither foreseen nor shared Ferguson’s doubts when he added, at the end
controlled by individuals, the theory also underlined of his life, that the disposition to admire the rich and
the limits of effective government action. 'Reason of the great did tend to corrupt moral sentiments. At a
state', the standby ofrulers and their advisers for fundamental level, however, there was general
over two centuries, still had the capacity to distort agreement. As a consequence of the progress of
and obstruct the economic activity of subjects and society, the multiplication of needs was not only
those with whom they would trade; but the Scots' irreversible; it was the essential characteristic of a
historical perspective showed it to be a doctrine ‘cultivated’ or 'civilized' as distinct from a
inadequate to the complexity of a modem ‘barbarian’ society. And civilization, however
commercial economy. morally ambiguous, was preferable to barbarism.
The moral thought of the Scottish Enlighten- With consensus on this, the moral premises of
ment was closely related to the historical, sharing a political economy were secure.
common origin in 17th-century natural jurispru- The definition of justice in simple corrective
dence. Here the inspiration was the jurisprudential terms provided the starting-point for the political
thinkers’ increasingly sophisticated treatment of dimension of the Scottish enquiry. The priority of
needs. These, it was recognized, could no longer be any government, the Scots believed, must be the
thought of primarily in relation to subsistence; with security of life and property, ensuring every indi-
the progress of society, needs must be understood to vidual liberty under the law. This, as Smith put it,
cover a much wider range of scarce goods, luxuries was freedom ‘in our present sense of the word’; and
as well as necessities. The potential of this insight there was a general confidence that it was tolerably
was seen by every Scottish moral philosopher, but secure under the governments ofmodem Europe,
again it was Smith who exploited it to the full, in including the absolute monarchies. In principle,
the T h e o r y ’ o f M o r a l individual liberty was a condition of a fully
S e n t i m e n t s (1756). Beyond the most commercial society: its provision, therefore, was the
basic necessities, Smith acknowledged, men’s needs institutional premise ofpolitical economy.
were always relative, a matter of status and Few of the Scots took their analysis beyond this
emulation, of bettering one’s individual condition. relatively simple, if vital, point; the theory of the
But it was precisely the vain desires of the rich and modem commercial state was not a Scottish
the envy of others which served, by ‘an invisible achievement. Both Hume and Smith were more
hand’, to stimulate men’s industry and hence to concerned to limit the opportunities for enlarging
increase the stock of goods available for all ranks. government at the expense of‘productive’ society,
Such an argument, however, had to overcome by confining the former to the minimum necessary
two of the most deeply entrenched convictions of provision of justice, defence and public works.
European moral thought: the Aristotelian view
But they also recognized that the proliferation of poorer ones, whether by flexible specialization and
interests in a commercial society would require product innovation (Hume) or by constantly
more sophisticated institutional mechanisms to increasing industrial productivity through the
ensure their adequate representation within the division of labotn (Smith). What distinguished
political system. Smith’s analysis in Book IV of the commercial superiority from military conquest was
W e a l t h o f N a t i o n s of the that it was achieved ‘without malice’; poor
growing alienation of the colonial elites in North countries would also develop if they followed the
America from parliamentary authority was an object same route, even if they might never catch up on the
lesson in the need for such representation - and a rich.
strong hint that it was incompatible with Brilliant as Hume’s economic essays were, it
maintaining an extended empire. was Adam Smith’s W e a l t h o f
A large part of the originality of the Scottish N a t i o n s (1776) which set the standard of
Enlightenment’s conception of political economy Enlightenment political economy. To be systematic
lay in this exploration of the historical, moral and and comprehensive had earlier been the ambition, at
institutional framework of economic activity. But of least, of Quesnay’s T a b l e a u
course the Scots also engaged directly in economic E c o n o m i q u e (1758-9), Genovesi’s
analysis; and one such work of analysis, Adam L e z i o n i d i C o m m e r c i o
Smith’s W e a l t h o f N a t i o n s (1765) and Steuart’s P r i n c i p l e s ; but
(1776), would so outshine all others that it came to the W e a l t h o f N a t i o n s eclipsed
be regarded as having established political economy them all. Its success, moreover, was such as to
as a science in its own right. suggest that political economy had an identity all of
The Scots’ attention focused on growth in a its own. Smith himself did not admit such an
context of international rivalry. In contemporary implication, continuing to insist that political
terms, Hont has shown, the issue was the means by economy was but ‘a branch of the science of a
which poor countries (of which Scotland might be statesman or legislator’: his own engagement with
regarded as one) could best hope to catch up on rich both jurisprudence and moral philosophy left him
countries (such as England certainly was). What is disinclined to drop the wider intellectual framework
striking is the hard- headedness with which Hume in which political economy had been conceived. But
and Smith tackled the issue. Responding to French a work at once as extensive and as self-contained as
economists - Hume to Jcan-Frangois Melon, Smith the W e a l t h o f N a t i o n s made it at
to the Physiocrats - who argued that agriculturally least plausible to suppose that what it presented was
endowed countries should follow a different path a distinct, autonomous science of political economy.
from purely commercial nations, the Scots insisted Smith’s death in 1790 coincided with the end of
that one analysis applied to all. Protection for the Scottish Enlightenment. In Scotland as
agricultural economies and their manufactures, a throughout Europe, the French Revolution trans-
policy supported by the former Jacobite exile Sir formed the conditions and assumptions of intel-
James Steuart in his P r i n c i p l e s o f lectual life, while political economy had to come to
P o l i t i c a l E c o n o m y (1767), was terms with the increasingly obvious impact of
futile and damaging. But theirs was no naive machinery. Within Scotland Dugald Stewart set
optimism in the equalizing powers of commerce. himself to adapt the Enlightenment conception of
The ideal of d o u x c o m m e r c e , by political economy to these new circumstances; but
which trade would be the agent of global peace and while he had French admirers, his expansive,
prosperity, was as much of a panacea as the belief didactic approach had few followers in Britain.
that commercial success would be selfcancelling, Another Scot, Thomas Chalmers, took the lead
because the advantage of low labour costs would alongside Malthus in attaching political economy to
always pass on to others. Instead, Hume and Smith newly urgent theological concerns, while Ricardo
suggested that rich countries could expect to and his followers simply took a narrower view of
maintain their advantage over the subject. Even so, it would be a mistake to see
19th-century classical political economy as
a new departure. As the philosophical analysis of
Hegel (who learnt much from Steuart) and the Enterprise Zones
radical critiques of Marx and the early socialists
pointed out, the historical, moral and institutional Leslie E. Papke
premises on which political economy rested were
still those elucidated by the Scots.

Abstract

See Also Enterprise zones are geographically targeted

economic development incentives used in the
► lume, David (1711-1776) United States by individual states since the early
► lutchesc 594-1746) 1980s and the federal government since 1993.
► Mandevi : . iai\l 1670-1733) Research on state zone programmes that
► Pufendoi Samuel /on (1632- 61 ) accounts for the endogeneity of zone designa-
► imith, Adam (1723-1790) tion finds little improvement in the employment
► .teuart, Sii '.'ernes ( 713-1780) and incomes of zone residents, but some
► itewart, Dugald (1753-1828) evidence that firms respond to tax incentives for
capital. In contrast, the federal empowerment
Bibliography zone programme combines tax incentives with
local initiatives and access to large federal
Berry, C. J. 1997. Social theory’ and the Scottish Enlighten- grants. Recent research on round one of the
ment. Edinburgh: Edinburgh University Press. federal programme finds mixed evidence on
Broadie, A. (ed.). 2003. The Cambridge companion to the zone resident employment.
Scottish Enlightenment. Cambridge: Cambridge
University Press.
Devine, T.M. 1994. The transformation of rural Scotland: Social Keywords
change and the agrarian economy 1660-1815. Edinburgh:
Enterprise Zones; Investment Subsidies; Labour
Edinburgh University Press.
Hont, I. 2005. Jealousy of trade: International competition and the Subsidies; Tax Competition; Tax Credits; Tax
nation-state in historical perspective. Cambridge, MA: Incentives
Harvard University Press.
Hont, I., and M. Ignatieff (eds.). 1983. Wealth and virtue: The
shaping of political economy in the Scottish Enlightenment.
Cambridge: Cambridge University Press. JEL Classifications
Phillipson, N.T. 1981. The Scottish Enlightenment. In The H3
Enlightenment in national context, ed. R. Porter and M. Teich.
Cambridge: Cambridge University Press. Enterprise zone programmes are geographically
Robertson, J.C. 2005. The case for the Enlightenment. Scotland targeted tax, expenditure, and regulatory induce-
and Naples 1680-1760. Cambridge: Cambridge University
Press. ments used by US state and local governments
Sakamoto, T., and H. Tanaka (eds.). 2003. The rise of political since the early 1980s and by the federal government
economy in the Scottish Enlightenment. London: Routledge. since 1993. While they differ in their specifics, all
Sher, R.B. 1985. Church and university in the Scottish the programmes provide development incentives,
Enlightenment. Princeton/Edinburgh: Princeton University
Press; Edinburgh: Edinburgh University Press. including tax preferences to capital and/or labour,
Sher, R.B. 2006. The Enlightenment and the book. Scottish authors in an attempt to induce private investment location
and their publishers in eighteenth-century Britain, Ireland and or expansion to depressed areas and to enhance
America. Chicago/London: Chicago University Press. employment opportunities for zone residents. Most
Winch, D. 1996. Riches and poverty: An intellectual history of
political economy in Britain 1750-1834. Cambridge:
enterprise zones are designated in urban areas, but
Cambridge University Press. there are some rural zones. Typically, state and
local zone programmes provide larger tax credits
for business investment than for employment
incentives. Investment
incentives include the exemption of business- economic characteristics that led to the initial zone
related purchases from state sales and use taxes, designation. If zone sites are better randomly
investment tax credits and corporate income or selected, the effect of the programme can be mea-
unemployment tax rebates. Labour subsidies sured by comparing the performance of the exper-
include employer tax credits for all new hires or imental and control groups. But zone designation in
zone-resident new hires, employee income tax the 43 state and local programmes in the United
credits and job-training tax credits. Some pro- States depends on comparative unemployment rates,
grammes assist firms financially with investment population levels and trends, poverty status, median
funds or industrial development bonds. incomes, and percentage of welfare recipients, so
Enterprise zones have been criticized as inef- the data are non-experimental. This sample
fective and inefficient in stimulating new economic selection problem can be addressed with a variety of
activity. This criticism is part of a longstanding econometric techniques.
debate on the effects of intersite tax differentials on Econometric analysis of a zone’s success faces a
the location of capital investment. It is argued that if practical difficulty in that conventional economic
tax-induced investment represents only relocation data are not available by zone. In most states, zones
from another state, then tax competition is a zero- do not coincide with census tracts or taxing
sum game for the country as a whole. In addition, jurisdictions. As a result, zone areas cannot be
the preferential treatment of certain types of pinpointed in standard data collections. Zip code
investment or employment within enterprise zones level data is available from the Census, but outcome
may induce decisions that would not be measures are ten years apart.
economically sound in the absence of the tax Econometric evaluations of the Indiana and
incentives. Often, however, redistribution of New Jersey programmes find mixed effects on
economic activity within a state may be a desirable investment and employment. Indiana zones are
goal. If investment is relocated from local labour estimated to have greater inventory growth and
markets with low unemployment to local labour fewer unemployment claims than they would have
markets with higher unemployment, the incentives in the absence of the zone designation (from 1983
may generate efficiency gains for the economy as to 2006, an inventory tax credit was the most
underutilized resources are tapped (Bartik ). lucrative incentive). However, in the 1980s,
Efficiency gains may also result if reductions in inventory investment came at the cost of a drop in
unemployment produce positive externalities, such the value of depreciable property (Papke ).
as reductions in social unrest. Moreover, despite the reduction in unemployment
A partial equilibrium model predicts that a rates in the zones, a comparison of incomes from
labour subsidy or an equal-cost subsidy to both zone the 1980 and 1990 Censuses suggests that zone
capital and zone resident labour will raise zone residents are not appreciably better off after the first
wages. A capital subsidy alone may actually reduce decade of the Indiana zone programme (Papke ) and
zone wages - yet many of the subsidies are for there is no discemable increase in capital
capital investment in the zone (Gravelle ; Papke ). investment or land values (Papke ). Similar
Empirical evaluations of zone programmes econometric analysis of the New Jersey enterprise
typically measure the amount of investment zone programme finds no positive effects on either
undertaken after the designation, for example, or the business investment or employment (Boamet and
increase in the number of firms in the zone, and the Bogart ). Multistate econometric analyses that
change in zone employment. Two key combine data from many states - thereby assuming
methodological issues in empirical evaluations are zone programmes have similar effects in every state
( a ) to separate the effects of zone designation - typically find no positive zone effects on business
from jobs and investments arising from other activity or employment (Bondonio 2003; Bondonio
factors - for example, general upswings in the and Engberg ). Peters and Fisher ( ) survey
economy; ( b ) to account for the depressed state evaluations.
 Cost-per-job estimates from zone programmes ) reports that Round I and II EZs and ECs are
are rare. The literature also lacks a discussion of the continuing to access their grant funds and Internal
distribution of the cost of the zone programme Revenue Service (IRS) data show that businesses
between state and local governments. For example, are claiming some tax benefits (Brashares ).
local governments may bear the brunt of the cost of However, the IRS does not collect data on other tax
a state enterprise zone programme if tax incentives benefits and cannot always identify the
are provided against local taxes without state communities in which they were used. The lack of
reimbursement. tax benefit data limits evaluation of the
Congress established the Empowerment Zone programmes.
and Enterprise Community (EZ/EC) programme in Evaluation of the federal programme is also
1993 and the Renewal Community (RC) confounded by its hybrid structure. The federal
programme in 2000 to provide assistance to the EZ/EC programme is based on the idea that effec-
nation’s distressed communities. By 2007, there had tive community revitalization results when the
been three rounds of EZs, two rounds of ECs, and strategy is tailored to the local site. The diverse
one round of RCs leading to a total of 40 nature of the Round I EZ/ECs - each may differ in
empowerment zones (30 urban and 10 rural), 95 terms of objective, size of targeted area, type of
enterprise communities (65 urban, 30 rural) and 40 designation, governance structure, projects used,
renewal communities. grant money, and strategies for implementation -
Empowerment zone incentives include a 20 per has made it difficult to generate general conclusions
cent employer wage credit for the first about even the early stages of Round I
15,1 dollars of wages for zone residents who implementation (GAO , ). Fur
work in the zone, additional expensing of equip- ther, the tax incentives changed over the three
ment investments of qualified zone businesses, and rounds of the federal programme. Third, no easy
expanded tax exempt financing for certain zone method of data collection was included in the tax
facilities. Each zone is eligible for 100 million forms so even usage is hard to measure.
dollars in Social Services Block Grant fluids. Using Census data, Hanson ( ) finds no
Selected areas needed to demonstrate pervasive effect of the first round zone programme on local
poverty, unemployment and general distress, and employment or poverty rates in the targeted areas,
applicants had to outline a plan of action that but instead finds capitalization into property values.
included local business and community interests. Busso and Kline ( ) find modest
The residence- based approach of the income tax improvements in labour market conditions, but
credit differs significantly from another federal sizable increases in owner-occupied housing values
programme designed to increase employment of the and rents along with small changes in the
disadvantaged. The Targeted Jobs Tax Credit demographic composition of neighbourhoods.
provides firms with a similar-sized subsidy for Taken together, these two papers suggest that
wages paid to targeted individuals - primarily improvements for residents have been limited at
welfare recipients and poor youth. Providing a best, but that property owners have benefited from
subsidy based on individual characteristics may the federal programme.
create a stigma that actually reduces the probability
of being hired. Residence-based eligibility may
eliminate this problem and encourage individuals See Also
who become employed to continue to live in the
zone.
Features of the programmes have changed over
time. Round I and II EZs and ECs received different
combinations of grant funding and tax benefits. By
round III, EZs and the RCs received mainly tax ►

benefits. The GAO ( , , ►

►
Bibliography
Entitlements
Bartik, T.J. 1991. Who benefits from state and local economic
development policies? Kalamazoo: W.E. Upjohn Institute Hillel Steiner
for Employment Research.
Boamet, M.G., and W.T. Bogart. 1996. Enterprise zones and
employment: Evidence from New Jersey. Journal of
Urban Economics AO: 198-215.
Bondonio, D., and J. Engberg. 2000. Enterprise zones and In the strong sense, an entitlement is something
local employment: Evidence from the states’ programs.
Regional Science and Urban Economics 30: 519-549.
owed by one set of persons to another. The thing
Brashares, E. 2000. Empowerment zone tax incentive use: owed is either a performance of a certain kind, such
What the 1996 data indicate. Statistics of Income as a dental extraction, or a forbearance from
Bulletin. interfering from some aspect of the title-holder’s
Busso, M., and P. Kline. 2006. Do local economic devel-
activity or enjoyment, such as not trespassing on
opment programs work? Evidence from the federal
empowerment zone program. Mimeo: University of someone’s land. Strong entitlements imply the
Michigan. presence of a right in the person entitled and a
Engberg, J., and R. Greenbaum. 1999. State enterprise zones corresponding or c o r r e l a t i v e obligation
and local housing markets. Journal of Housing Research
in the person owing the performance or forbearance.
10: 163-187.
GAO (General Accounting Office). 1991. Businesses' use of Typically, the person entitled is further vested with
empowerment zone incentives. RCED-99- 253. US ancillary powers to waive the obligation or, alter-
Government Accounting Office: Washington, DC. natively, to initiate proceedings for its enforcement.
GAO. 2004. Community development: Federal revitalization
A secondary (and contested) instance of a strong
programs are being implemented, but data on the use of
tax programs are limited. RCED 04-306. Washington, entitlement arises with respect to the position of a
DC: US Government Accounting Office. third-party beneficiary of a right- obligation relation
GAO. 2006. Empowerment zone and enterprise community between two other parties, such as the beneficiary
program: Improvements occurred in communities but the
of an insurance policy. Third parties usually lack
effect of the program is unclear. RCED- 06-727.
Washington, DC: US Government Accounting Office. powers of waiver and enforcement, for it is not
Gravelle, J.G. 1992. Enterprise zones: The design of tax strictly to them that fiilfilment of the obligation is
incentives, CRS Report for Congress 92-476 S. owed.
Washington, DC: Congressional Research Service, A weaker form of entitlement may be said to
Library of Congress.
Hanson, A. 2007. Poverty reduction and local employment pertain to those of a person’s activities which, while
effects of geographically targeted tax incentives: An not specifically protected by obligations in others
instrumental variables approach. Mimeo: Syracuse not to interfere, are nevertheless indirectly and
University. extensively protected by their other forbearance
HUD (U.S. Department of Housing and Urban Development).
1992. State enterprise zone update: Summaries ofthe obligations. Thus, while persons may be under no
state enterprise zone programs. Washington, DC: U.S. obligation specifically to allow someone to use a
Department of Housing and Urban Development. pay telephone, they probably do have forbearance
Papke, L.E. 1993. What do we know about enterprise zones? obligations with respect to assault, theft, property
In Tax policy and the economy, ed. J.M. Poterba, vol. 7.
Cambridge, MA: MIT Press.
damage, etc., the joint effect of which is to afford
Papke, L.E. 1994. Tax policy and urban development: some high (but incomplete) degree of protection to
Evidence from the Indiana enterprise zone program. someone using a pay telephone. However, such an
Journal of Public Economics 54: 37-49. entitlement amounts to less than the full protection
Papke, L.E. 2001. The Indiana enterprise zone revisited:
Effects on capital investment and land values. National
afforded by a right inasmuch as it does not, for
Tax Association Proceedings of the Ninety-Third Annual example, avail against anyone who may already be
Conference. Washington, DC: National Tax Association. using that telephone.
Peters, A.H., and P.S. Fisher. 2002. State enterprise zone Beyond strong and weak entitlements, one may
programs: Have they worked? Kalamazoo.
W.E. Upjohn Institute for Employment Research.
also possess many largely unprotected liberties.
These consist in those activities from which one has
no obligation to refrain but with which,
equally, no direct or extensive indirect claims to Procedural and substantive criteria that have been
non-interference. So, broadly speaking, persons’ offered for determining individuals’ entitlements
strong entitlements may be construed as conjunc- include: relative need, productivity, equal freedom,
tively constituting their spheres of ownership, while equal utility, personal moral worth, interpersonal
their weak entitlements and their unprotected neutrality, personal inviolability, initial contract and
liberties constitute the fields of activity within so forth. As is immediately obvious, the nature and
which they exercise the powers and privileges of distribution of the entitlements mandated by each of
ownership. Normally, it is persons’ strong these criteria are by no means self-evident, and their
entitlements that are of primary normative concern, identification thus requires supplementary
with weak entitlements and unprotected liberties postulates that are variously drawn from
being determined residually. psychological theories, from theories of moral and
Entitlements may be either legal or moral. Sets rational choice, and from conceptual analyses of the
of legal entitlements tend to reflect the multifarious criteria themselves. It is also true that not all of
demands of various customs, moral principles, these criteria are mutually exclusive: given a
judicial decisions and state policy. A set of moral plausible set of premises, some can be derived from
entitlements, on the other hand, is commonly others.
derived from some basic principle embedded in a There are other dimensions, apart from their
moral code. The nature of this derivation varies with distributive norms, in which theories of just enti-
the type of code involved. In many single-value tlements differ. Some of these differences are log-
codes (such as utilitarianism), entitlements are ically implied by the naUire of the norms
instrumental in character: whether and what sort of themselves, while others are independent of them.
an obligation is owed, by one person to another, One such dimension is the kinds of object to be
depends upon the relative magnitude of the distributed in conformity with a proposed criterion.
contribution that fulfilment of that obligation would Proffered items include all utility- producing goods,
make to realizing that value. Changing causal means of production, natural resources, the rents of
conditions of maximization warrant alterations in superior skills or talents, and even human body
the content and distribution of entitlements. Codes parts. What one may do with the things to which
containing a plurality of independent values one has strong entitlements - what weak
characteristically generate entitlements from a entitlements and unprotected liberties one possesses
principle of justice. The set of entitlements thus - is largely a function of the sorts of thing to which
derived possesses intrinsic and not merely others are strongly entitled. The intricate structure
instrumental value, though its normative status of permissibility, jointly formed by the rights one
depends upon the ranking of justice in relation to the has against others and the rights others have against
code’s other values. In such codes, the chief oneself, constitutes the fields of activity within
distinction between moral obligations that (like which each person exercises those rights. It thereby
kindness) are not correlative to any entitlement and also determines the respective spheres of market,
those of justice that are, lies in the fact that only the state and charitable activities.
latter are waivable and permissibly enforceable. A third differentiating dimension is the range of
Much of the philosophical treatment of entitle- subjects to be counted as having entitlements.
ments is located in discussions of rival theories of Generally accepting the membership of all adult
justice. These theories differ according to the var- human beings in the class of title-holders, theories
ious norms they propose for determining who owes differ over whether their distributive norms extend
what to whom. Endorsing the classical formal to minors, members of other societies, deceased
conditions of justice - ‘rendering to each what is due persons (in respect of bequest), persons conceived
to him’ and ‘treating like eases alike’ -they diverge but not yet bom (in respect of abortion), persons not
widely in their interpretations of what is due to a yet conceived (in respect of capital accumulation
person and what count as like cases. and environmental
conservation) and non-human animals. Again, the depends upon the size and nature of the stipulated
nature and interpretation of a theory’s distributive set of rights. Laws and constitutional rights imply
criterion often work to delimit its class of title- both restrictions on each person’s conduct but also,
holders. i p s o f a c t o , restrictions on the extent of
In the light of this multiplicity of differentiating permissible interference with others’ conduct.
dimensions, the classification - let alone assessment Dispensing with the initial contract device and
- of theories is no simple task. One, but by no hypothetical unanimous agreement, some theories
means the only, important respect in which many of derive a set of entitlements directly (non-
them can be compared is in terms of the scope they procedurally) from a substantive foundational
allow for unconstrained individual choice. Thus value. Among such theories, one type assigns
theories might be ranged along a spectrum from entitlements according to the differential incidence
those that prescribe only an initial set of of some stipulated variable in the population of
entitlements (permitting persons thereafter to title-holders. Need and productivity are particularly
dispose of these as they choose), to those that prominent variables in this field, often acquiring
require constant enforceable adjustment of the their normative import from the values of welfare
content and distribution of entitlements to conform equalization and maximization. Clearly,
to certain norms. However, even this way of applications of these distributive criteria
arraying competing theories is somewhat respectively presuppose accounts of essential
underspecified, inasmuch as it fails to capture the human requirements and of economic value.
varied ramifications of the restrictions implied by Although, for such theories, any shift in the inci-
different initial entitlements. dence of the stipulated variable occasions a
Hence it is an open question as to where on this corresponding adjustment of entitlements, the issue
spectrum one would locate theories that (via a of whether this adjustment must be imposed or
unanimity requirement) construe each person’s occurs spontaneously partly turns on the model of
initial entitlement as a veto on a social or consti- interactive behaviour employed. In general, models
tutional contract. Such an entitlement may in turn indicating spontaneous adjustment generate that
be derived from some interpretation of equal free- conclusion by ascribing dominance to altruistic
dom, personal inviolability or interpersonal neu- (need) or income-maximizing (productivity)
trality. Or it may itself be taken as an intuitively behaviour. To the extent that these ascription’s are
acceptable foundational postulate for deriving a empirically unrealistic, such theories mandate
more complex set of entitlements. Whether an enforceable restrictions on the scope for individual
initial contract theory is permissive or restrictive of choice.
wide individual choice depends upon its account of Another type of directly derived (non-contract-
the terms of that contract. The derivation of these based) entitlement set is drawn from foundational
terms usually proceeds from some conception of values like equal freedom, personal inviolability or
human nature - of human knowledge and interpersonal neutrality, which, by definition, are of
motivation - along with some meta- ethical theory uniform non-differential incidence in the population
about the nature of moral reasoning. Contractual of title-holders. Varying interpretations of these
terms generated by these premises may extend only concepts tend nonetheless to converge on the
to the design of political institutions, thereby Kantian injunction that persons must be treated as
leaving the determination of individuals’ ends in themselves and, more specifically, that no
substantive entitlements to the legislative process. person’s ends may be systematically subordinated
Alternatively, such contracts may stipulate a set of to those of another. Here the theoretical task is to
basic individual rights that are immune to design a set of entitlements that is independent of
legislative encroachment In either case, the resul- any particular conception of ‘the good’ -
tant scope for individual choice remains independent of particular preferences and (other)
underdetermined. In the first case it depends upon moral values - and that is such as to ensure that the
the extent of legislation, while in the second it consequences of persons’ actions,
whether harmful or beneficial, are not imposed on an undecidable number and size of partially con-
others. A typical, though by no means invariable, current future generations. These are among the
structural feature of such an entitlement set is its more salient problems commanding attention in
extensive use of a threefold classification of things current work on theories of entitlement.
in the world as selves, raw natural resources and
objects which are combinations of these. While
title-holders are each vested with ownership of See Also
themselves (their bodies and labour), such theories
► Economic Freedom
often contain some sort of egalitarian constraint on
► lit
individual entitlements to raw natural resources.
► qua
The precise form of this constraint determines the
► Justice
nature of the encumbrances that may be imposed on
the ownership of objects in the third category. But ► 'overty
since these encumbrances exhaust the restrictions ► 'roperty Rig

on what persons may do with what they own, such

theories are presumed to allow considerable scope ► ^distribution Wealth
for individual choice.
It is hardly worth remarking that many theories
Bibliography
of entitlement combine aspects of the three types
Buchanan, J.M. 1974. The limits of liberty. Chicago: University
outlined above. The assessment of competing
of Chicago Press.
theories - a complex task, as stated previously - Demsetz, H. 1964. Toward a theory of property rights.
commonly consists in testing for internal coherence American Economic Review, Papers and Proceedings 57: 347-
and in appraising the interpretations placed on core 359.
Dworkin, R. 1981. What is equality? Philosophy and Public
concepts in the theory. Thus, if it is supposed that
Affairs 10:185-246;283-345.
the moral principle underpinning a set of Hohfeld, W.N. 1919. Fundamental legal conceptions. New
entitlements is that of justice, and that justice is Haven: Yale University Press.
analytically linked to the concept of rights, there is Lyons, D. (ed.). 1979. Rights. Belmont: Wadsworth Pub-
lishing Company.
room for dispute as to whether the first (initial
Nozick, R. 1974. Anarchy, state and utopia. Oxford: Blackwell.
contract) and second (needs, productivity) types of Rawls, J. 1971 .A theory ofjustice, 1972. Oxford: Oxford University
theory are properly viewed as theories of Press.
entitlement. A distinctive normative feature of Sen, A.K. 1981. Rights and agency. Philosophy and Public
Affairs 11:3-39.
rights is that they are held non-contingently to
Steiner, H. 1987. An essay on rights. Oxford: Blackwell.
confer an element of individuated discretion on
their owners. It is unclear whether possession of a
veto in a collective- choice procedure amounts to a
sufficiently individuated sphere of discretion. On
the other hand, the entitlements generated by
considerations of need or productivity, while Entitlements in Laboratory Experiments
sufficiently individuated, appear to lack any Sheryl Ball
necessarily discretionary character. A difficulty
besetting the first and third types of theory arises
with regard to the notion of initial entitlements.
Specifically, it seems clear that the identification of
each person’s initial entitlement - either in a
collective-choice procedure or under an egalitarian Keywords
constraint on natural resource ownership - cannot be Altruism; Behavioural economics; Desert;
interpreted as an historically ‘one-off’ Entitlement programmes; Entitlements; Enti-
determination, in the face of tlements in laboratory experiments; Fair allo-
cation; Justice; Other-regarding behaviour;
 Procedural fairness; Psychological games; well as the fruits of their actions. Thus subjects
Rawls, J.; Reciprocity; Self-interest divided an endowment equally when the controller
was chosen according to the flip of a coin and had
low moral authority. On the other hand, both earn-
JEL Classifications ing the right to be controller and higher moral
C9 authority triggered changes in observed allocations,
so that outcomes favoured the controller. Entitle-
Entitlements are rights granted by contract, law or ments that were earned or that involved ‘morally
practice. Under the assumption of pure self- unequal’ agents were sufficient to trigger unequal
interest, modelling games with entitlements is fairly outcomes. Equity theory developed by social psy-
straightforward; however, work in behavioural chologists is similar in spirit to this theory of
economics has consistently demonstrated the justice.
existence of other-regarding preferences, with Ideas of procedural fairness also affect percep-
strong effects of perceptions of what is fair. In the tions of government entitlements. Fong ( )
laboratory, behaviour is affected not only by the looks at poll data on perceptions of poverty and
entitlement per se but also by the procedure by opportunity, and finds that beliefs about others’
which entitlements come about. One form of effort, luck and opportunity play the laigest role in
laboratory entitlement is a more advantageous determining support for government entitlement
position in an economic game, where the advantage programmes. In particular these beliefs outweigh
arises from a larger endowment, favourable concerns about tax costs in supporting these pro-
exchange mles or greater decision-making grammes. These results are consistent with the
authority. A second type of entitlement is a experimental results discussed above, where low
guaranteed payoff or a payoff floor. Experimental payoffs are acceptable if one displays low effort. If
results show that the means by which entitlements one’s situation is determined by poor luck, how-
are acquired is one cue that influences the nature of ever, one will give up some of one’s earnings to
other-regarding behaviour. This is important both increase the earnings of others.
for understanding behaviour and the design of A number of experimental studies on income
experiments. redistribution examine Rawls’s claim that individ-
In early experimental work on entitlements, uals prefer an income redistribution mle that max-
Hoffman and Spitzer ( ) demonstrate that imizes the position of the poorest member of society
both the existence of an entitlement and its source (Frohlich and Oppenheimer ). Studies where
determine economic outcomes. They study bilateral subjects must choose a principle of distributive
bargaining problems where one of the two subjects, justice and a tax system in addition to participating
called the ‘controller’, has unilateral authority to in a production task find that people choose rules
decide the outcome of a negotiation game in the that maximize the productivity of society while
event of disagreement. Authority is assigned based maintaining a minimum floor for the worst off
on either the outcome of a coin flip or the result of a members. Subjects generate greater output in
simple test of a skill that is irrelevant to the experiments where they are able to determine the
experimental task. They find that controllers are entitlements for the worst off individual in their
most willing to exploit their power when they are group, again demonstrating that the source of
assigned their role based on the skill test and are entitlements matters.
told that they ‘earned’ the right to be the controller - These results show that researchers need to pay
that is, that they have moral authority. These results attention to how entitlements are determined. This
are consistent with Burrows and Loomes ( ). is a complication for theories of behavioural eco-
The subjects’ behaviour illustrates Rawls’s ( nomics or psychological games. People do not have
) notion of ‘desert’, which requires that people a pure taste for fair allocations; they are more self-
deserve the conditions underlying their actions as interested, altruistic or fair according to
circumstances that depend on how advantage arises.
This behaviour is closely related to
reciprocity, but that is often modelled as ‘if you are
nice to me I’ll be nice to you’ (Bowles and Gintis ). Entrepreneur
In contrast, this collection of results can be
interpreted as, ‘I will respect your entitlement if Mark Casson
you deserve it’.
A preference for procedural factors also com-
plicates experimental design, since subjects behave
in a more self-interested manner when entitlements There are several theories of the entrepreneur, but
are earned than when they are randomly assigned. very few mathematical models which formally
Researchers must be careful to consider how analyse entrepreneurial behaviour within a closed
subjects will interpret the rules by which economic system. Indeed, it is often argued that by
advantages are assigned or they may risk its very nature entrepreneurial behaviour cannot be
introducing nuisance variables. Future work might predicted using deterministic models.
deliberately award entitlements in a manner that Entrepreneurship, it is claimed, is essentially a
subjects view as unjust to see whether that produces spontaneous and evolutionary phenomenon.
yet another pattern of behaviour. The term ‘entrepreneur’ seems to have been
introduced into economic theory by Cantillon ( ),
but the entrepreneur was first accorded
See Also prominence by Say ( ). It was variously trans
lated into English as ‘merchant’, ‘adventurer’ or
► Behavioural Game Theory
‘employer’, though the precise meaning is the
► doase Theorem
undertaker of a project. John Stuart Mill ( )
► Experimental Economics
popularized the term in England, though by the turn
► ail Alio
of the century it had almost disappeared from the
►
theoretical literature (though see Marshall )•
The ‘disappearance’ of the entrepreneur is
► Psychological Games
associated with the rise of the neoclassical school of
economics. The entrepreneur fills the gap labelled
Bibliography ‘fixed factor’ in the neoclassical theory of the firm.
Burrows, P., and G. Loomes. 1994. The impact of fairness on Entrepreneurial ability is analogous to a fixed factor
bargaining behavior. Empirical Economics 19: 201-22L endowment because it sets a limit to the efficient
Bowles, S. and Gintis, H. 2001. The inheritance of economic size of the firm. The static and passive role of the
status: Education, class and genetics. In Genetics, behav-
entrepreneur in the neoclassical theory reflects the
ior and society, ed. M. Feldman. In International
encyclopedia of the social and behavioral theory’s emphasis on perfect information - which
sciences, ed. N. Smelser and P. Baltes. Oxford: Elsevier. trivializes management and decision-making - and
Fong, C. 2001. Social preferences, self-interest, and the demand on perfect markets - which do all the coordination
for redistribution. Journal of Public Economics 82: 225- that is necessary and leave nothing for the
246.
Frohlich, N., and J.A. Oppenheimer. 1990. Choosing justice in
entrepreneur (cf. Baumol ).
experimental democracies with production. American According to Schumpeter ( ), the entrepre
Political Science Review 84: 461-477. Hoffman, E., and M.L. neur is the prime mover in economic development,
Spitzer. 1985. Entitlements, rights and fairness: An experimental and his function is to innovate, or ‘carry out new
examination of subjects’ concepts of distributive justice.
Journal of Legal Studies 14: 259-297. combinations’. Five types of innovation are
Lissowski, G., T. Tyszka, and W. Okrasa. 1991. Principles of distinguished: the introduction of a new good (or an
distributive justice: Experiments in Poland and America. improvement in the quality of an existing good), the
Journal of Conflict Resolution 35: 98-119. Rawls, J. 1971. introduction of a new method of production, the
A theoiy of justice. Cambridge, MA: Belknap, Harvard
University Press.
opening of a new market - in particular an export
market in new territory - the
‘conquest of a new source of supply of raw mate- off - through insurance markets, but uncertainties
rials or half-manufactured goods’ and the creation cannot. Those who take decisions in highly
of a new type of industrial organization - in par- uncertain environments must bear the frill
ticular the formation of a trust or some other type of consequences of those decisions themselves. These
monopoly. Schumpeter is also very clear about what people are entrepreneurs: they are the owners of
the entrepreneur is n o r . he is not an inventor, businesses and not the salaried managers that make
but someone who decides to allocate resources to day-to-day decisions.
the exploitation of an invention; nor is he a risk- It is not clear, at first sight, whether there is any
bearer: risk-bearing is the function of the capitalist common thread which runs through these various
who lends funds to the entrepreneur. Essentially, theories of the entrepreneur. Casson ( )
therefore, Schumpeter’s entrepreneur has a man- attempts to identify a shared element by introducing
agerial, or decision-making role. the concept entrepreneurial judgement. The
This view receives qualified support from Hayek entrepreneur is defined as someone who specializes
( ) and Kirzner ( ), who emphasize in taking judgemental decisions about the allocation
the role of the entrepreneur in acquiring and using of scarce resources. The essence of a judgemental
information. The entrepreneur’s alertness to profit- decision is that there is no decision rule that can be
opportunities, and his readiness to exploit them applied that is both obviously correct and involves
through arbitrage-type operations, makes him the using only freely available information. Suppose,
key element in the ‘market process'. Hayek and for example, that a decision rule, is used; then there
Kirzner regard the entrepreneur as responding to must be some initial judgement that the chosen rule,
change - as reflected in the information he receives and not some other rule, is the appropriate one. No
- whilst Schumpeter emphasized the role of the rule can ever be frilly self-justifying: there is no
entrepreneur as a source of change. These two definitive model which demonstrates that one rule is
views are not incompatible though: a change always superior to another. Ultimately, the
effected by one entrepreneur may cause spill-over justification for a rule must be some property of the
effects which alter the environment of other environment, which in many cases cannot be
entrepreneurs. Hayek and Kirzner do not insist on observed.
the novelty of entrepreneurial activity, however, and It is evident that this concept of judgemental
it is certainly true that a correct decision is not decision-making rejects the ‘naive neoclassical’
always a decision to innovate; premature innovation view that all decision-making merely involves
may be commercially disastrous. Schumpeter begs marginalist calculations based upon public infor-
the question of whether someone who is the first to mation supplied by the price system. It recognizes
evaluate an innovation, but decides (correctly) not that not only is information costly, but that the costs
to innovate, qualifies as an entrepreneur. of acquiring information are different for different
Leibenstein ( ) regards the entrepreneur as people. Furthermore, because then- access to
someone who achieves success by avoiding the information differs, different people will make
inefficiencies to which other people - or the orga- different decisions in the same situation. The
nization to which they belong - are prone. The main essence of judgemental decision-making is that the
virtue of Leibenstein’s approach is that it outcome depends upon w h o makes the decision.
emphasizes that, in the real world, success is When judgements differ, confident individuals
exceptional and failure is the norm. can back their own judgement by taking up spec-
Knight ( ) insists that decision-making ulative positions against other people who hold a
involves uncertainty. Each business situation is conventional view. The confident individuals ‘bet’
unique, and the relative frequencies of past events against others by acquiring assets that they believe
cannot be used to evaluate the probabilities of future other people have under-valued, disposing of assets
outcomes. According to Knight, measurable risks that they believe other people have overvalued,
can be diversified - or ‘laid undertaking projects that other people do
not consider profitable, and so on. Using this entering into entrepreneurial projects on its own
approach, the arbitraging activity described by account. In countries where the banking system is
Hayek and Kirzner, and the innovative activity underdeveloped, the extended family often fulfils a
described by Schumpeter, are seen to be special similar function of ‘honest broking’ between the
cases of the general concept of entrepreneurial older generation who are potential investors and the
speculation based upon self-confident judgement. younger generation who are potential entrepreneius.
In a market economy, individuals who lack Another method of building trust is to supply
confidence in their judgement can delegate deci- finance in a sequence of small instalments so that
sions to entrepreneius. The individual entrusts his both parties have an incentive to behave honourably
wealth to an entrepreneur, who allocates this wealth in order not to put future relations between them at
in accordance with his own judgement. In practice, risk.
the individual will often diversify his risks by using Much of the information required for decision-
a ‘portfolio’ of different entrepreneius. The making is not merely costly to obtain, but is not
delegation of decision-making can be effected in available by direct observation at all. Another way
various ways. An individual may supply capital at of saying this is that decisions are governed not
fixed interest to an entrepreneur who is self- only by objective information but also by subjective
employed or is the owner-manager of a firm. He beliefs. An individual’s beliefs originate with his
may own an equity stake in a firm where the culture and his religion as well as with his direct
entrepreneur acts partly as a salaried employee; or experience of life. Some cultures appear to give
he may deposit his funds in a bank whose managers greater encouragement to entrepreneurship than
advance loans to firms and self- employed others. A culture which stresses individuality rather
entrepreneius. than conformity encourages an individual to form
To overcome the principal-agent problems an independent judgement of a situation. A culture
involved in the delegation of decisions, it is nor- which emphasizes human autonomy rather than
mally necessary for the supplier of finance not only fatalistic submission to nature encourages the kind
to have confidence in the entrepreneur’s judgement, of self-confidence required of the entrepreneur. A
but also to trust the entrepreneur to exercise this culture which emphasizes the heroic aspects of
judgement in pursuit of maximum profit. Unless the leadership rather than the corrupting effects of
entrepreneur has an established reputation, he has a power-seeking encourages individuals to undertake
strategic problem in obtaining the confidence of ambitious projects which call for a high degree of
others. Because of the differences in judgement organization, and so on. Cultural values have
mentioned earlier, the entrepreneur will normally be always been emphasized in the literature on
more optimistic about a proj ect than are his entrepreneurship: Schumpeter, for example, refers
potential financial backers. His backers will to the dream and will to found a private dynasty, the
therefore perceive higher risks, and set a higher cost will to conquer and the joy of creating, while
of capital than the entrepreneur believes is Weber ( ) emphasizes the Protestant ethic and the
warranted. If, however, he persuades his backers to concept of calling and Redlich ( ) the milita
share his optimism, then they may preempt his ristic values of the ‘captains of industry’. Writers
project, since they already have the finance to on business history almost invariably stress the
proceed with it and he does not. influence of culture and personality on the behav-
This leads directly to the question of trust. Just iour of the entrepreneur.
as the financiers must trust the entrepreneur to use A common criticism of theories which place
his funds in their interests, so the entrepreneur must considerable weight on cultural characteristics and
trust his financial backers not to preempt his project personality traits is that they are difficult to test.
for themselves. Part of the problem can be solved Indeed, it is often suggested that because the
by using an ‘honest broker’ such as a bank, which behaviour of individual entrepreneurs tends to be
vets entrepreneurial projects on behalf of investors unpredictable, theories of entrepreneurship are
but ties its own hands by not
untestable. It is, however, quite possible that while the definition above, it is impossible to identify the
the behaviour of individual entrepreneurs cannot be entrepreneur simply by his contractual status in
predicted, the behaviour of entrepreneurs as a group employment. An increase in the supply of
is predictable. Furthermore, a theory of entrepreneurs is effected by individuals transferring
entrepreneurship may generate propositions relating out of manual work and non-entrepreneurial
to other social phenomena besides the behaviour of decision-making (i.e. routine management), and
entrepreneurs themselves. With certain from unemployment and leisure, and by net inward
qualifications, it is possible to develop a model in migration of entrepreneurs from abroad. The
which both the level of entrepreneurial activity and position and elasticity of the entrepreneurial supply
the functional distribution of income between curve depends upon the expected return to non-
entrepreneurship and other factors are simulta- entrepreneurial activity abroad, the distribution of
neously determined. judgemental ability within the indigenous
Given that the entrepreneur specializes in population, cultural attitudes, and barriers to entry
judgemental decision-making, it is possible to and exit which reduce mobility between the entre-
formulate a derived demand for entrepreneurial preneurial and non-entrepreneurial groups.
services which varies according to the demands Given both the long run supply and long mn
which the business environment places upon demand for entrepreneurs, it is possible to visualize
judgement. The more complex the environment, the a long equilibrium in which the marginal
faster the pace of change, and the more radical the entrepreneur earns an approximately normal return,
structural adjustments that these changes call for, intra-marginal entrepreneurs earn a quasirent to
the greater will be the demand for entrepreneurs. A superior judgement, and intra-marginal non-
large demand for entrepreneurs will be reflected in entrepreneurs earn quasi-rents for their non-
substantial profit opportunities for people who can entrepreneurial abilities. The equilibrium return to
anticipate changes and correctly foresee their entrepreneurship, and the equilibrium number of
consequences. Individual profit opportunities will entrepreneurs, depend upon the parameters of the
not be competed away so long as each opportunity demand and supply curves, as described above. This
can be preempted by a single entrepreneur before equilibrium is a partial equilibrium, conditional
others come to form the same judgement as he has upon the returns to non-entrepreneurial activity
done. In the short run, therefore, the successful within the economy. It is also possible to derive a
entrepreneur can earn a monopolistic rent to general equilibrium by endogenizing the return to
superior judgement. non-entrepreneurial activity.
In the long run, however, entry into entrepre- It should be emphasized, however, that any kind
neurship will tend to compete away any expected of ‘equilibrium’ in a ‘market for entrepreneurs’ is
return to entrepreneurial activity which exceeds the essentially an analytical fiction because the
expected return to non-entrepreneurial activity (after adjustment of this market to an equilibrium is itself
due allowance for different levels of risk and for the an entrepreneurial task. The decision whether to
non-pecuniary net benefits of the two kinds of hire an entrepreneur, and the decision whether to
activity). The competing away of entrepreneurial become one, are both entrepreneurial decisions. It is
rents may not be complete, however, because access difficult for entrepreneurs to intermediate in the
to capital may prove a barrier to entry for the market for entrepreneurs because it is difficult to
reasons explained above. buy and sell ‘human capital’ of this kind. To
Long-run entry corresponds to a movement introduce a Walrasian auctioneer to coordinate
along a long-run supply curve for entrepreneurs. supply and demand decisions in the market for
The total supply of entrepreneurs is measured by the entrepreneurs would be self-contradictory, for it is
number of individuals whose principal activity is to only because of the absence of the Walrasian
exercise their judgement to allocate resources. The auctioneer that entrepreneurs are required in the
people concerned may be senior salaried managers first place. Thus while the concept of a market
or the self-employed - given
equilibrium for entrepreneurs is a useful analytical Leibenstein, H. 1968. Entrepreneurship and development.
device, it is erroneous to suppose that the market for American Economic Review 58: 72-83.
Marshall, A. 1890. Principles of economics, 9th edn, 2 vols, ed.
entrepreneurs is ever in a full equilibrium. G.W. Guillebaud. London: Macmillan, 1961.
Twenty years ago, the study of the entrepreneur Mill, J.S. 1848. Principles of political economy, New edn, ed.
was regarded as a ‘gap’ in economic theory. It is W.J. Ashley. London: Longmans, 1909.
now recognized that this gap cannot be filled with- Nelson, R.R., and S.G. Winter. 1982. An evolutionary theory of
economic change. Cambridge, MA: Harvard University
out radically changing the nature of the theory itself. Press.
The entrepreneur can only be understood properly Redlich, F. 1956. The military enterpriser: A neglected area
in the context of an economic model which does Ml of research. Explorations in Entrepreneurial Histoiy, Series 1,
justice to the structural complexity and the 8: 252-256.
Say, J.B. 1803. A treatise on political economy: or the production,
evolutionary nature of the economy (Nelson and distribution and consumption of wealth. New York: Augustus
Winter ). Within such a model the ‘equilibrium’ M. Kelley, 1964.
concept remains a useM analytical device, but one Schumpeter, LA. 1934. The theory of economic development.
of limited practical relevance. The study of the Trans. R. Opie. Cambridge, MA: Harvard University
Press.
entrepreneur leads to a vision of economics much
Weber, M. 1930. The protestant ethic and the spirit of capitalism.
wider than that of a subject which parsimoniously Trans. T. Parsons. London: George Allen & Unwin.
derives a consistent set of price and quantity
equations. Aspects of human personality - such as
self-confidence - acquire a crucial role - and so too
does the malleability of the personality under the
influence of cultural attitudes. The theory of the
entrepreneur, therefore, is not the last step which Entrepreneurship
renders the conventional theory of value complete,
but the first step towards an economic theory which William J. Baumol and Melissa A. Schilling
forms part of a wider integrated body of social
science.

Abstract
See Also
This article describes the recent expansion of
► io : 5
I research on entrepreneurship, innovation and
► iorp.. - ! .. .. growth. Although the entrepreneur is widely
► iteir credited with critical contributions to innovation
and growth, the subject of entrepreneur- ship has
virtually disappeared from mainstream theory
► Profit and Profit Theory
and standard textbooks. Reasons explaining this
gap are indicated. In addition to some brief
Bibliography materials on earlier writings, the rich body of
Baumol, W.J. 1968. Entrepreneurship in economic theory. recent work on the subject, both theoretical and
American Economic Review: Papers and Proceedings 58:64-71. empirical, is surveyed, illustrating the wide
Cantillon, R. 1755. Essai sitr la nature du commerce en general, variety of subjects explored and the insights
ed. H. Higgs. London: Macmillan, 1931. Casson, M.C. 1982.
offered by the new literature.
The entrepreneur: An economic theory. Oxford: Martin Robertson.
Hayek, F.A. von. 1937. Economics and knowledge.
Economica, NS 4: 33-54.
Kirzner, I.M. 1973. Competition and entrepreneurship.
Keywords
Chicago: University of Chicago Press.
Knight, F.H. 1921. Risk, uncertainty and profit, ed. GJ. Stigler. Baumol, W.; Cantillon, R.; economic
Chicago: University of Chicago Press, 1971. growth; entrepreneurship; equilibrium;
innovation; Kirzner, L; Knight, F.; Marshall,
A.; Mill, J.S.; Neoclassical theory;
Opportunity costs;
 Patents; Product development; Property rights; Although economists have recently exhibited a
Risk; Say, J.-B.; Schumpeter, J.; Self- resurgence of interest in entrepreneurship, the
employment; Social status; Transfer of tech- entrepreneiu nevertheless rarely shows up in con-
nology; Uncertainty premium; Venture capital temporary mainstream economic theory.

JEL Classifications Early Writings and the Origin of the Term

L2; 012; 031; 033
Until the 20th century, writings in English referred
An entrepreneur is an individual who organizes, to entrepreneurs as ‘adventurers’ or ‘undertakers’
operates, and assumes the risk of creating new (see, for example, Marshall , p. 172). Apparently,
businesses. There are two types. A replicative the term ‘entrepreneur’ was introduced by Cantillon
entrepreneiu organizes a new business firm that is in the French translation of his great work,
like other firms already in existence. An innovating E s s a i S u r l a N a t u r e d e
entrepreneiu provides something new - a new C o m m e r c e e n G e n e r a l (1730,
product or process, or a new type of business p. 54), but what is apparently h i s English text
structure, a new approach to marketing, and so on. uses the word ‘undertaker’. The early writings on
These innovations need not be productive or entrepreneurship were descriptive rather than
beneficial. For example, Richard Cantillon (one of theoretical. Cantillon’s discussion (1730, ch. 11) is
the first great economic theorists) spoke of thieves brief, focusing on replicative entrepreneurs: ‘..
who are entrepreneurs (Cantillon , pp. 54-5). And .wholesalers in Wool and Com, Bakers, Butchers,
Joseph A. Schumpeter, arguably the contributor of Manufacturers and Merchants of all kinds.. ..’
the most important analysis of entrepreneurship, (1730, p. 51). Cantillon’s main point, like that of
included as an entrepreneurial act ‘.. .the creation of Frank H. Knight ( ), was the
a monopoly position (for example, through task’s riskiness: ‘These Undertakers can never
trustification).. ..’ (Schumpeter , p. 6 6 ). know how great will be the demand in their City,
Entrepreneurs (interpreted as the self- employed) nor how long their customers will buy of them since
are estimated to constitute about seven percent of their rivals will try all sorts of means to attract
the labour force in the United States (U.S. Bureau customers from them. All this causes so much
of the Census ). Most of them are probably uncertainty among these Undertakers that every day
replicative, not innovative, entrepreneurs. one sees some of them become bank- rapt’ (1730, p.
It is widely agreed that the entrepreneur plays an 51).
important role in economic growth. But the Nearly a century later, Jean-Baptiste Say’s (
evidence shows little correlation between an ) discussion is still brief, but richer. Say
economy’s number of replicative entrepreneurs and seems interested primarily in innovating entrepre-
its growth rate. Innovative entrepreneurs do make a neurs, dealing with three types of ‘producers’:
substantial difference to a nation’s growth rate, scientists, entrepreneurs and labourers. Using
having introduced many breakthrough innovations mechanical locks as an example, the scientist
like the telephone and the airplane. The primary investigates ‘.. .the properties of iron, the method of
social contribution of replicative entrepreneurship is extracting from the mine and refining the ore... ’
as a means for individuals to escape poverty, The entrepreneurs deal with ‘.. .application of this
because such undertakings require little capital, knowledge to a useful purpose...,’ while the third
education or experience. Still, the data show that group - the workers - actually make the product
entrepreneurs, on average, earn less than employees (1819, p. 80). And any successful economy needs
with similar education and experience (Freeman ; all three: ‘Nor can [industry] approximate to per-
Astebro ; Benz and Frey ). fection in any nation, till that nation excel in all
three branches’ (1819, p. 80).
Thus, Say blames poverty in Africa on the
absence of scientists and entrepreneurs. Lack of
entrepreneurs alone can undercut prosperity, even Disappearance of the Entrepreneur from
with scientific knowledge abundant, for without the Modern Mainstream Economics
entrepreneur, .that knowledge might possibly have
lain dormant in the memory of one or two persons, Given the acknowledged importance of the entre-
or in the pages ofliterature’ (1819,p. 81). This is preneur’s role, it could be hoped that modem
precisely the explanation that one of the present theoretical economics, with its powerful analytic
authors proposed for the failure of medieval China tools, would have produced an extensive entre-
and the Soviet Union to translate an abundance of preneurship analysis. Instead, the opposite
non-military inventions into viable consumer happened - the entrepreneur became the ‘invisible
products (Baumol , chs. 5, 14). Say also man’ in mainstream theory. There are at least two
foreshadows some of Schumpeter’s analysis (see reasons for this. First, the most advanced and
below): ‘In manufacture., .if success [in innovation] powerful microeconomic models predominately
ensue, the adventurer is rewarded by a longer study timeless static equilibria. But, for the entre-
period of exclusive advantage, because his process preneur, the transition process is the heart of the
is less open to observation’ (1807, p. 84). story. Schumpeter ( ) shows the entrepreneur
Finally, Say mentions the spillovers of innova- as a destroyer of equilibria by constant innovation,
tion and their justification for governmental while Israel Kirzner ( ) tells how the alert
financing: ‘The charges of experiment, when entrepreneur seeks out the arbitrage opportunities
defrayed by the government... [are] hardly felt at presented by disequilibria, thereby moving the
all, because the burthen is divided among innu- economy back toward equilibrium. Such a relentless
merable contributors; and the advantages resulting attack upon both equilibria and disequilibria does
from success being a common benefit to all, it is by not fit a stationary model from which firm creation
no means inequitable that the sacrifices, by which and invention are excluded.
they are obtained, should fall on the community at The second reason for the entrepreneur’s dis-
large’ (1819, p. 85). appearance from mainstream theory is that, by
Before Schumpeter’s breakthrough (see below), definition, an invention is something never avail-
the subject was touched upon by economists like able before. So invention is the ultimate heteroge-
J.S. Mill, Alfred Marshall and (a bit later) Knight. neous product. This impedes the optimality analysis
Generally, their focus was not on innovative underlying most microeconomic theory. Explicitly
entrepreneurship, and they emphasized or implicitly, an optimality calculation entails a
management’s directing of going concerns rather comparison among possible substitute choices,
than establishment of new firms. (But Marshall , p. while the innovating entrepreneur normally deals
172, does digress briefly to mention Matthew with no well-defined substitutes with quantifiable
Boulton’s significant role as an entrepreneur attributes. In contrast, the standard theory of the
dealing with James Watt’s inventions.) Today, firm analyses repetitious decisions of management
however, these discussions would hardly be in fully operational enterprises where the
considered theory. Rather, they are usually entrepreneur has already completed his job and left
narratives containing illuminating observations. to create other firms.
They assert that the entrepreneur’s payment is a Thus, neoclassical theory is justified in exclud-
residual after other inputs are compensated, and that ing the entrepreneur, because it deals with subjects
compensation is determined by the entrepreneur’s for which the entrepreneur is irrelevant. That does
ability and the supply of entrepreneurship in the not mean that no theory of entrepreneurship is
market. They note that entrepreneurs employ needed, or that such a theory is lacking, but it means
themselves, so that unlike other inputs there is no that a theory of entrepreneurship must be sought
demand function, as for other inputs. elsewhere, and that is what Schumpeter succeeded
in doing.
Brief Summary: Schumpeter's Model: Simg, and Ming Chinese empires, the captains of
The Supply and Earnings of late medieval private and mercenary armies, the
Entrepreneurial Activity rent-seeking contemporary lawyers, and the Mafia
Dons - all are clearly enterprising and often suc-
The basic Schumpeterian model ( ) notes that cessful. And when institutions have changed so as
the successful innovative entrepreneur’s reward is to modify profoundly the relative payoffs offered by
profit temporarily exceeding that of perfect com- the different enterprising activities, the supply of
petition. This attracts rivals who seek to share those entrepreneurs has shifted accordingly. Here, it is
profits by imitating the innovation, and thereby helpful to distinguish two categories of entre-
erode its super-competitive earnings. To prevent preneurs, the productive and the unproductive
termination of these rewards, the entrepreneur can entrepreneurs, with the latter, in turn, divided into
never desist from further innovation and cannot rest subgroups such as rent-seeking entrepreneurs and
on his laurels. destructive entrepreneurs, including the organizers
Perhaps most important, the Schumpeterian of private armies or criminal groups. Once there is a
analysis shows how the entrepreneur is driven to pertinent change in the institutions that govern the
work without let-up for economic growth. Thus, it relative rewards, the entrepreneurs will shift their
clearly reveals the tight association between inno- activities between productive and unproductive
vative entrepreneurship and growth. occupations, so the set of productive entrepreneurs
will appear to expand or contract autonomously. For
example, when institutions change to prohibit
Allocation Between Productive and private armies, entrepreneurs are led to look
Unproductive Entrepreneurship elsewhere to realize their financial ambitions. If,
simultaneously, rules against confiscation of private
Some work of one of the present authors (Baumol ,
property and for patent protection of inventions are
ch. 14) tells much of the rest of the story about the
adopted, entrepreneurial talent will shift into
supply and allocation of productive
productive, innovative directions.
entrepreneurship and the key role of evolving
institutions. In the economic growth literature, it has
often been asserted that an expanded supply of
Recent Studies: Other Disciplines and
entrepreneurs effectively stimulates growth, while
Empirical Approaches
shrinkage in the supply undermines growth. But the
standard explanation of the entrepreneurs’ Outside mainstream economic analysis, research on
appearance and disappearance is shrouded in entrepreneurship has expanded rapidly since the
mystery, with hints about cultural developments and 1980s, particularly that by specialists in man-
vague psychological and sociological changes. The agement, psychology, and sociology. We focus here
historical evidence suggests a more mundane on three streams of work that have attracted the
explanation: that entrepreneurs are always present most scholarly attention: ( a ) how differences
but, as the structure of rewards in the economy among individuals influence entry into (and success
changes, entrepreneurs switch their activities, in) entrepreneurship, ( b ) how environment
moving to where payoffs become more attractive. In influences entrepreneurship, and (c) the strategies
doing so, they move in and out of the activities and forms of organization used by entrepreneurs.
usually recognized as entrepreneurial, exchanging
them for other activities that also require Differences Among Individuals
enterprising talent but are often distant from There are numerous studies investigating how
production of goods and services. The generals of differences among individuals (in attributes such
ancient Rome, the Mandarins of the Tang,
as education, age, experience, social position and Environmental Factors
psychology) are associated with a propensity to A number of industry characteristics influence new
become self-employed and the likelihood of success venture formation. Market size (Pennings ) and
at entrepreneurship. A wide variety of studies have growth (Dean and Meyer ) increase the likelihood
indicated that individuals with higher education ofnew firm formation, while uncertainty from
than the general population are more likely to technological change decreases the rate of business
become entrepreneurs (Shane ). Robinson and start-ups (Audretsch and Acs ). Capital intensity
Sexton ( ) and others have found that also reduces new firm formation by raising entry
number of years of education is significantly related costs (Dean and Meyer ). The density of firms has
to likelihood of becoming self-employed, and Bates an inverted U-shaped relationship with new firm
( ) found that individuals with a formation (Carroll and Wade ). Too few firms in an
graduate education were significantly more likely to industry may signal that there is no opportunity
become self-employed. Age appears to have an worth pursuing, or scarcity of market information.
inverted U-shaped relationship with likelihood of Thus, initial increases in the density of firms in the
forming a new venture. Entrepreneurship first industry encourage business start-ups (Shane ),
increases with age because of experience, and then although high density can increase competition for
decreases with age because of opportunity costs and resources and create an entry barrier.
uncertainty premiums (Bates ; Not surprisingly, the institutional environment
Shane ). of an industry or region also affects new firm
A number of studies that look at how experience formation. Capital availability (for example, low-
influences likelihood of starting a business and the cost debt or venture capital) enhances firm
success of the new venture have found that general formation (McMillan and Woodruff ). Higher
business experience (Evans and Leighton ; marginal federal income tax rates decrease self-
Robinson and Sexton ), experience specific to the employment (Gentry and Hubbard ) and business
industry in which the entrepreneur later founds a tax concessions increase business startups (Dana ).
business (Aldrich ), and prior self-employment Stronger property rights encourage entrepre-
(Carroll and Mosakowski ) neurship, presumably because they assure entre-
all increase the likelihood that an individual will preneurs that they can appropriate the fruits of their
found a new business. Furthermore, such experi- efforts (McMillan and Woodruff ). Researchers
ence tends to improve new venture performance and have also investigated the role of university
survival rates (Gimeno et al. ). technology-transfer offices on entrepreneurship,
Studies have revealed that, in general, social with most research indicating that such offices
status increases the likelihood of forming a new increase rates of new venture formation, particularly
venture (for example, Stuart et al. ). The number when technology-transfer offices are structured to
and diversity of an individual’s social ties also profit from the transfers (Markman et al. ). Finally,
increase the likelihood of founding a company socio-cultural norms about the desirability of self-
(Aldrich et al. ), as well as the success of the employment or the risks of failure are significantly
venture (Hansen ). Psychological factors also related to rates of business start-ups in a nation or
influence an individual’s likelihood of becoming an ethnic group (Butler and Herring ).
entrepreneur (Shane ). In particular, extraversion
(Babb and Babb ), need for achievement (Homaday Strategy and Organization
and Aboud ), risk-taking propensity (Astebro ), self- The area of entrepreneurial strategy that has
efficacy (Zietsma ), overconfidence (Arabsheibani received most research attention is method of
et al. ), and creativity (Ames and Runco ) have all financing. Consistent with Knight’s ( ) argu
been shown to be significantly related to an ment that self-financing is needed to overcome
individual’s likelihood of becoming an
entrepreneur.
moral hazard problems, most entrepreneurs finance insight into the factors that increase the likelihood
their ventures primarily with their own capital of individuals engaging in, and being successful at,
(Aldrich ; Shane ). However, hinds provided by entrepreneurship.
‘angel’ investors (wealthy individuals who invest in Beyond the stationary analysis of standard
entrepreneurial companies, usually at an early stage) microeconomic theory, we see that the entrepre-
and venture capitalists are also important. The neurship models enable us to deal with such
research on angel investment is sparse, but there is important questions as what features of the struc-
more research on venture capitalst investment. A ture of the free market economy have caused it to
number of researchers have investigated how outperform by an order of magnitude the innovation
venture capitalists choose their investments, and growth of any alternative economic system.
mitigate risk, and influence new venture survival The institutional changes that reallocated much of
and growth (Bygrave and Timmons ). Some studies entrepreneurship from redistributive to productive
have also examined how entrepreneurs identify activities are, according to the model, the key to the
opportunities (Shane ), their degree of reliance on answer. And this has profound policy implications
patent protection (Shane ), the effect of both for developing countries seeking desperately
entrepreneurs’ new product development strategies to escape their poverty and for developed
(Zahra and Bogner ), and their breadth of market economies seeking to keep up the pace of their
focus (Bhide ; Gimeno et al. ). growth.
Finally, there also has been some research on the
organization of new ventures how they are formed
as legal entities, the performance implication of this See Also
choice (Delmar and Shane ), and the effect of
venture team size and background (Eisenhardt and
Schoonhoven ). In general, formation as a legal
entity and a large, diverse venture team appear to
improve new venture performance.

On the State of the Theory

of Entrepreneurship
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understanding of physical reality though it is,
entropy is one of the most poorly understood even
by many physicists as a keen
 --------------------B ^
U J

E other idealizations. First, the piston moves revers-

ibly, i.e., with an infinitesimally slow speed, an
assumption which does away with any friction. And
C1-----------------------------------D since any such motion would require an infinite
time, the point exposes one of the basic
anthropomorphic limitations. Second, the piston
performs no other work than turning the cam. And
G
the cam on turning does not change its potential
Entropy, Fig. 1 energy. Third, when the cycle begins, the volume of
the gas is at, say, V q , and its absolute tempera-
ture at 7j. A hot reservoir (a virtually limitless
thermodynamicist, D. ter Haar, opined. A ‘far- source of thermal energy at the same temperature 7j)
fetched’ notion, ‘obscure and difficult of compre- is already attached at AC. On expanding, the gas
hension’ judged J. Willard Gibbs, the architect of absorbs thermal energy from the reservoir at a rate
statistical thermodynamics. It was apposite for Lord that keeps its temperature constant throughout. The
Snow to argue that some familiarity with the law of work thus produced raises the weight from its initial
entropy, the second law of thermodynamics, position G o . Because the internal energy of an
separates the educated into two cultures. But this ideal gas remains constant if its temperature does
condition is quite curious given that the not change and because the work only raises the
fountainhead of thermodynamics is anthropomor- weight, the thermal energy, Q , absorbed by the
phic in a far more pronounced degree than that of gas from the reservoir must at any time be equal to
any other branch of physics. No other physical the work, W .
concept belongs to our ordinary experience as Two observations call now for undivided atten-
inherently as heat and work or temperature and tion. First, the phase considered so far proves that
pressure. Indeed, thermodynamics is at bottom a i t i s p o s s i b l e t o c o n v e r t
physics of economic value as Sadi Carnot initiated t h e r m a l e n e r g y ( h e a t )
it in his famous 1824 memoir about our efficient f r o m a s i n g l e s o u r c e
use of energy (Georgescu-Roegen ). i n t o p o t e n t i a l e n e r g y
An explication of entropy at the ground level ( w o r k ) . Hence, in principle, we could sail
being beset with unusual difficulties, over the years by tapping the immense energy of the ocean water.
the concept has received several, not always Lord Kelvin (1882,1) was not exact therefore when
logically related, definitions. However, there is an he said in 1852 that 7/ i s i m p o s s i b l e
original nature of that concept which can be grasped b y m e a n s o f a n i n a n i -
only by a punctilious description of the so-called m a t e m a t e r i a l a g e n c y , t o
Camot cycle (Georgescu-Roegen ). This cycle - the d e r i v e m e c h a n i c a l e f f e c t
pillar of thermodynamic theory - is a model of f r o m a n y p o r t i o n o f
unmatched idealization of an engine that converts m a t t e r b y c o o l i n g i t
thermal into potential energy. It consists of a piston- b e l o w t h e t e m p e r a t u r e o f
and-cylinder (Fig. ). The cylinder, ABCD, as well t h e c o l d e s t o f t h e
as the piston diaphragm, EF, are made of a perfect s u r r o u n d i n g o b j e c t s .’ The
thermal insulator; the head of the cylinder, AC, true reason is not technical (as we have just seen),
instead is a perfect thermal conductor. The piston- but still another anthropomorphic limitation: no
rod turns a noncircular cam which raises or lowers a human can work with a piston that expands beyond
suspended weight, G . The space AEFC is filled any limit; we must bring it back to begin another
with an ideal gas whose simple properties enable us conversion. But to bring it back we need some
to represent analytically the working of the engine energy. Of course, we could use the potential energy
(Fig. ). The model involves several of the weight to push the piston back reversibly.
That would not do for everything would be just as at
the beginning.
There is, however, a technical means to bring
Entropy, Fig. 2

bA B

C D
V0 V3 V1 V2

assume that the gas expands only to V \ which temperature T and a different cam replaces the
2

raises the weight to G \ (Fig. ). The performed previous one. From V on, Carnot’s law applies: an
2

work, IT, ( Q i ) , is represented by the area energy Q obtained by lowering G to G - , is

2 2

below the segment p o p , of the curve p V constant transmitted to the reservoir through the interme-
which represents the isothermal expansion of the diary of the gas which contracts so that its tem-
ideal gas. The reason for using a cam is that the perature and hence its energy remain constant. At
workp d V is not uniform as V increases. V again the cam is exchanged and the reservoir
3

At V \ , an idealized operation takes place: replaced by a perfect insulator over AC. The gas
instantaneously the hot reservoir is replaced by a continues then to contract this time adiabatically,
perfect insulator covering AC and a different cam from V to V 0 . The work IT3 4 supplied by the
3

replaces the old. During this second phase the gas lowering of the weight from G 3 to G 4 is
expands adiabatically (i.e. without exchanging heat converted into internal energy Q34 Q ]2 because
with the outside) to V 2 , converting Q of its
]2
equal
internal energy into work, IT',2 = Q n - This raises temperature changes cause equal changes of the
the weight further to G 2. By V the temperature of
2
internal energy of an ideal gas.
the ideal gas has decreased to, say, T 2 . Another To sum up: the cycle of the piston is complete,
idealized operation now replaces the thermal from T0 back to T0. Yet the weight is not back at
insulator with a cold reservoir of G 0 , but at G4. For the puzzling contrast we
should recall the role of the cams in the model. It
not be otherwise since the final work of the cycle, In 1865, on the basis of ( ) he defined a new
W , is positive, being represented by the area thermodynamic fimction, S , by
P0P1P2P3; accordingly,

Sa ~ Sb = d Q/T (5)
W = Q\ + 2i2 — Q2 ~ QiA = Qi — Qi (1)

The foregoing analysis proves the correctness of for any reversible path from a state a to b . Then,
the so-called Carnot’s principle, that any heat by ( ) and ( ), always
engine needs two sources of energy of different
temperatures. The point is explicit in Planck’s AS > dQ/T, (6)
amended form of the second law of thermody-
namics as given by Lord Kelvin:
‘It is impossible to construct an engine which will the equality prevailing only for reversible
work in a complete cycle, and produce no effect transformations.
except the raising of a weight and the cooling of a At that juncture, Clausius replaced the term,
heat-reservoir’ (Planck ).
‘transformation’ by its Greek equivalent,
Planck thus negated what Wilhelm Ostwald e n t r o p i , and ended the memoir by the
called perpetual motion of the second kind. famous stanza:
From the equations of the curves of Fig. there
follows an expression of Carnot’s law 1. The energy of the universe is constant.
2. The entropy of the universe tends to a
maximum.
Q2IT2 - Q1/T1 = 0. (2) Although S was then defined only for thermal
equilibrium, it was one of the greatest novelties ever
This surprising relation led Rudolf Clausius (in thought up by a scholarly mind.
an 1854 essay) to interpret Q / T as t h e Once the idea that heat is not an indestructible
t r a n s f o r m a t i o n fluid but a kind of molecular motion gained
e q u i v a l e n t - v a l u e of Q at the credence, to explain thermodynamic phenomena by
temperature T . And, as Lord Kelvin had done a the laws of mechanics became a vital programme.
few months earlier, he proved that for a reversible The most ambitious attempt was that of an 1872
cycle epochal, albeit hard-going, essay by Ludwig
Boltzmann (Brush ). He argued that if the collisions
between molecules follow some (apparently
N = ^ 2 Q i / T i
= 0 or w
=| d Q / T innocuous) rules, the distribution, f i x . l ) , of
= 0. (3) their velocities at any time, t , is such that

Both based the t h e o r e m on the first law H { t ) = J/log/dv (7)

of thermodynamics, W = Y J Q t T = 0 for
an isolated system, and on a formulation of the is never increasing,
second law. Clausius’, which is equivalent to that of
Kelvin- Planck, is still the most transparent one: d H ( t ) / d t < 0, (8 )
H e a t c a n n o t b y i t s e l f
p a s s f r o m a c o l d e r t o a the equality prevailing only for thermal equilibrium.
w a r m e r b o d y . Naturally, Boltzmann went on to claim not only that
Clausius also proved the epochal result that, S = I I , but that ( ) defined entropy for any
with the convention for signs as in ( ), for an thermodynamic system as well.
irreversible cycle
 Since to derive an irreversible property from a (Georgescu-Roegen , VI. 1 and App. F). Then,
completely reversible axiomatic basis was as observing that any state ultimately reaches one of
incredible a feat as claiming that the angles of a the molecular structures corresponding to thermal
triangle in an Euclidean plane add to more than two equilibrium, and that the number, Q, of those
right angles, protests had to come. In 1876, a structures is far greater than that of any other state,
Boltzmann colleague, Joseph Loschmidt, pointed Boltzmann proposed that for thermal equilibrium
out that if at any time the velocities of a system S = log Q, which after the dimensional correc-
satisfying ( ) are reversed, we obtain a system for tion by Max Planck became
which H increases. And twenty years later, Ernst
Zermelo, a pupil of Max Planck, recalled that in 5 = k log Q, (9)
1890 Henri Poincare had proved that any finite
where k is now registered as Boltzmann’s constant.
mechanical system must eventually return as close
As has been observed by Planck ( ),
as we wish to any of its p r e v i o u s positions
the logarithm function must be used in ( ) because
(cf. the elementary illustrations in Georgescu-
for a thermal equilibrium composed of two such
Roegen , pp. 154f). Hence, if I I decreases for
states we know that S = S x + S whereas 2
some time, it must necessarily increase before the
O = Oi + 02 . Later, Boltzmann ( /8 )
return. Boltzmann was at a loss to defend his strong
connected ( ) with ( ) and ( ) by observing that n h
position of 1872 (see Brush ). He asserted that if
being the number of molecules in some state i ,
velocities are reversed the entropy most probably
with n = Y j i i , then the number of possible
would still increase, since his theorem was not
structural combinations for that system is
based on ‘the nature of the forces’ but on the
immensely greater probability of the initial W = n\I n\\m\■ ■ ■ n m\
conditions that yield ( ). But there is no reason for
these conditions - known as (10)
S t o s s e n a n z a h l (statistical postulate) -
to be perpetuated from one collision to the next Hence, granting that every n , is sufficiently
(Georgescu-Roegen , App. C). As to Zermelo’s great, by Stirling’s asymptotic formula for n \ we
entropy recurrence, Boltzmann dismissed it as obtain log W = Y . n , log( n / n ) , where
irrelevant in practice because of the extremely long by putting f = n / n , by analogy to ( ) and ( )
time for the return of present conditions (Brash ). Boltzmann put
Loschmidt’s objection, however, had a weak point,
S = -n k X f l \ o g f l - —nkH,
namely, that systems with reversed velocities do not
exist always in actuality. And in favour of (11)
Zermelo’s, one could imagine that we may be in the
middle of a recurrence period begun eons ago. still another expression for entropy. At least, this
Pressed by persistent criticism Boltzmann formula fared well with the advent of Planck’s
abandoned his purely mechanistic basis of entropy, quantum theory, which explains why Planck, who at
to concede that his 77-theorem ‘can never be proved first opposed Boltzmann’s position, ultimately
from the equations of motions alone, [it] can only changed his mind (1897, seventh edn).
be deduced from the laws of probability’ To buttress the probabilistic interpretation of
(Boltzmann ). Already in 1877, he anchored the law entropy, Boltzmann ( 8 ) ultimately brought
of increasing entropy on the postulate that every in the ideas of ordered and disordered states. Her-
state always passes to one of greater probability. man von Helmholtz had already defined (in 1892)
Reasonable though the postulate may seem, it is not entropy as the measure of disorder, an unfortunate
supported by probability laws: the occurrence of connection as disorder certainly cannot be defined
highly improbable bridge hands is subject to no analytically. Curiously, this definition has had
sequential condition amazing success: the entry for ‘entropy’ in T h e
E n c y c l o p e d i a o f
P h i l o s o p h y opens with it.
a simple, natural explanation of that notion, writers at all that it should also exist. That is why several
have moved deeper and deeper into purely formal scholars have argued that in nature there must also
lucubrations, so that Jacques Hadamard in his 1910 be at work an anti-entropy principle -
review of J. Willard Gibbs’s treatise could say that e k t r o p y , coined by G. Hirth and adopted
statistical thermodynamics is only mathematics by Felix Auerbach, or a n t i - c h a n c e , Sir
(cited in Georgescu-Roegen ). Yet as early as 1882 Arthur Eddington’s term (Georgescu-Roegen ). The
Helmholtz placed entropy in an accessible cadre as dissipative structures, recently set forth by Ilya
he showed that the internal energy, U , of an Prigogine ( ) to
isolated system consists of free (or available) portray the entropic process specific to living
energy, h \ and of bound (or unavailable) energy organisms imply as Prigogine recognizes, a new
measured by T S . Hence, if we represent U by a crowning of the Spencerian tenet.
rectangle of base T , the entropy would indicate A real imbroglio involving the entropy concept
the height for separating the b o u n d energy. It grew from the seminal work of Claude H. (Shannon
was with the introduction of the relation F = U and Weaver ) on the purely technical problem of
— T S that the importance of the singular communication, which is to find out how many
concept, entropy, was brought to the surface. It was distinct sequences (messages) of a given length can
only thereafter that one could translate Clausius’s be formed by a code, a set of different single
entropy law into signals. For the communication engineer it is totally
irrelevant what each message may mean. However,
The free energy of any isolated system continuously
degrades into bound energy. that meaning must be understood by both the
originator and the intended receiver. Knowledge
It is this form that pinpoints the reason for the thus passes from the former to the latter; while in
supreme role of entropy in all nature, as has been transit, it is information (a distinction analogous to
recognized by great luminaries such as Sir Arthur the heat being thermal energy in transit).
Eddington and Albert Einstein. Interestingly, Lord For messages transmitted in a vernacular lan-
Kelvin who first spoke (in 1852) of ‘The Universal guage, Shannon found that the ratio of messages per
Tendency in Nature to the Dissipation of Energy’, letter is given by the same formula as H in ( ) if
hardly ever used the term ‘entropy’. And Walter the f ' s represent the statistical frequencies
Nemst, another illuminator of thermodynamics, ofthe corresponding alphabet. Seeking a name for
even decided not to have recourse to it. his new formula (a measure ofthe efficiency ofthe
We should next recall that just as the foundation code), Shannon accepted the suggestion of John von
of classical thermodynamics was being laid, Herbert Neumann: ‘entropy’. But the mere coincidence of
Spencer came forth with some tenets that presaged formulae was not a basis for justifying the
Darwin’s own theory. One was that ‘the terminological transfer. We would not call ‘kinetic
homogeneous is the hotbed ofthe heterogeneous’, energy’ the second moment of a distribution just
which looks like a characterization of living sys- because both formulae are a sum of squares:
tems. Lord Kelvin (quoted earlier) as well as t ] t X j . With that transfer, the
Helmholtz thus were not prepared to admit that the concept
entropic degradation applies to animated matter, of entropy started travelling from one domain to
too. Later Henri Bergson even claimed that life another with hardly any discrimination. One now
opposes that degradation. Of course, life does not speaks of the income distribution in country A
violate the entropy law, for as Erwin Schrodinger being greater than in B, although the student
was to put it not very long ago, a living creature is interested in B will certainly think otherwise. And
not an isolated system: it exchanges entropy with its the reader is dizzied by the frequent phrases in
environment. Yet from the fact that such a which ‘information’, ‘knowledge’, ‘negentropy’,
phenomenon is not impossible thermodynamically, intervene pell-mell. Further, O, Onicescu suggested
it does not follow that can also serve as ‘informational energy’, which,
of course, could not be related to the real entropy.
Most important, in a
vignetted article, ‘The Bandwagon’, Shannon Pynchon in 1960, A g a i n s t E n t r o p y
himself protested without delay the use of ‘entropy’ by Michael Frayn (1967). Clausius certainly did not
beyond the domain of technical communication foresee this development from his coinage of the
(Georgescu-Roegen ). bizarre word.
The idea that the entropic degradation of any-
thing is in fact a Toss of information’ was set forth See Also
earlier by a consummate thermodynamicist,
G. N. Lewis ► nformatio 7 1 ory
(S c i e n c e , 1930). But it was
E.T. Jaynes who after the spread of Shannon’s
theorem set out to erect thermodynamics on that Bibliography
basis alone. In spite of its bizarreness, or perhaps
Boltzmann, L. 1895. On certain questions of the theory of
because of it, the idea is still running in some
gases. Nature 51: 413-415.
circles. So, in his recent primer ( T h e Boltzmann, L. 1896-98. Lectures on gas theory. Trans, from
S e c o n d L a w , 1984), P.W. Atkins was German by S.G. Brush. Berkeley: University of
in good order to deliberately omit any reference to California Press, 1964.
Brush, S. 1966. Kinetic theory, vol. 2. Oxford: Pergamon
entropy and information because of the Press.
‘muddleheadedness’ of the idea that entropy is not a Carnot, S. 1824. Reflections on the motive power of fire, and
property, of an engine but of the engineer’s mind. on the machinesfitted to develop that power. Trans, and
While the concept of entropy was thus ed. R.H. Thurston. New York: Dover, 1960.
Clausius, R. 1867. In The mechanical theory of heat with its
converted almost at will, a vital issue found no application to the steam engine and to the physical
place in thermodynamics, namely, the macroscopic properties of bodies, ed. T.A. Archer. London: John van
role of matter. Matter is mentioned but only Voorst.
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 potential entrant is non-positive. This value, X , is
Entry and Market Structure called the l i m i t o u t p u t (and the
corresponding price the l i m i t p r i c e )
B. Curtis Eaton because, given the Sylos postulate, there will be no
entry if and only if X > X . (We assume for
convenience that zero profit does not induce entry. )
Two important insights are already clear. First,
Entry - and its opposite, exit - have long been seen potential competition constrains the ability of the
to be the driving forces in the neoclassical theory of established firm to exploit its position of market
competitive markets. Long-run equilibrium in such power since the no-entry condition (X > X) places a
a market requires that no potential entrant finds lower bound on industry output in long- run
entry profitable, and that no established firm finds equilibrium. Second, by producing at least X units
exit profitable. In conjunction with the price-taking of output, the established firm can deter entry. In
assumption, the first condition requires that price be one case central to the evolution of the literature,
no greater than minimum average cost, AC , and the entry deterrence is also always profitable.
second that price be no less than AC . Hence, in Suppose that the established firm’s average cost
equilibrium, price is equal to AC . There is very function is nowhere upward-sloping, and that the
little more to the theory of equilibrium in a interest rate is not too high. In this situation, the
competitive market than this simple yet powerful established firm will always choose to deter entry
story of no-entry and no-exit. by producing at least X . There are two sorts of
Surprisingly, considerations of entry and solutions. If the ordinary monopoly output, M, is
potential competition, so central to the economist’s greater than or equal to X , then the monopolist will
view of competitive markets, played almost no role produce M, and we have what we could call
in oligopolistic and monopolistic markets until the n a t u r a l m o n o p o l y , in the positive
work of Bain ( ) and Sylos-Labini sense of the term. If M < X , the monopolist
( ) in the mid-1950s. One important strand of produces X to deter entry strategically, a case of
the modem literature on entry combines, in essence, a r t i f i c i a l m o n o p o l y . When
their insights into the role of potential competition M < X the monopolist must choose between
in oligopolies with Schelling’s ( ) ideas on deterring and accommodating entry. Relative to the
commitment. This essay focuses deterrence strategy - produce X today and forever -
on this strand of literature. accommodation produces larger profit for the one
In reviewing Bain ( ) and Sylos-Labini established firm today (since today’s output will be
( ), Modigliani ( ) proposed what has M) but smaller profit tomorrow and forever (since
come to be known as the l i m i t - o u t p u t price will be no higher than the limit price and the
(more commonly, l i m i t - p r i c e ) model, established firm’s output will be less than X ). If the
which is a formalization of one of the key ideas in rate of interest is not too high, it is obvious that the
these books. One version of this model has been the established firm will choose to deter entry.
focal point of much of the recent literature on entry. The essence of both solutions is a message
Consider a market for some undifferentiated good, which the established firm wants to communicate to
currently served by o n e e s t a b l i s h e d potential entrants. ‘If you enter, then my output will
firm, in which demand and cost conditions are be (no smaller than) X .’ This ‘deterrence message’
unchanging over an infinite time horizon. Now has the property that it deters entry - if it is
suppose that all potential entrants take the believed. It raises the obvious credibility question,
established firm’s output today, denoted by X, as ‘Would the established firm really produce the
the output which it will produce tomorrow and promised output post-entry’? Much of the recent
forever - the so-called Sylos postulate. Let X denote literature on entry has implicitly or
the smallest value of X such that the maximized
profit of a representative
explicitly focused on this question. Four interrelated important features: (1 ) commitments, which inev-
insights have emerged. itably involve s u n k c o s t s , are made in
First, to answer the credibility question we can earlier stages of the game; ( 2 ) the net revenues
use Schelling’s distinction between threats and which justify these sunk costs are generated only in
commitments ( ). The deterrence message is later stages. As Brander and Spencer ( ) observe,
a commitment if, entry having occurred, it is in the this form is an unavoidable feature of economic
established firm’s self-interest to produce X , or if reality. Product development costs, for example,
the production of X follows automatically. Other- must be sunk prior to production; the costs asso-
wise the message is a threat and is not credible. To ciated with specific capital goods must be sunk prior
implement this approach we need a model of to production, and so on.
oligopoly. Given such a model, all interested parties A rational firm must therefore think of com-
can compute the post-entry equilibrium, providing a mitments in the way it thinks of other investment
direct answer to the credibility question. decisions. In particular, it must form expectations
Second, by virtue of being there first, the about how decisions with respect to today’s com-
established firm has the opportunity to make mitments will alter its net revenues tomorrow, and
i r r e v e r s i b l e d e c i s i o n s thereafter. In the presence of sunk costs,
which alter its real economic circumstances in any r a t i o n a l or c o n s i s t e n t
post-entry oligopoly game. These irreversible expectations are a desirable feature of any
decisions can sometimes make the established firm equilibrium concept. If firms’ expectations are not
a more aggressive competitor post-entry, and constrained to be rational, then any outcome is
therefore serve to make the deterrence message possible - that is, given an outcome, there is a set of
more believable. That is, the established firm has expectations which will produce it. Rational
the opportunity to do some things prior to entry expectations are then necessary to constrain results.
which cannot be undone subsequent to entry, and See, for example, the discussions in Eaton and
which affect the profitability of entry. It is Lipsey ( , ) and
convenient to refer to these irreversible decisions as Dixit ( ) on this point. Given this view,
c o m m i t m e n t s . As Spence ( ) Selten’s ( ) notion of sub-game perfection is
observed, since the rate at which output is the appropriate equilibrium concept in these entry
produced is reversible, producing the limit output games.
prior to entry is not a commitment and therefore has To convey the flavour of modem theories of
no bearing on the credibility of the deterrence entry and to see how rational expectations enter the
message. However, holding the capacity or capital analysis, it is instructive to write down a simple
to do so is - provided that it is specific. By acquiring entry game and to consider the way in which one
specific capital, the established firm reduces its finds the perfect equilibrium. Most of the recent
marginal cost, making it more aggressive in any literature on entry has focused on exercises which
post-entry oligopoly game. Inventory (analysed by involve one established firm and one potential
Ware ) is a particularly illuminating commitment entrant, and which are not a great deal more
since it puts the firm in the position of having zero complex than the following illustration.
marginal cost post-entry (until its inventory is Consider an entry game played in three stages.
exhausted). In stage 1, firm 1 (the established firm) chooses the
The third insight, which arises from the attempt value of some commitment, c \ . In stage 2 ,
to implement the first two, concerns the f o r m knowing the value of c \ , which firm 1 chose in
of the game which established firms and potential stage 1 , firm 2 chooses a value for its commitment,
entrants play, and the appropriate c2. By appropriate choice of units, we can interpret
e q u i l i b r i u m c o n c e p t which c \ and c2 as costs, which once they are incurred
this form seems to imply. Even in the simplest of are sunk. These sunk costs might, for example, be
circumstances, any game involving established expenditures on advertising or on cost-reducing
firms and potential entrants is a m u l t i - research and development. In stage 3, the two firms
s t a g e g a m e played out in real time with play a market game in
two
which goods are produced and sold and the net (Schmalensee ), the location of retail outlets (Eaton
revenues which justify the upstream sunk costs are and Lipsey ), patenting (Gilbert and Newbery ),
realized. leaming-by-doing (Spence ), the durability of
To find the perfect equilibrium of this game we specific capital (Eaton and Lipsey ), the exercise of
work backwards. monopsony power (Salop and Scheffman ) and, of
course, specific capital (Spence ; Dixit and Ware )
Stage 3 Given an oligopoly model which deter- are just some of the vehicles for commitment which
mines the equilibrium of the market game, the net have been considered.
revenue to each firm in stage 3 is determined by c \ This rich set of games and possible solutions
and c 2 . Denote these net-revenue functions by brings us to the fourth insight in this literature.
I h ( c u Cl) and Fhfyi, c 2 ) If, for example, Implicit in this way of thinking about oligopolistic
the oligopoly model is the Cournot model, then in markets, and the role which entry plays in those
stage 3 each firm chooses its own quantify to markets, is much more than a theory of how one
maximize its revenues minus its a v o i d a b l e established firm strategically positions itself with
costs. The net-revenue functions are simply respect to one potential entrant. There is, in this
revenues minus avoidable costs in the Cournot paradigm, a theory of market structure, a theory
equilibrium. which remains largely unexplored.

Stage 2 If firm 2 is to have rational expectations, it

must know ILfTh c i ) ' This, of course, means See Also
that it knows the oligopoly model which determines
the equilibrium of the market game. In stage 2 ,
knowing its net-revenue function and the value of
c firm 2 chooses c2 to maximize [n2 (ci, c ) - 2

c 2 ] . The solution to this maximization problem

determines c as a function of c i : c = g(ci).
2 2

Stage 1 Rational expectations for firm 1 means that

it knows both g(e, ) and fy[, (c ,, c 2). In stage 1 it
Bibliography
chooses c i to maximize [rii(ci> c i ) ~ c i \
subject to c 2 = g(ci). The only endogenous Bain, J.S. 1956. Barriers to new competition. Cambridge:
variable in this maximization problem is c \ and Harvard University Press.
the solution to it therefore determines a value for Brander, J.A., and B.J. Spencer. 1983. Strategic commitment
with R&D: The symmetric case. Bell Journal of
c \ say c !. Firm 2 then chooses Ify (c i, c 2), and Economics 14(1): 225-235.
in the third stage of the game the firms realize Il 2 (c Cubbin, J. 1981. Advertising and the theory of entry barriers.
i, c * 2 ) and c* = g(c*). Economica 48: 289-298.
Dixit, A. 1980. The role of investment in entry deterrence.
In this sort of game the established firm may or may Economic Journal 90: 95-106.
Eaton, B.C., and R.G. Lipsey. 1979. The theory of market
not be able to deter entry, and if it is able, it may or preemption: The persistence of excess capacity and
may not choose to. Duopoly solutions will, monopoly in growing spatial markets. Economica
however, be asymmetric. The established firm will 46(182): 149-158.
rig the duopoly market structure to its own Eaton, B.C., and R.G. Lipsey. 1980. Exit barriers are entry
barriers: The durability of capital as a barrier to entry.
advantage. Bell Journal of Economics 11(2): 721-729.
Using this approach, or one that is in the spirit Gilbert, R.J., and D.M.G. Newbery. 1982. Preemptive
of this one, the recent literature on entry has patenting and the persistence of monopoly. American
focused on many of the commitments which Economic Review 72(3): 514—526.
Modigliani, F. 1958. New developments on the oligopoly
established firms can and, indeed, must make. front Journal of Political Economy 66: 215-232.
Advertising (Cubbin ), brand proliferation Salop, S.C., and D.T. Scheffinan. 1983. Raising rivals’ costs.
American Economic Review 73(2): 267-271.
Schelling, T.C. 1956. An essay on bargaining. American
JEL Classifications
Economic Review 46: 281-306.
D2
Schmalensee, R. 1978. Entry deterrence in the ready-to-eat
breakfast cereals industry. Bell Journal of Economics
9(2): 305-327. The origin of this famous theorem is the discussion
between Jacob Viner (
Selten, R. 1975. Re-examination of the prefectness concept ) and his
for equilibrium points in extensive games. International
draughtsman Y.K. Wong concerning the relation-
Journal of Game Theory 4(1): 25-55.
ship between short- and long-run average cost
Spence, A.M. 1977. Entry, capacity, investment and oli-
curves. Viner had apparently reasoned that since in
gopolistic pricing. Bell Journal of Economics 8(2): 534-
544. the long run average costs should be at a minimum,
Spence, A.M. 1981. The learning curve and competition. Bell
the long-run average cost (LRAC) curve should not
Journal of Economics 12(1), Spring: 49-70.
only always be below the short-run average cost
Sylos-Labini, P. 1956. Oligopolio e progresso technico.
Milan: Giuffrc. (SRAC) curves, but should also pass through the
minimum points of each short- run curve. Wong
Ware, R. 1984. Sunk costs and strategic commitment: A
proposed three-stage equilibrium. Economic Journal 94:
pointed out the impossibility of this joint
370-378.
occurrence, and Viner opted to draw the long-mn
Ware, R. 1985. Inventory holding as a strategic weapon to
deter entry. Economica 52: 93-101. curve through the minimum points, thereby
necessarily passing above sections of the short mn
curves. It was also puzzling (in the now corrected
diagram) that at the point of tangency between the
LRAC and a SRAC, the rate of change of average
cost with respect to output was the same when
Envelope Theorem capital was fixed as when it was allowed to vary.
The puzzle was solved by Samuelson ( ),
Eugene Silberberg who showed in a general
way why the long-run curve would be the ‘enve-
lope’ curve to the set of short-ran curves. Perhaps
the most surprising result of all was that this
Abstract seeming mathematical curiosity turned out to be the
The envelope theorem appeared in economics fundamental basis for the development of refutable
following the 1931 Viner-Wong diagram comparative statics implications in economics.
(incorrectly drawn in the original paper). This
famous paper indicated that, starting at some
Unconstrained Maximization Models
minimum cost input combination, the change of
average cost when output changed was the same The most general comparative statics model with
whether or not other inputs were allowed to vary explicit maximizing behavioin is m a x i m i z e
or were held fixed. This puzzling result y = f i x , a ) subject to g ( . x , a ) =
remained mostly a curiosity until the 1970s
0 , where x = (*!,..., x „ ) is a vector of decision
when, with the use of a generalization of this
variables, a = (alv .., t x m ) is a vector of
diagram, the modem theory of duality was
parameters (though for simplicity, we treat a as a
developed. This new approach to comparative
scalar in the discussion below), and g(') represents
statics provided a clearer explanation for the
one or more constraints. Models at this level of
appearance of refutable implications in maxi-
generality, however, imply no refutable implications
mization models.
and are hence largely uninteresting. In particular,
Keywords there are never refutable implications for parameters
Comparative statics; Constrained optimization that enter the constraint (see, for example,
models; Cost functions; Envelope theorem; Silberberg and Suen ). We therefore initially restrict
Lagrange multipliers; Primal-dual model; the
Shadow pricing
analysis to models of unconstrained maximization: non-maximizing) x,’s are chosen, and, since
< f > ( a) is the m a x i m u m value of / for
maximize y = f ( x , a ) (1 ) given a, f i x 0 , a) < < p ( a) in any
neighbourhood around a0. This implies that r/j and /
The necessary first-order conditions (NFOC) are must be tangent at a0 - (assuming differentiability),
and, moreover, / must be either more concave or less
f f x , a) = 0 i = 1 ,n (2 ) convex than < f i there. Since this must happen for
The sufficient second-order conditions (SSOC) are arbitrary a, similar tangencies occur at other values
that the H e s s i a n matrix H = iffi is negative of a . It is apparent from Fig. that </>(a) is the
definite. Alternatively, the principal minors of order e n v e l o p e of the /(x|, x2, a)’s for each a .
(size) k of the Hessian determinant H = |/,;| What surprised most researchers was the discovery
have sign ( I )/l . Assuming the sufficient second- that all comparative statics theorems in
order conditions hold, we can in principle ‘solve’ maximization models are in fact consequences of the
for the n explicit choice functions x = x (a). relative curvatures of f and f
Of coiuse, since these choice functions are the result From the above discussion, the function F ( x ,
of solving the NFOC simultaneously, each indi- a ) = f i x , a ) — ( p ( a ) has a
vidual X j is a function of a l l the parameters, maximum of zero, with respect to both x and a. Thus
not just ones which might appears in some f. we consider the p r i m a l — d u a l model
Substituting thex*’s into the objective function
yields the i n d i r e c t o b j e c t i v e
m a x i m i z e F { x , a) =/(x, a) —
f u n c t i o n < p ( a ) f i x (- a), a), < p ( y ) (3)
the maximum value of/for given a. Since
< f > ( y ) is by definition a maximum value,
4> ( a ) > f i x , a ) , but r/)(z) = where the maximization runs over x and also a .
f i . x , a) when .r = .r . In Fig. , a typical (In the latter instance, we ask, for given x,’s, what
( f i x ) is plotted. For an arbitrary a 0, an x° = values of the parameters would make these x,’s the
A'*(Z°) is implied. Consider the behaviour of f ( x , maximizing values?) The NFOC with respect to x
a ) when the x j s are held fixed at x° as opposed are the same as in the original model. With respect
to when they are variable. When a = a 0, the ‘correct’ to a, the NFOC yield the famous ‘envelope theorem’
x,’s are chosen, and therefore < p ( a ) — which is the tangency off and < f i in Fig. :
f i x 0 , a) at that one point. However, both to the
left and to the right of a0, the ‘wrong’ (that is
Fa = f a - 4> « = 0 (4)

a
In the a dimensions, the second-order conditions are Each parameter vv, enters only the i t h
simply NFOC, and/, „ = — 1 , so that ( ) yields the slope
property d x * / d W i < 0 ; the factor
F a a =/«« - 4 > m < 0. (5) demand functions are downward sloping in their
own price.
This inequality says that in the a dimensions,/is
The envelope theorem also yields the non-
relatively more concave than /. (When a is a vector,
intuitive ‘reciprocity’ conditions. Suppose there are
this second-order condition is that the Hessian
two parameters a and /). Then from invariance of
matrix (Faa) is negative semi-definite. ) This is the
second partial derivatives to the order of differ-
fundamental geometrical property that underlies all
entiation (Young’s theorem), ( p y . / t =
comparative statics relationships. The NFOC ( ) are
</>#*• Using Eq. ( ) above,
identities when .r = x * . That is, ^ da
(10)
<£«(«) = f a (**(«),«) (6)
When the objective function contains a linear
Differentiating with respect to a, expression such as in the profit maximization
model, that is, H'JXJ + ... + w , p c , „ we have
// d x* f X j W j = —1 andf x w = 0,/ j . In that case,
= (7) ( ) reduces to the simple expression = -j-A This
result also occurs in consumer theory for the
Rearranging terms, using ( ) and invariance to the Hicksian demands.
order of differentiation,

Constrained Maximization Models

n
fly*
0
<faa -fa a = Y^fia ~g^ > 8
( ) Consider now the general comparative statics model
with constraints, m a x i m i z e y =
This is the fimdamental relation of comparative f i x , a ) subject to g ( x , a ) = 0 ,
statics. From it, we can derive Samuelson’s famous where g( ) represents one or more constraints.
‘conjugate pairs’ theorem that refutable Assuming just one constraint for the moment, the
implications occur in maximization models when Lagrangian for this model is L f ( x , a) +
and only when a parameter enters one and only one X g ( x ) , producing the NFOC
firstorder condition. For in that case, where say a
L i = f i ( x , a ) + Xg - t ( x , a) 0 i
enters only/ = 0 , f j a 0 , / / i , and so ( ) reduces
to one term: (1 1 )

L A = g ( x, x ) = 0 (12)
Assuming the SSOC, we can in principle ‘solve’
for the n + 1 explicit choice functions x = v iz)
In this case we can say that the response of .r, is and / (z). We derive the indirect objective function
in the same direction as the disturbance to the as before by substituting thc/ ’s into the objective
equilibrium (or, in the case of minimization models, function producing /(a) f ( x ( x ) , a), the maximum
in the opposite direction). For example, consider value o f f for given a, now also subject to the
the profit-maximization model constraint. Proceeding as above, since /(a) is by
definition a maximum value, /- (a) > f [ x , a ) ,
maximize n = f ( x , w , p ) but /(a) f [ x , a) when v x * . Thus the
function F ( x , a) = f i x , a) — /(a) has a
= p d( xu . . ., x „ ) ~Y W ‘ X ‘ (constrained) maximum of zero, with respect to
both x and a. Thus we consider the p r i m a l -
 m a x i m i z e F ( x , a) =/(x, a) — multiplier imputes a ‘shadow price’, a marginal
/(a) (13) evaluation of that resource, since X ( k ) is the
rate of change of the maximum value of output with
subject to g( x , a) = 0 (14)
respect to a change in the availability of that
where the maximization runs over .r and also a . resource. This is a very widespread use of
The Lagrangian for this model is Lagrangian analysis in economics. For example, the
fundamental model from which we derive the cost
L = f ( x , a) — ( f ) (o t ) + Xg ( x , a) (15) curves for a firm is, m i n i m i z e C =
' F w j x l subject t o f i x ) = y, where y
The first-order conditions with respect to .r are the
is a parameter. Using ( ), the Lagrange multiplier in
same as in the original model. With respect to a ,
this model is the marginal cost function
we get the envelope theorem in its most general
d C * / d y = A,*(w, y ) .
form,
To further show the powerful nature of this
analysis, consider the two-factor, two-goods model
4>* = L « = f « + X g a (16)
that plays an important part of international trade
At this level of generality, it is not possible to theory:
generate any useful curvature properties of </>(a).
However, consider the case where a does not enter maximize NNP = p l y l + p y2 2

any constraint. In that case, g a = 0 and the subject to :

y, = f ( L u K ) y = f { L , K ) L x + L
1
NFOC reduce to ( ) above, that is, F a = f a 1 2 2 2 2

( j ) v _ 0. = LKi + K 2 = K
Moreover, when a does not enter the constraint, where / 1 and / 2 are production functions using
the primal-dual model is a n
labour ( L ) and capital (AT) in each of two
u n c o n s t r a i n e d m a x -
industries with outputsy 1 and y2; output pricesp \
i m i z a t i o n i n a . Hence in the a
andp 2 and labour and capital endowments L and
dimensions, the second-order conditions are as
K are parametric. We can enumerate the salient
before:
properties of this model just by inspection, using the
above results. The Lagrangian for this model is L
Fa* = f * * - <t>** < 0. (17)
= P i y 1 + P m + h ( f \ L x , K l ) - y i )
Thus in this important class of models, the com- + h ( f ( L 2 , K 2 ) - y 2 ) + X l ( L
2

parative statics are identical to the models with no - L x - L 2 ) + X t f i K - K i -

constraints. We obtain the inequalities ( ) and ( ) in K 2 ) . Assuming the NFOC and SSOC hold, we
the same manner as above. solve the NFOC for the output supply functions
Consider now an important class of models y * i ( P i ’ P 2 ’ L ’ K ) an
d
having the structure maximize f i x ) subject to y ( p i , p , L , K ) , and the Lag- range
2 2

gf.r) k , where we suppress all parameters except multipliers, particularly X * L ( p , p , L , K ) 1 2

k , which is the focus of this analysis. The and X * K { p 1 , p 2 , L , K ). Substituting yj(')

Lagrangian for this model is L f i x ) + X ( k and y 2 ( - ) into the objective function, we get
— g ( x )); assuming the NFOC and SSOC are the maximum value of N N P for given prices and
valid, we solve for the explicit choice functions x resource constraints, 4 > i P u P 2, k ,
= x ( k ) and X (k ) . The indirect K ) . Since prices enter the objective function
objective function is < f > - ( k ) f ( x only, and in the classic linear form, ( ) immediately
( k j ) , the maximum value o f f for given k . yields the envelope relations = y*(-). We also note
The envelope theorem ( ) yields ( f ) L = X * L { - ) a n d ( f > K =
Ijj(-). The primal-dual model is, m a x i m i z e
&=X * { k ) (18) F = P i } ’ i + P 2 > > 2 - <^(p>b P 2 ,
L , K ) subject to the same constraints above.
Suppose the function / represents the value of
Since p \ and p 2 do not enter the constraints, F
output, and the constraint describes a limitation on
sloping. Furthermore, from ( ), the Lagrange criterion and the related method of assessment
multipliers X* and X' are the imputed values of
L K known as benefit-cost analysis. Also reviewed
laboiu and capital. If an additional increment of are the means of environmental policy, that is,
labour, say, became available, X* would represent its
L
the choice of specific policy instruments, fea-
marginal value product, and hence its implied wage turing an examination of potential criteria for
in a competitive economy. Without further assessing alternative instruments, with focus on
assumptions (for example, concavity of the pro- cost-effectiveness. The theoretical foundations
duction functions), we cannot determine a sign for and experiential highlights of individual
how these imputed values change when the resource instruments are reviewed, including conven-
endowment changes: d X* / d L L / 0 . The tional command-and-control mechanisms and
reciprocity relationships are straightforward: market-based instruments.
4’ p , r = d X\/ d p 2 = d Xy d p 1 = <t> , and simi-
P2Pl

larly, (f> = d X* / d K = d X* j d L = (f> . We also find

LK L K KL Keywords
< p P i L = d X\/ d L = d Xj d =
p Asymmetric information; Averting behaviour;
< f > L p , and so on. It seems unlikely that Jacob Benefit-cost analysis; Bequest value; Coase, R.;
Viner could have imagined what the corrected Command-and-control instruments; Contingent
version of his diagram would eventually lead to! valuation (CV); Cost- effectiveness; Efficiency;
Environmental economics; Existence value;
General equilibrium analysis; Hedonic pricing
See Also methods; Hedonic wage method; Insurance
premium taxes; Kaldor-Hicks criterion; Market-
based instruments; Net present value (NPV)
analysis; Nonuse value; Pareto, V.; Partial
► Hicksian and Marshallian Demands
► Le Chatelier Principle equilibrium analysis; Pigou, A.; Pigouvian tax;
Pollution charges; Random utility models;
Bibliography Recreation; Reservation price; Revealed
preference; Revenue cycling; Risk reduction;
Samuelson, P.A. 1947. Foundations of economic analysis. Social discount rate; Tax differentiation;
Cambridge, MA: Harvard University Press. Tradable permits; Travel cost method; Use
Silberberg, E., and W. Suen. 2000. The structure of eco- value; Value of a statistical life (VSL);
nomics. 3rd ed. New York: McGraw-Hill.
Viner, J. 1931. Cost curves and supply curves. Zeitschrift fur Willingness to accept; Willingness to pay
Nationalokonomie 3, 23-46. Repr. in American Economic
Association. 1952. Readings in price theory. Homewood:
Irwin.

JEL Classifications
Q5

The fundamental theoretical argument for govern-

ment activity in the environmental realm is that
Environmental Economics
pollution is an externality - an unintended conse-
quence of market decisions which affect individuals
Robert N. Stavins
other than the decision maker. Providing incentives
for private actors to internalize the full costs of their
actions was long thought to be the theoretical
solution to the externality problem. The primary
Abstract
advocate of this view was Arthur Pigou, who in
An overview is provided of the economics of
T h e E c o n o m i c s o f
environmental policy, including the setting of
W e l f a r e ( )
goals and targets, notably the Kaldor-Hicks
proposed that the government should impose a tax
on emissions equal to the cost of the related dam- function for the source, and q * is the efficient
ages at the efficient level of control. level of protection (pollution abatement). The key
A response to the Pigouvian perspective was necessary condition that emerges from the
provided by Ronald Coase in ‘The problem of maximization problem of Eq. is that marginal
social cost’ ( ). Coase demonstrated that, in a benefits be equated with marginal costs (on the
bilateral assumption of convexity of the respective
bargaining environment with no transaction costs, functions).
wealth or income effects, or third-party impacts, The Kaldor-Hicks criterion is clearly more
two negotiating parties will reach socially desirable practical than the strict Pareto criterion, but its
agreements, and the overall amount of pollution normative standing is less solid. Some have argued
will be independent of die assignment of property that other factors should be considered in a measure
rights. At least some of the specified conditions are of social well-being, and that criteria such as
unlikely to hold for most environmental problems. distributional equity should trump efficiency
Hence, private negotiation will not - in general - considerations in some collective decisions
frilly internalize environmental externalities. (Sagoff ). Many economists would agree with this
assertion, and some have noted that the Kaldor-
Hicks criterion should be considered neither a
Criteria for Environmental Policy necessary nor a sufficient condition for public
Evaluation policy (Arrow et al. ).

More than 100 years ago Vilfredo Pareto ( )

enunciated the well-known normative criterion for Benefit-Cost Analysis of Environmental
judging whether a social change makes the world Regulations
better off: a change is Pareto efficient if at least one
person is made better off and no one is made worse The soundness of empirical benefit-cost analysis
off. This criterion has considerable normative rests upon the availability of reliable estimates of
appeal, but virtually no public policies meet the test. social benefits and costs, including estimates of the
Nearly 50 years later Nicholas Kaldor ( ) social discount rate. The present value of net
and John Hicks ( ) postulated a more prag benefits (PVNB) is defined as:
matic criterion that seeks to identify ‘potential T
Pareto improvements’: a change is welfare- PVNB = Y { ( B , - C t ) ■ (1 + r)-'} (2)
improving if those who gain from the change could (=0

- in principle - fully compensate the losers, with (at where B t are benefits at time t , C t are costs
least) one gainer still being better off. at time t , r is the discount rate, and T is the
The Kaldor-Hicks criterion - a test of whether terminal year of the analysis. A positive PVNB
total social benefits exceed total social costs - is the
means that the policy or project has the potential to
theoretical foundation for the use of the analytical yield a Pareto improvement (meets the Kaldor-
device known as benefit-cost (or net present value) Hicks criterion). Thus, carrying out benefit-cost or
analysis. If the objective is to maximize the ‘net present value’ (NPV) analysis requires
difference between benefits and costs (net benefits), discounting to translate future impacts into
then the related level of environmental protection equivalent values that can be compared. In essence,
(pollution abatement) is defined as the efficient the Kaldor-Hicks criterion provides the rationale
level of protection: both for benefit-cost analysis and for discounting
(Goulder and Stavins ).
Choosing the discount rate to be employed in an
max Y \BMi) - CMi)} <7*
analysis can be difficult, particularly where impacts
(x) are spread across a large number of years involving
more than a single generation. In
where q , is abatement by source i ( i = 1 to
theory, the social discount rate could be derived by recycling (using emission tax or auctioned permit
aggregating the individual time preference rates of revenues to reduce distortionary taxes ) can make
all parties affected by a policy. Evidence from the costs of pollution control significantly less than
market behaviour and from experimental economics they would otherwise be (Goulder ).
indicates that individuals may employ lower In a retrospective examination of 28 environ-
discount rates for impacts of larger magnitude, mental and occupational safety regulations, Har-
higher discount rates for gains than for losses, and rington et al. ( ) found that 14 cost estimation
rates that decline with the time span being analyses had produced ex ante cost estimates that
considered (Cropper et al. ; Cropper and Laibson ). exceeded actual ex post costs, apparently due to
In particular, there has been support for the use of technological innovation stimulated by market-
hyperbolic discounting and similar approaches with based instruments (see below).
declining discount rates over time (Ainslie ;
Weitzman , ), The Benefits of Environmental Regulations
but most of these approaches are subject to time Protecting the environment usually involves active
inconsistency. employment of capital, labour, and other scarce
resources. The benefits of an environmental policy
The costs of Environmental Regulations are defined as the sum of individuals’ aggregate
In the environment context, the economist’s notion willingness to pay (WTP) for the reduction or
of cost (or, more precisely, opportunity cost ) is a prevention of environmental damages or
measure of the value of whatever must be sacrificed individuals’ willingness to accept (WTA) com-
to prevent or reduce the risk of an environmental pensation to tolerate such environmental damages.
impact. A full taxonomy of environmental costs In theory, which measure of value is appropriate for
ranges from the most obvious to the least direct assessing a particular policy depends upon the
(Jaffe et al. ). related assignment of property rights, the nature of
Methods of direct compliance cost estimation, the status quo, and whether the change being
which measure the costs to firms of purchasing and measured is a gain or a loss; but under a variety of
maintaining pollution-abatement equipment plus conditions the difference between the two measures
costs to government of administering a policy, are may be expected to be relatively small (Willig ).
acceptable when behavioural responses, transitional Empirical evidence suggests larger than expected
costs, and indirect costs are small. Partial and differences between willingness to pay and
general equilibrium analysis allows for the willingness to accept (Fisher et al. ). Theoretical
incorporation of behavioural responses to changes explanations include psychological aversion to loss
in public policy. Partial equilibrium analysis of and poor substitutes for environmental amenities
compliance costs incorporates behavioural (Hanemann ).
responses by modelling supply and/or demand in The benefits people derive from environmental
major affected markets, but assumes that the effects protection can be categorized as ( a ) related to
of a regulation are confined to one or a few markets. human health (mortality and morbidity), ( b )
This may be satisfactory if the markets affected by ecological (both market and non-market), or (c)
the policy are small in relation to the overall materials damage. The distinction between use
economy; but, if an environmental policy is value and non-use value is critical. In addition to
expected to have large consequences for the the direct benefits (use value) people receive
economy, general equilibrium analysis is required, through protection of their health or through use of
such as through the use of computable general a natural resource, they derive passive or non-use
equilibrium models (Hazilla and Kopp ; Conrad ). value from environmental quality, particularly in
The potential interaction of abatement costs with the ecological domain. For example, an individual
pre-existing taxes indicates the importance of may value a change in an environmental good
employing general equilibrium models for because she wants to preserve the good for her
comprehensive cost analysis. Revenue
heirs (bequest value). Still other people may envi- Revealed Preference Methods of Environmental
sion no current or future use by themselves or their Benefit Estimation
heirs, but still wish to protect the good because they The a v e r t i n g b e h a v i o u r
believe it should be protected or because they m e t h o d , in which values of willingness to
derive satisfaction from simply knowing it exists pay are inferred from observations of people’s
(existence value). behavioural responses to changes in environmental
How much would individuals sacrifice to quality, is grounded in the household production
achieve a small reduction in the probability of death function framework (Bockstael and McConnell ).
during a given period of time? How much People sometimes take actions to reduce the risk
compensation would individuals require to accept a (averting behaviour) or lessen the impacts
small increase in that probability? These are (mitigating behaviour) of environmental damages,
reasonable economic questions because most for example by purchasing water filters or bottled
environmental regulations result in very small water. In theory, people’s perceptions of the cost of
changes in individuals’ mortality risks. Hedonic averting behaviour and its effectiveness should be
wage studies, averted behaviour, and contingent measured (Cropper and Freeman ), but in practice
valuation (all discussed below) can provide actual expenditures on averting and mitigating
estimates of marginal willingness to pay or behaviours are typically employed. An additional
willingness to accept related to small changes in challenge is posed by the necessity of disentangling
mortality risk, and such estimates can be attributes of the market good or service.
normalized as the ‘value of a statistical life’ (VSL). Recreational activities represent a potentially
The VSL is n o t the value of an individual large class of benefits that are important in
life, whether in ethical or technical, economic assessing policies affecting the use of public lands.
terms. Rather it is simply a convention: The models used to estimate recreation demand fall
within the class of household production models.
VSL T r a v e l c o s t m o d e l s (or
MWTP or MWTA (from hedonic wage orCV) Hotelling-Clawson-Knetsch models) use
Small risk change information about time and money spent visiting a
(3) site to infer the value of that recreational resource
where M W T P and M W T A , respectively, (Bockstael ). The simplest version of the method
refer to marginal willingness to pay and marginal involves one site and uses data from surveys of
willingness to accept. For example, if people are users from various geographic origins, together
willing, on average, to pay $12 for a risk reduction with estimates of the cost of travel and opportunity
cost of time, to infer a demand function relating the
from 5 in 500,000 to 4 in 500,000, Eq. would yield:
number of trips to the site to a function of people’s
willingness to pay for the experience.
$12
V S L = —----- = R a n d o m u t i l i t y m o d e l s
$6,000,000- (4)
1. 000002 explicitly model the consumer’s decision to choose
a particular site from among recreation locations,
Thus, VSL quantifies the aggregate amount that assessing the probability of visiting each location.
a group of individuals are willing to pay for small Such models can be used to value changes in
reductions in risk, standardized (extrapolated) for a environmental quality by comparing decisions to
risk change of 1.0. It is not the economic value of visit alternative sites (Phaneuf and Smith ).
an individual life because the VSL calculation does All recreation demand models share limitations.
not signify that an individual would pay $6 million First, the valuation of costs depends on estimates of
to avoid (certain) death this year, or accept (certain) the opportunity cost of (leisure) time, which is
death this year in exchange for $6 million. notoriously difficult to estimate. Also, most trips to
a recreation site are part of a
multi-purpose experience. In addition, random attribute in question. For purposes of benefit esti-
utility models rely on people’s perceptions of mation, the demand function for the attribute is
environmental quality changes. Finally, like all required, and so it is necessary to examine how the
revealed-preference approaches, recreation demand marginal implicit price of the environmental attri-
models can be used to estimate use value only; non- bute varies with changes in the quantity of the
use value cannot be examined. attribute and other relevant variables. If the hedonic
An alternative approach to assessing people’s price Eq. is nonlinear, then fitted values of P e can
willingness to pay for recreational experiences is to be calculated as e is varied, and a second- stage
draw on evidence from p r i v a t e equation can be estimated:
o p t i o n s t o u s e p u b l i c
g o o d s . This approach also fits within the P e = g( e , y J (7)
household production framework, and is based upon
the notion of estimating the derived demand for a where P e = the fitted value of the marginal
privately traded option to utilize a freely available implicit price of e from the first-stage equation;
public good. In particular, the demand for state and y . . . a vector of factors that affect marginal
fishing licences has been used to infer the benefits willingness to pay for e , including buyer
of recreational fishing. Using panel data on fishing characteristics.
license sales and prices, combined with data on Equation , above, has been interpreted as the
substitute prices and demographic variables, demand function for the environmental attribute,
Bennear et al. ( ) estimated a licence from which benefits (consumers surplus) can be
demand function from which the expected benefits estimated in the usual way; but there are problems.
of a recreational fishing day were derived. Most important among these is the question of
H e d o n i c p r i c i n g whether a demand function has actually been esti-
m e t h o d s are founded on the proposition that mated, since environmental quality may affect both
people value goods in terms of the bundles of the demand for housing and its supply, raising the
attributes that constitute those goods. classic identification problem. In addition,
H e d o n i c p r o p e r t y v a l u e informational asymmetries may distort the analysis.
m e t h o d s employ data on residential property Also, because the hedonic property method is based
values and home characteristics, including on analysis of marginal changes, it should not be
structural, neighbourhood, and environmental applied to analysis of policies with large anticipated
quality attributes (Palmquist ). By regressing the effects.
property value on key attributes, the hedonic price A related benefit-estimation technique is the
function is estimated: h e d o n i c w a g e m e t h o d , based
on the reality that individuals in well-functioning
where P housing price (includes land); x vector labour markets make trade-offs between wages and
of structural attributes; z = vector of risk of on- the-job injuries (or death). A job is a
neighbourhood attributes; and e = environmental
bundle of characteristics, including its wage,
attribute of concern.
responsibilities and risk, among others factors. Two
From the estimated hedonic price function of
jobs that require the same skill level but have
Eq. , the marginal implicit price of any attribute,
different risks of on-the-job mortality will pay
including environmental quality, can be calculated
different wages. On the labour supply side,
as the partial derivative of the housing price with
employees tend to require extra compensation to
respect to the given attribute:
accept jobs with greater risks; and on the labour
demand side, employers are willing to offer higher
d P df ( - ) wages to attract workers to riskier jobs. Hence,
(6)
d e de labour market data on wages and job characteristics
can be used to estimate people’s marginal implicit
This marginal implicit price, P e , measures
price
the aggregate marginal willingness to pay for the
of risk, that is, their valuation of risk. By regressing lifetime utility (Moore and Viscusi ; Cropper and
the wage on key attributes, the hedonic price Sussman ). In contrast, some models and empirical
function is estimated: evidence suggest that older people may in fact have
a higher demand for reducing mortality risks than
W = h ( x, r ' j (8) younger people, and that the value of a life may
follow an ‘inverted-U’ shape over the life cycle,
with its peak during mid-life (Shepard and
where W = wage (in annual terms); x =
vector of Zeckhauser ; Mrozek and Taylor ; Viscusi and Aldy
; Alberini et al. ).
worker and job characteristics; and r = mortality
risk of job. Stated Preference Methods of Environmental
The marginal implicit price of risk is calculated Benefit Estimation
as the partial derivative of the annual wage with In the best known stated preference method,
respect to the measured mortality risk: c o n t i n g e n t v a l u a t i o n (CV),
survey respondents are presented with scenarios
d W dh (- ) that require them to trade off, hypothetically,
Wr (9) something for a change in an environmental good or
d r dr
service (Mitchell and Carson ; Boyle ). The simplest
approach is to ask people for their maximum
This marginal implicit price of risk is the aver-
willingness to pay, but as there are few real markets
age annual income necessary to compensate a
in which individuals are actually asked to generate
worker for a marginal change in risk throughout the
their reservation prices, this method is considered
year, and it varies with the level of risk.
unreliable. In a bidding game, the researcher begins
Many of the issues that arise with the hedonic
by stating a willingness-to-pay number, asks for a
property value method have parallels here. First,
yes-no response, and then increases or decreases the
there is the possibility of simultaneity: causality
amount until indifference is achieved. The problem
between risk and wages can run in both directions.
with this approach is starting-point bias. A related
Also, if individuals’ perceptions of risk do not
approach is the use of a payment card shown to the
correspond with actual risks, then the marginal
respondent, but the range of WTP on the card may
implicit price of risk calculated from a hedonic
introduce bias, and the approach cannot be used
wage study will be biased, and imperfections in
with telephone surveys. Finally, the referendum
labour markets (less than perfect mobility) can
(discrete choice) approach is favoured by
cause further problems.
researchers. Each respondent is offered a different
Direct application of the method in the envi-
WTP number, to which a simple yes-no response is
ronmental realm is limited to occupational (as
solicited.
opposed to environmental) exposiues and risks. Yet
The primary advantage of contingent valuation
hedonic wage methods are of considerable
is that it can be applied to a wide range of situa-
importance in the environmental policy realm,
tions, including use as well as non-use value; but
because the results from hedonic wage studies have
potential problems remain. Respondents may not
frequently been used through ‘benefit transfer’ to
understand what they are being asked to value. This
infer the VSL. In such applications, the hedonic
may introduce greater variance, if not bias, in
wage method brings with it possible bias, because
responses. Likewise, respondents may not take the
studies typically focus on risky occupations, which
hypothetical market seriously because no budget
may attract workers who are systematically less
constraint is imposed. This can increase variance
risk-averse.
and bias. Yet if the scenario is ‘too realistic,’
Standard economic theory would suggest that
strategic bias may be expected to show up in
younger people would have higher values for risk
responses. Finally, the ‘warm glow effect’ may
reduction because they have a longer expected life
plague some stated preference surveys: people
remaining before them and thus a higher expected
may purchase moral satisfaction with large but defined as the allocation of control among sources
unreal statements of their willingness-to-pay that results in the aggregate target being achieved at
(Andreoni ). the lowest possible cost, that is, the allocation
The 1989 Exxon Valdez oil spill off the coast of which satisfies the following cost-minimization
Alaska led to massive litigation, and resulted in the problem:
most prominent use ever of the concept of non-use
N
value and the method of contingent valuation for its
min C = y c;(r;) (10)
estimation. The result was a symposium sponsored
<ri> l=i
by the Exxon Corporation attacking the CV method
(Hausman ), and the subsequent creation of a N

government panel - established by the National s.t. [uj — r;] < E (11)
Oceanic and Atmospheric Administration (NO A A) ;=i
and chaired by two Nobel laureates in economics -
and 0 < r, < M, (12)
to assess the scientific validity of the CV method.
The NOAA panel concluded that ‘CV studies can
produce estimates reliable enough to be the starting where r t = reductions in emissions (abatement
point of a judicial process of damage assessment, or control) by source i ( i = 1 to N ); c/r,) = cost
including lost passive (non-use) values’ (Arrow et function for source i ; C = aggregate cost of
al. , p. 4610). The panel offered its approval of CV control; U j = uncontrolled emissions by source
methods subject to a set of best- practice guidelines. i ; and E = the aggregate emissions target
It is important to distinguish between legitimate imposed by the regulatory authority.
methods of benefit estimation and approaches If the cost functions are convex, then necessary
sometimes encountered in the policy process that do and sufficient conditions for satisfaction of the
not measure willingness-to-pay or willingness-to- constrained optimization problem posed by Eqs. -
accept. Frequently misused techniques include: are the following (among others) (Kuhn and Tucker
( a ) employing, as proxies for the benefits of a ):
poli cy, estimates of the ‘cost avoided’ by not using
the next most costly means of achieving the policy’s dn
- A >0 (13)
goals; ( h ) ‘societal revealed preference’ models,
which seek to infer the benefits of a proposed policy
from the costs of previous regulatory actions; and
(c) cost-of-illness or human- capital measures which 0 (14)
estimate explicit market costs resulting from
changes in morbidity or mortality. Because none of
Equations and together imply the crucial
these approaches provides estimates of WTP or
condition for cost- effectiveness that all sources
WTA, these techniques do not provide valid
(that exercise some degree of control) experience
measures of economic benefits.
the same marginal abatement costs (Baumol and
Oates ). Thus, when one examines environmental
policy instruments, a key question is whether
marginal abatement costs are likely to be being
equated across sources.
Choosing Instruments: The Means of
Environmental Policy Command-and-Control Versus Market-
Based Instruments
Even if the goals of environmental policies are Conventional approaches to regulating the
given, economic analysis can bring insights to the environment - frequently characterized as
assessment and design of environmental policies. command-and-control - allow relatively little
One important criterion is c o s t - flexibility in the means of achieving goals. Such
e f f e c t i v e n e s s ,
min [c;(r;) + t • (M, - r,)]
'-sCo (15)

(16)
policy instruments tend to force firms to take on instruments have the potential to bring down
equal shares of the pollution-control burden, abatement costs over time by providing incentives
regardless of the cost. The most prevalent form of for companies to adopt cheaper and better pollution-
uniform command-and-control standards is control technologies. This is because, with market-
technology standards that specify the adoption of based instruments, most clearly with emission taxes,
specific pollution-control technologies, and per- it pays firms to clean up a bit more if a sufficiently
formance standards that specify uniform limits on low-cost method (technology or process) of doing
the amount of pollution a facility can generate. In so can be identified and adopted (Downing and
theory, non- uniform performance standards could White ; Maleug ; Milliman and Prince ; Jaffe and
be made to be cost-effective, but the government Stavins ). However, the ranking among policy
typically lacks the requisite information (on instruments in terms of their respective impacts on
marginal costs of individual sources). technology innovation and diffusion is ambiguous
Market-based instruments encourage behaviour (Jaffe et al. ).
through market signals rather than through explicit Closely related to the effects of instrument
directives regarding pollution-control levels or choice on technological change are the effects of
methods. Market-based instruments fall within four vintage-differentiated regulation on the rate of
categories: pollution charges, tradable permits, capital turnover, and thereby on pollution abatement
market-friction reductions, and government subsidy costs and environmental performance. Vintage-
reductions. Liability rales may also be thought of as differentiated regulation is a common feature of
a market-based instrument, because they provide many environmental policies, whereby the standard
for regulated units is fixed in terms of their date of
incentives for firms to take into account the
entry, with later vintages facing more stringent
potential environmental damages of their decisions.
regulation. Such vintage-differentiated regulations
Where there is significant heterogeneity of
can be expected to retard turnover in the capital
abatement costs, command-and- control methods
stock, and thereby to reduce the cost- effectiveness
will not be cost-effective. In reality, costs can vary
of regulation. Under some conditions the result can
enormously due to production design, physical
be higher levels of pollutant emissions than would
configuration, age of assets, and other factors. For
occur in the absence of regulation. Such economic
example, the marginal costs of controlling lead
and environmental consequences are not only
emissions have been estimated to range from $13 to
predictions from theory (Maloney and Brady ); both
$56,000 per ton (Hartman et al.
types of consequences have been validated
; Morgenstem ). But where costs are similar
empirically (Graenspecht ; Nelson et al. ).
among sources, command-and- control instruments
may perform as well as (or better than) market- Pollution Charges
based instruments, depending on transactions costs, P o l l u t i o n c h a r g e systems assess
administrative costs, possibilities for strategic a fee or tax on the amount of pollution that firms or
behaviour, political costs, and the nature of the sources generate (Pigou ). By definition, actual
pollutants (Newell and Stavins )• emissions are equal to unconstrained emissions
In theory, market-based instruments allow any minus emissions reductions, that is, e , = «, - r,.
desired level of pollution clean- up to be realized at A source’s cost minimization problem in the
the lowest overall cost by providing incentives for presence of an emissions tax, t , is given by:
the greatest reductions in pollution by those firms
that can achieve the reductions most cheaply.
Rather than equalizing pollution levels among
firms, market-based instruments equalize their
marginal abatement costs (Montgomery ). In
addition, market- based
 The result for each source is: ), and the concept has also been applied to
lead-acid batteries. There has also been considerable
dcijn) use of e n v i r o n m e n t a l u s e r
drj - t > 0 (17)
(18) c h a r g e s , through which specific
'dci(ri) environmentally related services are funded.
n
' [ dn Examples include i n s u r a n c e
p r e m i u m t a x e s (Barthold ). Another
Equations and imply that each source (that set of environmental charges are s a l e s
exercises a positive level of control) will carry out t a x e s on motor fuels, ozone-depleting
abatement up to the point where its marginal control chemicals, agricultural inputs, and low-mileage
costs are equal to the tax rate. Hence, marginal motor vehicles. Finally, t a x d i f -
abatement costs are equated across sources, f e r e n t i a t i o n has been used to
satisfying the condition for cost- effectiveness encourage the use of renewable energy sources.
specified by Eqs. and , at least in the simplest case
of a uniformly mixed pollutant. In the non- Tradable Permit Systems
uniformly mixed pollutant case, where ‘hot spots’ T r a d a b l e p e r m i t s can achieve the
can be an issue, the respective cost-effective same costminimizing allocation as a charge system,
instrument is an ‘ambient charge’. while avoiding the problems of uncertain firm
A challenge with charge systems is identifying responses and the distributional consequences of
the appropriate tax rate. For social efficiency, it taxes. Under a tradable permit system, an allowed
should be set equal to the marginal benefits of overall level of pollution, E is established, and
clean-up at the efficient level of clean-up (Pigou ); allocated among sources in the form of permits.
but policymakers are more likely to think in terms Firms that keep emission levels below allotted levels
of a desired level of clean-up, and they do not know may sell surplus permits to other firms or use them
beforehand how firms will respond to a given level to offset excess emissions in other parts of their
of taxation. An additional problem is that, although operations. Let q 0 i be the initial allocation of
such systems minimize aggregate social costs, these emission permits to source i , such that:
systems may be m o r e costly than comparable
N
command-and-control instruments f o r
r e g u l a t e d f i r m s , because firms J2<loi = E
pay both their abatement costs a n d taxes on their
residual emissions. (19)
If charges are broadly defined, many applica- ii

tions can be identified (Stavins ). Coining closest to

true Pigouvian taxes are the increasingly common min [c;(r;) I p ■ ( u , - r, - q 0 i ) } (2 0 )
u n i t - c h a r g e systems for financing
municipal solid waste collection, where households
S.t.n > 0 (2 1 )
and businesses are charged the incremental costs of
collection and disposal. Another important set of
The result for each source is:
charge systems has been d e p o s i t
r e f u n d s y s t e m s , whereby
dcftfi
consumers pay a surcharge when purchasing drt p> 0 (22)
potentially polluting products, and receive a refund
when returning the product to an approved centre
Ocfir,)
for recycling or disposal. A number of countries and = 0 (23)
states have implemented this approach to control dr
litter from beverage containers and to reduce the
flow of solid waste to landfills (Bohm ; Menell
will carry out abatement up to the point where its markets depend, in part, on the existence of well-
marginal control costs are equal to the market- informed producers and consumers,
determined permit price. Hence, the environmental i n f o r m a t i o n p r o g r a m m e s
constraint, E , is satisfied, and marginal abatement can help foster market-oriented solutions to
costs are equated across sources, satisfying the environmental problems. These programmes have
condition of cost-effectiveness. The unique cost- been of two types. P r o d u c t
effective equilibrium is achieved independently of l a b e l l i n g r e q u i r e m e n t s
the initial allocation of permits (Montgomery ), have been implemented to improve information sets
which is of great political significance. available to consumers, while other programmes
The performance of a tradable permit system have involved r e p o r t i n g
can be adversely affected by: concentration in the r e q u i r e m e n t s (Hamilton ; Konar and
permit market (Hahn ; Misolek and Elder ); Cohen ; Khanna et al. ).
concentration in the product market (Maleug );
transaction costs (Stavins ); non-profit maximizing Government Subsidy Reduction
behaviour, such as sales or staff maximization G o v e r n m e n t s u b s i d y
(Tschirhart ); the preexisting regulatory r e d u c t i o n constitutes another category of
environment (Bohi and Burtraw ); and the degree of market-based instruments. Subsidies are the mirror
monitoring and enforcement (Montero ). image of taxes and, in theory, can provide incentives
Tradable permits have been the most frequently to address environmental problems. Although
used market-based system (US Environmental subsidies can advance environmental quality (see,
Protection Agency ). Significant applications for example, Jaffe and Stavins ), it is also true that
include: the emissions trading programme subsidies, in general, have important disadvantages
(Tietenberg ; Hahn ); the leaded gasoline phase- relatives to taxes (Dewees and Sims ; Baumol and
down; water quality permit trading (Hahn ; Oates ). Because subsidies increase profits in an
Stephenson et al. ); CFC trading (Hahn and industry, they encourage entry, and can thereby
McGartland ); the sulphur dioxide (S02 ) allowance increase industry size and pollution output
trading system for acid rain control (Schmalensee et (Mestelman ; Kohn ). In practice, rather than
al. ; Stavins ; Carlson et al. ; Ellerman et al. ); the internalizing externalities, many subsidies promote
RECLAIM programme in the Los Angeles economically inefficient and environmentally
metropolitan region (Harrison ); tradable unsound practices. In such cases, reducing subsidies
development rights for land use; and the European can increase efficiency and improve environmental
Union’s greenhouse gas emission trading scheme. quality. For example, because of concerns about
global climate change, increased attention has been
Market Friction Reduction given to cutting inefficient subsidies that promote
M a r k e t f r i c t i o n the use of fossil fuels.
r e d u c t i o n can serve as a policy
instrument for environmental protection. Implications of Uncertainty for Instrument
M a r k e t - c r e a t i o n establishes Choice
markets for inputs or outputs associated with The dual task facing policymakers of choosing
environmental quality. Examples of market creation environmental goals and selecting policy instru-
ments to achieve those goals must be carried out in
include measures that facilitate the voluntary
the presence of the significant uncertainty that
exchange of water rights and thus promote more
affects the benefits and the costs of environmental
efficient allocation and use of scarce water supplies
protection. Since Weitzman’s ( ) classic paper
(Howe ), and policies that facilitate the restructuring
on ‘Prices vs. quantities’, it has been widely
of electricity generation and transmission. Since
acknowledged that benefit uncertainty on its own
well-functioning
has no effect on the identity of the efficient control
instrument, but that cost uncertainty can have
significant effects, depending upon the relative
slopes of the marginal benefit (damage ) and mar- The significant changes that have taken place
ginal cost functions. In particular, if uncertainty over the past 2 0 years with regard to the means of
about marginal abatement costs is significant, and if environmental policy - that is, acceptance of
marginal abatement costs are flat relative to market-based environmental instruments - may
marginal benefits, then a quantity instrument is provide a model for progress with analysis of the
more efficient than a price instrument. ends - the targets and goals - of public policies in
In the environmental realm, benefit uncertainty this domain. The change in the former realm has
and cost uncertainty are usually both present, with been dramatic. Market-based instruments have
benefit uncertainty of greater magnitude. When moved centre stage, and policy debates today look
marginal benefits are positively correlated with very different from those of 2 0 years ago, when
marginal costs (which, it turns out, is not uncom- these ideas were routinely characterized as ‘licences
mon), then there is an additional argument in favour to pollute’ or dismissed as completely impractical.
of the relative efficiency of quantity instruments Market-based instruments are now considered
(Stavins ). Nevertheless, the regulation of stock seriously for nearly every environmental problem
pollutants will often favour price instruments, that is tackled, ranging from endangered species
because the marginal benefit function - linked with preservation to regional smog and global climate
the stock of pollution - will tend to be flatter than change. Of course, no individual policy instrument -
the marginal cost function - linked with the flow of whether market- based or conventional - is
pollution (Newell and Pizer ). In theory, there appropriate for all environmental problems. Which
would be considerable efficiency advantages in the instrument is best in any given situation depends
presence of uncertainty of hybrid systems - for upon a variety of characteristics of the
example, quotas combined with taxes - or nonlinear environmental problem, and the social, political,
taxes (Roberts and Spence ; Weitzman ; Kaplow and economic context in which it is regulated.
and Shavell ; Pizer ), but such systems have not
been adopted.

Conclusion See Also

The growing use of economic analysis to inform ► dimate Change, Economics :::
environmental decision-making marks greater ► Common Property R sourne:
acceptance of the usefulness of these tools in ► Contingent Valuation
improving regulation. But debates about the nor- ► Ecological Economics
mative standing of die Kaldor-Hicks criterion and ► inergy Econot: :
the challenges inherent in making benefit-cost ► environmental Z x - r - r .
analysis operational will continue. Nevertheless, ► ledonic Pric
economic analysis has assumed a significant posi- ► 10
tion in the regulatory state. At the same time, ► Pollution Haven Hypothesis
despite the arguments made for decades by econo- ► Pollution Permits
mists, there is only limited political support for ► Social Discount Rate
broader use of benefit-cost analysis to assess pro- ► 'aI -of . •:
posed or existing environmental regulations. These
analytical methods remain on the periphery of
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of its resemblance to the pattern of inequality and have their turning points at the highest incomes, or
income described by Simon Kuznets ( ), this even no turning points at all, as pollution appears to
pattern of pollution and income has been labelled an increase steadily with income. Carbon emissions
‘environmental Kuznets curve’ (EKC). provide one such example. This, too, is not
Grossman and Krueger ( ) and the World necessarily a rejection of the EKC; the turning
Bank ( ) first popularized this idea, using a points for these pollutants may come at levels of
simple empirical approach. They regress data on income per capita higher than in today’s wealthiest
ambient air and water quality in cities worldwide on economies.
a polynomial in GDP per capita and other city and Another general empirical result is that the
country characteristics. They then plot the fitted turning points for individual pollutants differ across
values of pollution levels as a function of GDP per countries. This difference shows up as instability in
capita, and demonstrate that many of the plots empirical approaches that estimate one fixed turning
appear inverse-U-shaped, first rising and then point for any given pollutant. Countries that are the
falling. The peaks of these predicted pollution- first to deal with a pollutant do so at higher income
income paths vary across pollutants, but ‘in most levels than following countries, perhaps because the
cases they come before a country reaches a per following countries benefit from the science and
capita income of $8000’ in 1985 dollars (Grossman engineering lessons of the early movers.
and Krueger , p. 353). Most researchers have been careful to avoid
In the years since these original observations interpreting these reduced-form empirical correla-
were made, researchers have examined a wide tions structurally, and to recognize that economic
variety of pollutants for evidence of the EKC growth does not automatically cause environmental
pattern, including automotive lead emissions, improvements. All of the studies omit country
deforestation, greenhouse gas emissions, toxic characteristics correlated with both income and
waste and indoor air pollution. Some investigators pollution levels, the most important being envi-
have experimented with different econometric ronmental regulatory stringency. The EKC pattern
approaches, including higher-order polynomials, does not provide evidence of market failures or
fixed and random effects, splines, semi- and non- efficient policies in rich or poor countries. Rather,
parametric techniques, and different patterns of there are multiple underlying mechanisms, some of
interactions and exponents. Others have studied which have begun to be modelled theoretically.
different groups of jurisdictions and different time In theory, the EKC relationship can be divided
periods, and have added control variables, including into three parts: scale, composition, and technique
measures of corruption, democratic freedoms, (see Brock and Taylor ). If as an economy grows
international trade openness, and even income the s c a l e of all activities increases propor-
inequality (bringing the subject full circle back to tionally, pollution will increase with economic
Kuznets’s original idea). growth. If growth is not proportional but is accom-
Some generalizations across these approaches panied by a change in the c o m p o s i t i o n
emerge. Roughly speaking, pollution involving of goods produced, then pollution may decline or
local externalities begins improving at the lowest increase with income. If richer economies produce
income levels. Fecal coliform in water and indoor proportionally fewer pollution-intensive products,
household air pollution are examples. For some of because of changing tastes or patterns of trade, this
these local externalities, pollution appears to composition effect can lead to a decline in pollution
decrease steadily with economic growth, and we associated with economic growth. Finally, if richer
observe no turning point at all. This is not a countries use less pollutionintensive production
rejection of the EKC; pollution must have increased t e c h n i q u e s , perhaps because
at some point in order to decline with income environmental quality is a normal good, growth can
eventually, and there simply are no data from the lead to falling pollution. The EKC summarizes the
earlier period. By contrast, pollutants involving very interaction of these three processes.
dispersed externalities tend to
 Beyond this aggregate decomposition of the Bibliography
EKC, some attempts have been made to formalize
structural models that lead to inverse-U- shaped Brock, W., and M. Taylor. 2005. Economic growth and the
environment: A review of theory and empirics. In The
pollution-income patterns. Many describe handbook of economic growth, vol. 1, ed. S. Durlauf and
economies at some type of comer solution initially, P. Aghion. Amsterdam: North-Holland.
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trade environmental quality for income at a faster the environment. Quarterly Journal of Economics 110:
353-377.
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resources. As the model economies become American Economic Review 45: 1-28.
wealthier and their environments dirtier, eventually Stokey, N. 1998. Are there limits to growth? International
Economic Review 39: 1-31. E
the marginal utility of income falls and the marginal
World Bank. 1992. World development report 1992. New
disutility from pollution rises, to the point where York: Oxford University Press.
people choose costly abatement mechanisms. After
that point, the economies are at interior solutions,
marginal abatement costs equal marginal rates of
substitution between environmental quality and
income, and pollution declines with income (see Envy
Stokey ). In frameworks of this type, there is typi-
cally zero pollution abatement until some threshold Peter J. Hammond
income level is crossed, after which abatement
begins and pollution starts declining with income.
To date, the practical lessons from this theoret-
ical literature are limited. Most of the models are Envy is a deadly sin, but then so is avarice or greed,
designed to yield inverse-U-shaped pollution- and greed seems not to trouble economists. Envy
income paths, and succeed using a variety of does, however, perhaps because it is an externality.
assumptions and mechanisms. Hence, any number Different economists have also used the term in
of forces may be behind the empirical observation different senses. Veblen ( ) avoids
that pollution increases and then decreases with the word ‘envy’, but one feels that some of the
income. Moreover, that pattern cannot be pleasiue of conspicuous consumption may come
interpreted causally, and is consistent with either from the malicious belief that it induces envy in
efficient or inefficient growth paths. Perhaps the others. Brennan ( ) uses the term ‘malice’ to
most important insight is in Grossman and indicate negative altruism - a distaste for the income
Krueger’s original paper: ‘We find no evidence that of others - and ‘envy’ to indicate that the marginal
economic growth does unavoidable harm to the disutility of another’s income increases as their
natural habitat’ ( , p. 370). Economists income increases. For other concepts of envy, see
have long argued that environmental degradation is Nozick ( ) and Chaudhuri ( ).
not an inevitable consequence of economic growth. Most economists now use the word ‘envy’ in a
The EKC literature provides empirical support for narrow technical sense due to Foley ( ), who
that claim. was much more interested, however, in finding an
adequate concept of ‘equity’. First, however, one
should turn to Rawls ( ), whose
T h e o r y o f
J u s t i c e has 12 pages of very pertinent
See Also
► Environme Rawls on Envy and Justice
nt
► Growth and
► Pollution
Ha
‘envy’ from ‘jealousy’, which can be thought of as Equity as Absence of 'Envy*
a protective response to envy:
we may think of envy as the propensity to view More recently, however, ‘envy’ has acquired a
with hostility the greater good of others even precise technical sense in economic theory, fol-
though their being more fortunate than we are does
lowing the (apparently independent) lead taken by
not detract from our advantages. We envy persons
whose situation is superior to ours... and we are Feldman and Kirman ( ) and by Varian ( )
willing to deprive them of their greater benefits in analysing a concept of ‘equity’ due to Foley (
even if it is necessary to give up something , p. 75). Apparently Foley was the first to
ourselves. When others are aware of our envy, they use the term ‘envy’ in this sense, though only
may become jealous of their better circumstances
and anxious to take precautions against the hostile informally: Feldman, Kirman and Varian include it
acts to which our envy makes us prone. So in their titles.
understood envy is collectively disadvantageous: Consider any allocation ( x ' g ) (g = 1 to n ;
the individual who envies another is prepared to do i = 1 to m ) of n goods to each of m
things that make them both worse off, if only the
discrepancy between them is sufficiently reduced individuals. Suppose these individuals have
(p. 532). preferences represented by ordinal utility functions
I f ( x ‘ ) ( i = 1 to i n ) of each individual
This is in section 80, on ‘the problem of envy’
V s own (net) consumption vector x . Then
in which Rawls asks whether his theory of justice is
individual i is said to e n v y j if U f f ) >
likely to prove impractical because ‘just
U 1 ( x 1 ) , so that i prefers f s allocation to
institutions... are likely to arouse and encourage
his own. Notice that this i s a purely technical
these propensities [such as envy] to such an extent
definition; it tells us nothing about V s emotional or
that the social system becomes unworkable and
psychological state, whether i is unhappy because
incompatible with human good’ (p. 531). This is a
he prefers what j has, or whether V s ‘envy’
positive question; a normative one arises when one
makes him want to harm j . There is no sin in this
recognizes the possibility of ‘excusable envy’
unemotional economists’ concept of envy, but no
because ‘sometimes the circumstances evoking
particular ethical appeal either. Indeed, it might be
envy are so compelling that, given human beings as
better to say that H finds f s position to be
they are, no one can reasonably be asked to
e n v i a b l e ' , to minimize the suggestions
overcome his rancorous feelings’ (p. 534). In the
of emotion.
following section 81, on ‘envy and equality’, Rawls
Nevertheless, Foley was concerned to introduce
argues carefully that his ‘principles of justice are
a concept of equity of welfare which overcomes the
not likely to arouse excusable... envy... to a
deficiencies of equality of after-tax income -
troublesome extent’ (p. 537). Thereafter, he
deficiencies which are obvious when there are
discusses the conservative contention ‘that the
different public goods in different areas, different
tendency to equality in modem social movements is
preferences for leisure as against consumption, and
the expression of envy’ (p. 538), and Freud’s
different needs as well. Thus Foley proposes the
lamentable suggestion that an egalitarian sense of
absence of ‘envy’ as a test of whether an allocation
justice is but an adult manifestation of childish
is equitable. Formally, ( x l g ) is
feelings of envy and jealousy. Recently, indeed, a 1
e q u i t a b l e if If ( x ) > If (f) for all pairs
particular progressive tax in West Germany has
of individuals i and j .
been labelled an ‘envy tax’
Foley ( ) was careful to qualify this test.
( N e i d s t e u e r ) , as noted by Bos and
First, lifetime consumption plans must be consid-
Tillmann ( ). Anyway, Rawls is careful to
ered so that the prodigal do not envy the higher later
distinguish ‘rancorous’ envy from the justifiable
consumption enjoyed by the thrifty. Second, as he
feelings of resentment at being treated unjustly.
says:
While envy may often form the basis of an appeal
to justice, the claims that all appeals to justice rely if a gas station attendant has the desire to be a painter
on envy often fail to distinguish envy from resent- but not the ability, it may be necessary to make the
ment. I shall return to this later. painter’s life very unattractive in other ways before
the gas station attendant will prefer his own; so
unattractive, perhaps, that the painter
 will envy the attendant while the attendant is still Envy and Resentment Reconsidered
envying him. These cases must be interpreted
flexibly; either equivalents to the talents must be In the definition of envy, each individual i
postulated which the gas station attendant does
possess, or reasonable alternatives flamed that compares the consumption vector x ’ of another
abstract from the glamour and prestige of certain with his own, x \ using V s own utility function
activities (p. 75). I f . But I f ( f ) > I f ( x ' ) is insufficient
for V s envy to be excusable, in Rawls’s sense.
Foley ( , p. 76) concludes his discussion of Indeed, if f is preferable for i because j has some
‘equity’ as follows: special needs met, V s envy is quite unjustifiable.
If tastes differ greatly, there is very little gained by As Sen ( , eh. 9)
the analysis since a very wide range of allocations
points out in his discussion of Suppes’s ( ) E
will meet the equity criterion. The definition is
offered only as a tentative contribution to a difficult grading principles of justice, comparisons of f
and murky subject and concludes the sketchy dis- and x ‘ must allow for differences in tastes, needs,
cussion this paper will make of welfare economics. and so on. Thus the appropriate comparison in
determining what is inequitable is rather whether
l f ( f ) > I f ( x ) . If this is true, we might
Fairness and Other Extensions of Equity say that i r e s e n t s j . Absence of
resentment then requires all individuals to have
In a one-good problem of dividing a cake, pro- equal utility levels; of course, this requires
cedures for achieving ‘fair’ allocations, without interpersonal comparisons of utility levels, of the
envy and with no cake wasted, were discussed in kind used to make decisions ‘in an original
works such as Steinhaus ( , ), and position’, behind the ‘veil of ignorance’, before
Dubins and Spanier ( ) before Foley. Fairness each individual knows his tastes. The technical
with many goods was considered by Schmeidler sense of envy defined earlier differs from this
and Vind ( ), by adding Pareto efficiency to technical notion of resentment precisely because it
the requirement that nobody should envy anybody ignores the original position; not surprisingly, then,
else’s n e t t r a d e v e c t o r (as envy has no moral force, whereas resentment may
opposed to the consumption vector, which includes well have.
the endowment). Pazner and Schmeidler ( ) Complete absence of resentment in this sense is
and Varian ( ) probably too strong; but one should look for there
then came up with examples of economies with to be no resentment in the weaker sense that no
production in which there are no fair allocations, individual can legitimately feel treated unjustly by
because Pareto efficiency requires skilled workers the institutions that determine his welfare. That, of
to supply more hours of labour than unskilled course, reverts to Rawls ( ),
workers, and tastes are such that no allocation of though not necessarily to his particular concept of
consumption then avoids envy. Feldman and
Kirman ( ) considered reducing
the degree of envy, whereas Pazner and Schmeidler See Also
( ) weakened the notion of equity
to ‘egalitarian equivalence’ finding an allocation ► dtruisrr
( x ' g ) in which each individual i is indifferent
between x ‘ and a consumption in an ‘egalitarian’
allocation ( x ' g ) with x . 1 ndependent of i .
Of course, in this egalitarian allocation there is no
Bibliography
envy. These later developments all seem like
attempts to rescue a dubious notion of equality Bos, D., and G. Tillmann. 1985. An ‘Envy Tax’: Theoretical
without giving up first-best Pareto efficiency, even principles and applications to the German surcharge on
though that is surely unattainable anyway in the rich. Public Finance/Finances Publiques 40: 35-63.
economies with private information.
 French economic periodical issued in three series
Brennan, G. 1973. Pareto desirable redistribution: The case of
malice and envy. Journal of Public Economics 2: 173-
under different names from 1766 to 1772, 1774 to
183.
1776 and in 1788. Published first as a bimonthly by
Chaudhuri, A. 1985. Formal properties of interpersonal envy.
Theory and Decision 18: 301-312. its founder and first editor, l’Abbe Baudeau, it
became a monthly as from January 1767 after
Dubins, L.E., and E.H. Spanier. 1961. How to cut a cake
fairly. American Mathematical Monthly 68: 1-17.
Baudeau’s conversion to Physiocracy by Mirabeau
Feldman, A., and A. Kirman. 1974. Fairness and envy.
American Economic Review 64: 995-1005.
and Le Trosne. Its contents included contributed
articles on economic and political subjects, book
Foley, D.K. 1967. Resource allocation and the public sector.
Yale Economic Essays 7: 45-198. reviews, comments and letters to the editor, together
Nozick, R. 1974. Anarchy, state, and utopia. New York:
with a chronicle of public events of interest to its
Basic Books.
readership. This provided its format from January
Pazner, E., and D. Schmeidler. 1974. A difficulty in the
1769, when Du Pont de Nemours took over the
concept of fairness. Review of Economic Studies 41: 441-
443. editorship. Although censorship problems troubled
Pazner, E., and D. Schmeidler. 1978. Egalitarian equivalent
the journal persistently (as disclosed in the Turgot-
allocations: A new concept of economic equity. Quarterly
Journal of Economics 92: 671-687.
Du Pont correspondence, for this reason many issues
appeared well after the ostensible month of
Rawls, J. 1971. A theory of justice. Cambridge, MA/Oxford:
Harvard University Press/Clarendon Press. publication) the first series was terminated by
Schmeidler, D., and K. Vind. 1972. Fair net trades.
TAbbe Terray in November 1772, presumably
Econometrica 40: 637-642.
because it contained much vigorous criticism of his
Sen, A.K. 1970. Collective choice and social welfare. San
Francisco: Holden-Day. abolition of domestic free trade in grain. The first
series produced therefore six issues in 1766 as a bi-
Steinhaus, H. 1948. The problem of fair division.
Econometrica 16: 101-104. monthly and 63 monthly issues from January 1767
Steinhaus, H. 1949. Sur la division pragmatique.
to March 1772 inclusive. Under the title
Econometrica 17: 315-319.
N o u v e l l e s
Suppes, P. 1966. Some formal models of grading principles. E p h e m e r i d e s
Synthese 16: 284-306. o u B i b l i o t h e q u e
Varian, H.R. 1974. Equity, envy and efficiency. Journal of
r a i s o n n e e d e l ’ h i s t o i r e ,
Economic Theory 9: 63-91.
d e l a m o r a l e e t d e l a
Veblen, T. 1899. The Theory of the leisure class, 1967. New
York: Macmillan and Viking. p o l i t i q u e , it was revived by Baudeau
after Turgot became Controleur-general in 1774,
publishing 18 issues in all from January 1775 to
June 1776, that is, the month after Turgot's dismissal
from the ministry. A third series,
N o u v e l l e s E p h e m e r i d e s
e c o n o m i q u e s published three issues
Ephemerides du citoyen ou chronique de
from January to March 1788, again under Baudeau’s
I'esprit National
editorship, but his failing mental powers were
Peter Groenewegen presumably the reason why this final series ended so
quickly.
Although initially set up by Baudeau in imita-
tion of the English S p e c t a t o r , within a
year of its inception economics began to dominate
Keywords its contents and many of the leading Physiocrats, in
Baudeau, N.; Du Pont de Nemours, P.S.; particular Mirabeau, Baudeau and Du Pont de
E p h e m e r i d e s d u Nemours, contributed most of the articles. A
C i t o y e n ; Mirabeau, V.R. Marquis de; detailed discussion of its contents is given in Bauer (
Physiocracy ) and in Coquelin and Guillaumin
( , pp. 710—12). Perhaps the most important
JEL Classifications piece it contained is Turgot’s R e f l e x i o n s
A1
s u r l a f o r m a t i o n e t
d i s t r i b u t i o n d e s
pp. 113-73), although with considerable JEL Classification
unauthorized alterations and notes by Du Pont (see Cl
Groenewegen , pp. xix-xxi). It also published
foreign contributions in French translation, The following three articles survey some aspects of
including Beccaria’s inaugural lecture with copious the foundations of noncooperative game theory. The
notes and comments by Du Pont goal of work in foundations is to examine in detail
(E p h e m e r i d e s , 1769, No. 6 , pp. 57- the basic ingredients of game analysis.
152) and a contribution by Franklin on the The starting point for most of game theory is a
increasing troubles between England and her ‘solution concept’ - such as Nash equilibrium or one
American colonies (.E p h e m e r i d e s , of its many variants, backward induction, or iterated
1768, No. 8 , pp. 159-92). As an early, if not the dominance of various kinds. These are usually
first, economic journal, the E p h e - thought of as the embodiment of ‘rational
m e r i d e s remains an important part of behaviour’ in some way and used to analyse game
economic literature and an indispensable source for situations.
those interested in the study of Physiocracy. One could say that the starting point for most
game theory is more of an endpoint of work in
foundations. Here, the primitives are more basic.
The very idea of rational - or irrational - behaviour
See Also
needs to be formalized. So does what each player
might know or believe about the game - including
►
about the rationality or irrationality of other players.
Foundational work shows that even what each
Bibliography player knows or believes about what other players
Bauer, S. 1894. Ephemerides. In Dictionary of political know or believe, and so on, can matter.
economy, vol. 1, ed. R.H.I. Palgrave. London: Investigating the basis of existing solution con-
Macmillan. cepts is one part of work in foundations. Other work
Coquelin, C. and Guillaumin, H., ed. 1854. Ephemerides. In
in foundations has uncovered new solution concepts
Dictionnaire de Veconomie politique, vol. 1. Paris:
Guillaumin, Hachette. with useful properties. Still other work considers
Groenewegen, P.D. 1977. The economics of'A.RJ. Turgot. changes even to the basic model of decision making
The Hague: Martinus Nijhoff. by players - such as departures from the expected
utility model or reasoning in various formal logics.
The first article, epistemic game theory: beliefs
and types, by Marciano Siniscalchi, describes the
formalism used in most work on foundations. This
is the ‘types’ formalism going back to Harsanyi (
Epistemic Game Theory: An -8 ). Originally proposed to describe the
Overview players’ beliefs about the structure of the game
(such as the payoff functions), the types approach is
Adam Brandenburger equally suited to describing beliefs about the play of
the game or beliefs about both what the game is and
how it will be played. Indeed, in its most general
form, the formalism is simply a way to describe any
Keywords multi-person uncertainty. Harsanyi’s conception of
Common knowledge; Complete information; a ‘type’ was a crucial breakthrough in game theory.
Epistemic game theory; Epistemic game theory: Still, his work left many fundamental questions
an overview; Game theory; Harsanyi, J. C; about multi-person
Incomplete information; Morgenstem, O; Non-
cooperative game theory; Rational behaviour;
Uncertainty; von Neumann, J
uncertainty unanswered. Siniscalchi’s article sur- ►: Game Incomplete
veys these later developments.
The second and third articles apply these tools to ► ee:: j
the two kinds of uncertainty mentioned. The second ► Nash Equilibrium, Refinements of
article, epistemic game theory: complete My thanks to Rena Henderson and Michael James. The Stem
information, concerns the case where the matrix or School of Business provided financial support.
tree itself is ‘transparent’ to the players, and what is
uncertain are the actual strategies chosen by the
players. The third article, epistemic game theory:
Bibliography
incomplete information, by Aviad Heifetz, has the
opposite focus: it covers the case of uncertainty Aumann, R., and A. Brandenburger. 1995. Epistemic con-
ditions for Nash equilibrium. Econometrica 63: 1161-
about the game itself. (Following Harsanyi, the
1180.
third article focuses on uncertainty about the Harsanyi, J. 1967-8. Games with incomplete information
payoffs, in particular.) played by ‘Bayesian’ players, I III. Management Science
Both cases are important to the foundations 14, 159-182, 320-334, 486-502.
programme. Because Nash equilibrium is ‘as if’ Von Neumann, J., and O. Morgenstem. 1944. Theory of
games and economic behavior. Princeton: Princeton
each player is certain (and correct) about the strat- University Press. 60th anniversary edn, 2004.
egies chosen by the other players (Aumann and
Brandenburger , Section 7h), uncertainty of the first
kind has played a small role in game theory to date.
Uncertainty of the second kind is the topic of the Epistemic Game Theory: Beliefs
large literatures on information asymmetries, and Types
incentives, and so on.
Interestingly, though, von Neumann and Marciano Siniscalchi
Morgenstem ( ) already appreciated the signif
icance of both complete and incomplete information
environments. Indeed, they asserted that phenomena
often thought to be characteristic of incomplete-
Abstract
information settings could, in feet, arise in
Modelling what each agent believes about her
complete-information settings ( , p. 31):
Actually, we think that our investigations - although
opponents, what she believes her opponents
they assume ‘complete information’ without any believe about her, and so on, plays a prominent
further discussion - do make a contribution to the rote in game theory and its applications. This
study of this subject. It will be seen that many article describes Harsanyi’s formalism of type
economic and social phenomena which are usually
spaces, which provides a simple, elegant rep-
ascribed to the individual’s state of ‘incomplete
information’ make their appearance in our theory and resentation of probabilistic belief hierarchies. A
can be satisfactorily interpreted with its help. special emphasis is placed on the construction of
This is indeed true, as work in the modem rich type spaces, which can generate all
foundations programme shows. (Some instances are ‘reasonable’ beliefhierarchies in a given game.
mentioned in what follows.) Overall, the foun- Recent developments, employing richer repre-
dations programme aims at a ‘neutral’ and com- sentation of beliefs, are also considered.
prehensive treatment of all ingredients of a game.
Keywords
See Also Belief hierarchies; Common knowledge; Epi-
stemic game theory: beliefs and types; Harsanyi,
► ipistemic Game U:1 cry ;E - an:. / _ 1 J.C.; Kolmogorov’s extension theorem;
► ipistemi Game Ui.eory Complete, FUc.mation Monotonicity; Polish spaces; Preferences;
Recursive preferences; Type spaces; Universal
type space
 JEL Classifications separable and completely metrizable; in this case, X
Cl is itself deemed a Polish space. Examples include
finite sets, Euclidean space M" and closed subsets
John Harsanyi ( ) introduced the formalism thereof. A countable product of Polish spaces,
of type spaces to provide a simple and parsimoni- endowed with the product topology, is itself Polish.
ous representation of belief hierarchies. He explic-
For any topological space X , the notation A(A)
itly noted that his formalism was not limited to
indicates the set of Borel probability measures on
modelling a player’s beliefs about payoff-relevant
X . If the topology on X is Polish, then the weak
variables: rather, its strength was precisely the ease
topology on A ( X ) is also Polish (for example,
with which Ann’s beliefs about Bob’s beliefs about
Aliprantis and Border , Theorem 14.15). A sequence
payoff variables, Ann’s beliefs about Bob’s beliefs
{ / . i k } k > 1 in A (A) con- verges in the weak*
about Ann’s beliefs about payoff variables, and so
sense to a measure f i e A(x), written //
on, could be represented.
L o n g R i g h t A mm;1 1 /(, if and only if,
This feature plays a prominent role in die episte-
for every bounded, continuous function i f / :
mic analysis of solution concepts (see epistemic
X —> M,
game theory: complete information), as well as in if / d / 2 k —> ij / d f i . The weak*
die literature on global games (Morris and Shin ) topology on A(A)
and on robust mechanism design (Bergemann and Jx Jx
is especially meaningful and convenient when Ais a
Morris ). All these applications place particular
Polish space: see Aliprantis and Border (
emphasis on the expressiveness of the type- space ,
Chapter 14) for an overview of its properties.
formalism. Thus, a natural question arises: just how
expressive is Harsanyi’s approach? Finally, if /< is a measure on some product space Ax
For instance, solution concepts such as NashY , the marginal of /< on A is denoted margY/i.
equilibrium or rationalizability can be characterizedThe basic ingredient of the players’ hierarchical
by means of restrictions on the players’ mutual beliefs is a description of payoff-relevant or
fundamental uncertainty. Fix two sets Si and S2,
beliefs. In principle, these assumptions could be
hereinafter called the u n c e r t a i n t y
formulated directly as restrictions on players’ hier-
d o m a i n s ' , the intended interpretation is
archies of beliefs; but in practice the analysis is
that S_, describes aspects of the strategic situation
mostly carried out in the context of a type space a la
that Player i is uncertain about. For example, in an
Harsanyi. This is without loss of generality only if
Harsanyi type spaces do not themselves impose independent private-values auction, each set S,
could represent bidder i’s possible valuations of the
restrictions on the belief hierarchies that can be
represented. Similar considerations apply in theobject being sold, which is not known to bidder —
context of robust mechanism design. i . In the context of interactive epistemology, S, is
usually taken to be Player i’s strategy space. It is
A rich literature addresses this issue from dif-
sometimes convenient to let = S 2 = S ; in
ferent angles, and for a variety of basic represen-
this case, the formalism introduced below enables
tations of beliefs. This article focuses on hierarchies
one to formalize the assumption that each player
of probabilistic beliefs; however, some extensions
are also mentioned. For simplicity, attention isobserves different aspects of the common uncer-
tainty domain S (for instance, different signals
restricted to two players, denoted ‘ 1 ’ and ‘2 ’ or ‘f
and ‘ — /.’ correlated with the common, unknown value of an
object offered for sale).
An (5i, S 2) - b a s e d t y p e
Probabilistic Type Spaces and Belief s p a c e is a tuple J = ( t y , g j ) j =
Hierarchies j 2 such that, for each / 1,2, 1 )
is a Polish space and g, : 7} —> A (.S' , x T _ f )
Begin with some mathematical preliminaries. A is continuous. As noted above, type spaces can rep-
topology on a space A is deemed Polish if it is resent hierarchies of beliefs; it is useful to begin
with an example. Let .S) .S'? {a, b} and con
sider the type space defined in Table . To interpret,
T\ a, to af2 b. t2 b, 12
t\ 1 0 0 0
ei 0 0.3 0 0.7
To ", t\ ", 11 b. b, /' i
h 0 0.5 0.5 0
^2 0 0 0 1

corresponding to t , and (.v t ,) is g,(/,)({(i „ t - Observe that type s second-order beliefs are
i )}). Thus, for instance, g x (ty)({( a - f2)}) defined over X 2 A(Xj) = S o x A(Si), rather than
=0 ;g2 fe)(m >< T x ) = 0.5. just over A ( X ® ) A(Si); a similar statement
Consider type t \ of Player 1. She is certain holds for her ( k + 1 )-th order beliefs. This is
that S o a : furthermore, she is certain that crucial in many applications. For instance, a typical
Player 2 believes that .s, a and .v, b are equally assumption in the literature on epistemic
likely. Taking this one step further, type t \ is foundations of solution concepts is that Player 1
certain that Player 2 assigns probability 0.5 to the believes that Player 2 is rational. Letting S ; be the
event that Player I believes that s . b with prob- set of actions or strategies of Player i in the game
ability 0.7. under consideration, this can be modelled by
These intuitive calculations can be formalized as assuming that the support of/tj(?i) consists of pairs
follows. Fix an (Si, ,S2)-based type space J = (T ,, (,v2, j i \ ) C S 2 A(*Sj) wherein s 2 is a best
g i ) i = u; for eveiy / = I, 2 define the setX°; and response to //1 . Clearly, such an assumption could
the function h ] : T , — A(A'0') by not be formalized if h \ ( i \ ) only conveyed
information about type t x ’s beliefs on Player 2’s
X°_i=S i and Vf, t T,, h) { t i ) first- order beliefs: even though type t {s beliefs
= marg s - t S i i h ) - (!) about the action played by Player 2 could be
retrieved from h \ i f ), it would be impossible
Thus, h ] (t , ) represents thef i r s t - to tell whether each action that type expects to be
o r d e r b e l i e f s of type t t in type played is matched with a belief that rationalizes it.
space T - her beliefs about the uncertainty Note that, since X f- 1 and X k f are assumed
domain S ,. Note that each X n t S , is Polish. Polish, so are A(x^_1) and X k. Also, each function
Proceeding inductively, assuming that X ° _ r .... h k is continuous.
X k _ ]1 and h ) , .... h k have been defined up Finally, it is convenient to define a function that
to some k > 0 for i = 1,2, and that all sets X 1 associates to each type t , C 7} an entire
;,
b e l i e f h i e r a r c h y , to do so,
/ = 0...............k I are Polish, define the setX1; define the set I l j and, for i = 1 ,2 , the function
and the functions h f + 1 : T, » A ( X l l l ) for i h t : I ) > I l j by
1,2 by
H i = II A ( X k andVocT/.
Xf-Xf1 ■ A (X*~1) and Vf,- G T,, hf+1 (f,-) (E) G3» - (3)

„ t ,) C S. i x T eE}) h f t i ) = ( h j ( t i ) ......h f + 1 ( t i ) , . .. ) .
( 2)
Thus, I l j is the set of ah hierarchies of
for eveiy Borel subset E of X k : . Thus, beliefs; notice that, since each X k _ t is Polish, so
h 2 f l \ ) represents the s e c o n d - is //,.
o r d e r b e l i e f s of type t \ - her
beliefs about b o t h the uncertainty domain S o
= ^ and Player 2’s beliefs about S \ , which by
definition belong to the set A(Aj) = A(S,). Sim-
ilarly, h f ~ ' ('/,) represents type s ( k + 1 )-th
notion of a type space is: can one construct a type the opponent, and conversely. Furthermore, this
space that generates a l l hierarchies in / I f homeomorphism is canonical, in the following
A moment’s reflection shows that this question sense. Note that S - i x //_,• = S - i x IN>oA
must be refined. Fix a type space C l ) , g f = 1 - ( K k ) = K k _ i x Y l l > k A ( X ‘ ) .
2 and a type t t e 7}; recall that, for reasons Then it can b e shown that, if ^ ( / i j .
described above, the first- and second-order beliefs j u f , . . . )
of type t i satisfy h \ ( t f ) e A(S_/) and e H \ , then margXi g- (/r,-) g ) 1 1 Intuitively,
h j ( t i ) e A ( X ° _ i x A(A°)) = A ( S - i the marginal belief associated with g \ over the
x A ( S i ) ) respectively. This, however, creates first k orders of the opponent’s beliefs is precisely
the potential for redundancy or even contradiction, what it should be, namely /<( 1. The proof of these
because both h ] ('/,) and margs j c i h ) can be results builds upon Kolmogorov’s extension the-
viewed as ‘type f,’s beliefs about S_,-’. A similar orem, as may be suggested by the similarity of the
observation applies to higher-order beliefs. coherency condition in Eq. ( ) with the notion of
Fortunately, it is easy to verify that, for every type Kolmogorov consistency: cf. for example
space (1 ) , g,), = , , 2 and type /, C I ) , the Aliprantis and Border ( , Theorem 14.26).
following c o h e r e n c y condition holds: This result does not quite imply that all coherent
hierarchies can be generated in a suitable type
space; however, it suggests a way to obtain this
\ / k > 1, margxt- 2 A*(A) = (4)
result. Notice that the belief on S , x H , associ-
ated by the homeomorphism g- to a coherent
To interpret, recall that A* (f/) € (A^A 1) = A hierarchy /iz- may include incoherent hierarchies v_;
(A^ 2 x A(A<A2)). Thus, in particular, margs / ? 2 (t;) C H - i / H c _ i in its support. This can be
= A)(t;). interpreted in the following terms: if Player i’s
Since Ht is defined as the set of all hierarchies of hierarchical beliefs are given by /r„ then she is
beliefs for Player i , some (in fact, ‘most’) of its coherent, but she is not certain that her opponent is.
elements are not coherent. As noted above, no type On the other hand, consider a type space
space can generate incoherent hierarchies; more ( T „ g d i = 1 ,2 ; as noted above, for every
importantly, coherency can be viewed as an integral player i , each type t i C_ T i generates a
part of the interpretation of interactive beliefs. How coherent hierarchy A;(t;) C_ //'. So, for instance, if ,
could an individual simultaneously hold (infinitely) ij) is in the support of g2 (A) then t \ also generates
many distinct first-order beliefs? Which of these a coherent hierarchy. Thus, not only is type t 2 of
should be used, say, to verify whether she is Player 2 coherent: he is also certain (believes with
rational? This motivates restricting attention to probability one) that Player 1 is coherent. Iterating
coherent hierarchies, defined as follows: this argument suggests that h i e r a r c h i e s
o f b e l i e f s g e n e r a t e d b y
H) = {(/<), > 1, marg^./if = /4 'j. t y p e s p a c e s d i s p l a y
(5) c o m m o n c e r t a i n t y o f
c o h e r e n c y .
Since margxt 2 : A ( X k ~ l ) —> A ( X k /2)
Motivated by these considerations, let
is continuous, //' is a closed, hence Polish subspace
o f H i . //*' //' and \ / k >
Brandenburger and Dekel ( , Proposition
0,
I) show that there exist homeomorphismsg- : //■
k
> A(,S' x // ,-): that is, every coherent hierarchy H = {/-, €//(-' : g ' i ( i y ) ( S , x//V) =
corresponds to a distinct belief over the uncertainty 1}.
domain and the hierarchies of (6)

Thus, H { i
t is the set of coherent hierarchies
for Player i ; H j is the set of hierarchies that
 Brandenburger and Dekel ( , Proposition which has the virtue of relying on familiar ideas
2) show that the restriction g * of g c t to H * from the theory of stochastic processes. However,
is a homeomorphism between H * and A ( S , the first constructions of universal type spaces
x // t ); furthermore, it is canonical in the sense consisting of hierarchies of beliefs are due to
described above. This implies that the tuple (//*, Armbruster and Boge ( ), Boge and Eisele
g *) , = 1 , is a type space in its own right - the (Si, ( ) and Mertens and Zamir ( ).
S2)-based u n i v e r s a l t y p e From a technical point of view, Mertens and
s p a c e . Zamir ( ) assume that the state space S is
The existence of a universal type space hilly compact Hausdorff and beliefs are regular proba-
addresses the issue of richness. Since the homeo- bility measures. Heifetz and Samet ( )
morphism g * is canonical, it is easy to see that instead drop topological assumptions altogether: in
the hierarchy generated as per Eqs. ( ) and ( ) by their approach, both the underlying set of states and
any ‘type’ t j = ( p 1, p 2, s ) €//* in the the sets of types of each player are modelled as
universal type space (H * , g * ) . = 1 , is l, measurable spaces. They show that a terminal type
itself; thus, since H * c o n s i s t s of all space can be explicitly constructed in this
hierarchies that are coherent and display common environment.
certainty of consistency, the universal type space In all the contributions mentioned so far, beliefs
also g e n e r a t e s all such hierarchies. are modelled as countably additive probabilities.
The type space ( H * , g * ) j = 1 , is rich in The literature has also examined other
representations of beliefs, broadly defined.
two additional, related senses. First, as may be
A p a r t i t i o n a l s t r u c t u r e
expected, every belief hierarchy for Player i
(Aumann ) is a tuple (Q,(cr;, P i ) i = 1 ,2 ), where
generated by an arbitrary type space is an element
O is a (typically finite) space of ‘possible worlds’,
off/*; this implies that every type space g t). 2
every <r,: Q —> S i indicates the realization of
can be uniquely embedded in (//*,g*) as a ‘belief-
the basic uncertainty corresponding to each element
closed’ subset: see Battigalli and Siniscalchi ( ,
of Q, and every £, is a partition of Q. The
Proposition 8 .8 ). Call a type space interpretation is that, at any world 0 0 e Q, Player i
t e r m i n a l is only informed that the tme world lies in the cell
if, like ( / / * , # * ) ; = 1 ,, it embeds all other type of the partition £, containing 0 0 , denoted £,(0 0 ).
spaces as belief-closed subsets. The k n o w l e d g e o p e r a t o r for
Second, since each function g * is a Player i can then be defined as
homeomorphism, in particular it is a surjection (that
is, onto). Call a type space (//', g i ) i = ij 2 V£ c C l , K i ( E ) = {ru G Q : £,(m) C £}.
c o m p l e t e if every map g t is onto. (This
should not be confused with the topological notion Notice that no probabilistic information is pro-
of completeness.) Thus, the universal type space vided in this environment (although it can be easily
( H *, g *) , = 1 , is complete. It is often the case added).
that, when a universal type space is employed in the Heifetz and Samet ( ) show that a termi
epistemic analysis of solution concepts, the nal partitional structure does not exist. This result
was extended to more general ‘possibility’ struc-
objective is precisely to exploit its completeness.
tures by Meier ( ). Brandenburger and Keisler
Furthermore, for certain representations of beliefs,
( ) establish related non-existence results for
it is not known whether universal type spaces can
complete structures. However, recent contributions
be constructed; however, the existence of complete
show that topological assumptions, which play a
type spaces can be established, and is sufficient for
key role in the constructions of Mertens and Zamir (
the purposes of epistemic analysis. The next section
) and Brandenburger and Dekel
provides examples.
( ), can also deliver existence results in
non-probabilistic settings. For instance, Mariotti
Alternative Constructions
and Extensions
et al. ( ) construct a structure that is universal, techniques to analyse self-control preferences over
complete and terminal for possibility structures. infinite-horizon consumption problems.
Other authors investigate richer probabilistic
representations of beliefs. Battigalli and Siniscalchi
( ) construct a universal, terminal,
and complete type space for c o n d i t i o n a l See Also
p r o b a b i l i t y s y s t e m , or
collections of probability measures indexed by
relevant conditioning events (such as histories in an
extensive game) and related by a version of Bayes’s
rule. This type space is used in ( ) to provide
an epistemic analysis of forward
induction. Brandenburger et al. ( ) construct a
complete type space for
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s e q u e n c e s , which may be thought of as Ahn, D. 2007. Hierarchies of ambiguous beliefs. Journal of
an extension of lexicographic probability systems Economic Theory 136: 286-301.
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Epistemic Analysis

Under the epistemic approach, the traditional

description of a game is augmented by a mathe-
matical framework for talking about the rationality
or irrationality of the players, their beliefs and
knowledge, and related ideas.
Epistemic Game Theory: Complete The first step is to add sets of t y p e s for
Information each of the players. The apparatus of types goes
back to Harsanyi ( -8 ), who introduced it as a way
Adam Brandenburger to
talk formally about the players’ beliefs about the
payoffs in a game, their beliefs about other players’
beliefs about the payoffs, and so on. (See epistemic
game theory: incomplete information.) But the
Abstract
technique is equally useful for talking about
The epistemic programme can be viewed as a
uncertainty about the actual play of the game - that
methodical construction of game theory from its
is, about the players’ beliefs about the strategies
most basic elements - rationality and irra-
chosen in the game, their beliefs about other
tionality, belief and knowledge about such
players’ beliefs about the strategies, and so on. This
matters, beliefs about beliefs, knowledge about
survey focuses on this second source of uncertainty.
knowledge, and so on. To date, the epistemic
It is also possible to treat both kinds of uncertainty
field has been mainly focused on game matrices
together, using the same technique.
and frees - that is, on the non-cooperative branch
We give a definition of a type structure as
of game theory. It has been used to provide
commonly used in the epistemic literature, and an
foundations for existing non-cooperative
example of its use.
solution concepts, and also to
Epistemic Game Theory: L R
Complete Information,
Fig. 1.1
U 2,2 0,0
Fix an n-player finite strategic-form game (S1, ‘correct’ about Bob's strategy. (Her type f assigns
D 0,0
... , 5", rc1, ... , n " ) . Some 1,1 given sets
notation: probability 1 to Bob's playing R.) Likewise, Bob is
X \ . . „ X \ let X = x i = l X and J T 1 =
n
correct about Ann’s strategy. Ann, though, thinks it
xy ^ f f . Also, given a finite set Q, write AT (Q) possible Bob is wrong about her strategy. (Her type
for set of all probability measures on Q. assigns probability 1/2 to type it for Bob, which
assigns probability 1/2 to Ann's playing U, not D.)
Definition 1.1 An ( S ' _____S'ybased (finite) type Again, likewise with Bob.
structure is a structure
What about the rationality or irrationality of the
players? At state (D, C, R, t b), Ann is rational. Her
( S \ .. . ,S n ;T \ .. . T " ; l1, ...A"),
strategy maximizes her expected payoff, given her
first-order belief (which assigns probability 1 to R).
where each T is a finite set, and each X1 : T‘ —> AT
Likewise, Bob is rational. Ann, though, thinks it
(S~l x T ~ l ). Members o f T ' are called types for
possible Bob is irrational. (She assigns probability
player i. Members o f S x Ta r e called states (of the
1/2 to (R, ub). With type ub, Bob gets a higher
world).
expected payofffrom L than R.) The situation with
For some purposes - see, for example, sections “ Bob is again symmetric.
and Summing up, the example is just a description
of a game situation, not a prediction. A type struc-
” - it is important
ture is a descriptive tool. Note, too, that the example
to consider infinite type structures. Topological
includes both rationality and irrationality, and also
assumptions are then made on the type spaces f .
allows for incorrect as well as correct beliefs (for
A particular state (s'1, s n , f ) describes
example, Ann thinks it possible Bob is irrational,
the strategy chosen by each player, and also each
though in fact he isn’t). These are typical featiues of
player’s type. Moreover, a type /' for player i
the epistemic approach.
induces, via a natural induction, an entire hierarchy
of beliefs - about the strategies chosen by the
players j / i , about the beliefs of the players j
f i , and so on. (See epistemic game theory:
beliefs and types.)
The following example is similar to one in
Aumann and Brandenburger ( , pp. 1166-7).

Example 1.1 (A Coordination Game) Consider the

coordination game in Fig. (where Ann chooses the
row and Bob the column), and the associated type
structure in Fig.
There are two types f, ua for Ann, and two types
t , ub for Bob. The measure associated with each
b

type is as shown. Fix the state (D, f, R, f). At this

state, Ann plays D and Bob plays R. Ann is
 Two comments on type structures. First, we can Type structures allow a formal treatment of this
ask whether Definition above is to be taken as idea. First the formal definition of rationality. This
primitive or derived. Arguably, hierarchies of is a property of strategy-type pairs. Say (s' 1, i ) is
beliefs are the primitive, and types are simply a rational if s' maximizes player/’s expected payoff
convenient tool for the analyst. See epistemic game under the marginal on S of the measiue X \ t l ) .
theory: beliefs and types for further discussion. Say type /' of player i believes an event E C S
Second, note that Definition applies to finite ‘ x T ~ ’ if X ' ( t ' ) ( E ) = 1, and write
games. These will be the focus of this survey. There
is nothing yet approaching a developed literature on B\E) = { f e r : f believes#}.
epistemic analysis of infinite games.
Now, for each player i , let R \ be the set of
all rational pairs (s'1, /'), and for m > 0 define
Early Results R ‘ m inductively by

A major use of type structures is to identify con- <+i=<n [s'x

ditions on the players’ rationality, beliefs, and so
on, that yield various solution concepts. Definition 2.1 I f ( s l , t1........ s", f ) e R„,+ i, say
A very basic solution concept is iterated dom- there is rationality andrn th-order elief of ratio-
inance. This involves deleting from the matrix all nality (RntBR) at this state. If(slsn, tn) e nm=\Rm
strongly dominated strategies, then deleting all say there is rationality and common belief of
strategies that become strongly dominated in the rationality (RCBR) at this state.
resulting submatrix, and so on until no further
deletion is possible. (It is easy to check that in finite These definitions yield an epistemic characteriza -
games - as considered in this survey - the residual tion of IU: Fix a type structure and a state (s 1, t1,...,
set will always be non-empty.) Call the remaining s", f) at which there is RCBR. Then the strategy
strategies the i t e r a t i v e l y profile (s1,..., s") is IU. Conversely, fix an IU profile
u n d o m i n a t e d ( I U ) strategies. (s ,..., s"). There is a type structure and a state (s,
There is a basic equivalence: a strategy is not r,...,s", i') at which thereis RCBR. Results like this
strongly dominated if and only if there is a can be found in the early literature - see, among
probability measure on the product of the other others, Brandenburger and Dekel ( )
players’ strategy sets under which it is optimal. and Tan and Werlang ( ).
Using this, IU can also be defined as follows: delete An important stimulus to the early literature was
from the matrix any strategy that isn’t optimal under the pair of papers by Bemheim ( ) and
some measure on the product of the other players’ Pearce ( ), which introduced the solution
strategy sets. Consider the resulting sub-matrix and concept of r a t i o n a l i z a b i l i t y .
delete strategies that don’t pass this test on the sub- This differs from IU by requiring on each round that
matrix, and so on. a player’s probability measure on the product of the
The second definition suggests what a formal other players’ (remaining) strategy sets be a product
epistemic treatment of IU should look like. A measure - that is, be independent. Thus the set of
rational player will choose a strategy which is rationalizable strategy profiles is contained in the
optimal under some measure. This is the first round IU set. It is well known that there are games (with
of deletion. A player who is rational and believes three or more players) in which inclusion is strict.
the other players are rational will choose a strategy The argument for the independence assumption
which is optimal under a measure that assigns is that in non-cooperative game theory it is
probability 1 to the strategies remaining after the supposed that players do not coordinate their strat-
first round of deletion. This gives the second round egy choices. Interestingly though, correlation is
of deletion. And so on.
 In Across
Out Out Down

1 4
consistent with the non-cooperative approach. This assessment, except for being conditioned on what
4 3
view is put forward in Aumann ( ). the type in question knows. A number of papers
(Aumann, , introduced the study of correlation into have investigated foundations for this assumption -
non-cooperative theory.) Consider an analogy to see, among others, Morris ( ),
coin tossing. A correlated assessment over coin Samet (1998), Bonanno and Nehring ( ),
tosses is possible, if there is uncertainty over the Feinberg ( ), Halpem ( ), and also the
coin’s parameter or ‘bias’. (The assessment is exchange between Gul ( ) and Aumann
usually required to be conditionally i.i.d., given the (1998).
parameter.) Likewise, in a game, Charlie might
have a correlated assessment over Ann’s and Bob’s
strategy choices, because, say, he thinks Ann and Next Steps: The Tree
Bob have observed similar signals before the game
(but is uncertain what the signal was). An important next step in the epistemic programme
The same epistemic tools used to understand IU was extending the analysis to game trees. A big
can be used to characterize other solution concepts motivation for this was to understand the logical
on the matrix. Aumann and Brandenburger ( , foundation of b a c k w a r d
Preliminary Observation) point out that i n d u c t i o n ( B I ). At first sight, BI is
pure-strategy Nash equilibrium is characterized by one of the easiest ideas in game theory. If Ann, the
the simple condition that each player is rational and last player to move, is rational, she will make the BI
assigns probability 1 to the actual strategies chosen choice. If Bob, the second- to-last player to move,
by the other players. (Thus, in Example above, is rational and thinks Ann is rational, he will make
these conditions hold at the state ( D , f , R , the choice that is maximal given that Ann makes
t b ) , and ( D , R ) is indeed a Nash the BI choice - that is, he too will make the BI
equilibrium.) As far as mixed strategies are choice. And so on back in the tree, until the BI path
concerned, in the epistemic approach to games is a identified (Aumann, )•
these don’t play the central role that they do under For example, Fig. is three-legged centipede
equilibrium analysis. Built into the set-up of section (Rosenthal, ). (The top payoffs are Ann’s, and the
“ bottom payoffs are Bob’s.) BI says Ann plays
” is that each player makes a definite O u t at her first node. But what if she doesn’t?
choice of (pure) strategy. (If a player does have the How will Bob react? Perhaps Bob will conclude
option of making a randomized choice, this can be that Ann is an irrational player, who plays
added to the - pure - strategy set. Indeed, in a finite A c r o s s . That is, Bob might play I n ,
game, a finite number of such choices can be hoping to get a payoff of 6 (better than 4 from
added.) It is the other players who are uncertain O u t ) . Perhaps, anticipating this, Ann will in
about this choice. Harsanyi ( ) originally pro fact play D o w n , hoping to get 4 (better than 2
posed this shift in thinking about randomization. from playing O u t ) .
Aumann and Brandenburger ( ) give an epi Many papers have examined this conceptual
stemic treatment of mixed-strategy Nash equilib- puzzle with BI - see, among others, Binmore
rium along these lines.
Aumann ( ) asks a question about an out
side observer of a game. He provides conditions
A B A 3
under which the observer’s assessment of the
strategies chosen will be the distribution of a
correlated equilibrium (as defined in his 1974
paper). The distinctive condition in (1987) is the so-
called Common Prior Assumption, which says that
the probability assessment associated with each
player’s type is the same as the observer’s
1 [0] 0 [0] 0 [0]

0 [0] 0 [0] 0 [1]

Out Down Across

Sa
{ D o w n , t a , I n , t b ) , the bluff fact, both types strongly believe Bob is rational.
works. By contrast, at the state { D o w n , f , Since, under type f , Ann’s second node gets
O u t , u b ) , Atm attempts the bluff and it positive probability (in fact, probability 1 ) under her
fails.) initial measure, we need only check this for type
But what about epistemic conditions? Are the u a . But at Ann’s second node, type u a assigns
players rational in this situation? Does each think probability 1 to the rational pair ( I n , /').
the other is rational? And so on. Turning to Bob, both of his types initially
To answer, we need a definition of rationality believe that Ann is rational. Type u even strongly
with CPS’s. Fix a strategy-type pair ( s ' , /'), believes Ann is rational; but type ( ’ doesn’t. This
where { is associated with a CPS. Call this pair is because, at Bob’s node, type t h assigns positive
rational (in the tree) if the following holds: fix probability (in fact, probability 1 ) to the irrational
any information set H for i allowed by s ' , and pair (A c r o s s , f ) .
look at the measure on the other players’ strategies, Staying with initial belief (we come back to
given H . (This means given the event that the strong belief below), we can parallel Definition and
other players’ strategies allow H . ) Require that define inductively rationality and mth- order
s ' maximizes V s expected payoff under this initial belief of rationality (RtmIBR) at a state
measure, among all strategies r ' of i that allow of a type structure, and rationality and common
H . initial belief of rationality (RCIBR) (see Ben
With this definition, the rational strategy-type Porath, ). In Fig. , since all four types initially
pairs in Fig. are { D o w n , f ) , believe the other player is rational, a simple
{ O u t , u a ) , ( I n , t b ) , and induction gives that at the state ( D o w n ,
( O u t , u b ) . t a , I n , t b ) for instance, RCIBR holds.
Next, what does Ann think about Bob’s ratio- In words, Ann plays across at her first node,
nality? To answer, we need a CPS-analogue to believing (initially) that Bob will play I n , so she
belief (as defined in section “ "). can get a payoff of 4. Why would Bob play In?
Ben Porath ( ) proposed the following Because he initially believes that Ann plays
(we have taken the liberty of changing terminology, O u t . But in the probability-0 event that Ann
for consistency with ‘strong belief’ below): Say plays across at her first node, Bob then assigns
player i initially believes event E if, under /’s probability 1 to Ann’s playing across at her second
CPS, E gets probability 1 at the root of the tree. node - that is, to Ann’s being irrational. He there-
(Formally, the conditioning event consists of all fore (rationally) plays I n . All this is consistent
strategy profiles of the other players. ) Battigalli with RCIBR.
and Siniscalchi ( ) strengthened this defini
tion to: Say player i strongly believes event E
if, under /’s CPS, E gets probability 1 at every
Conditions for Backward Induction
information set at which E is possible. Under
initial belief, E also gets probability 1 at any Interestingly, this is exactly the line of reasoning
information set H that gets positive probability
which, as we said, was the original stimulus for
under V s initial measure (that is, V s measure
investigating the foundations of BI. So, there is no
given the root). This is just standard conditioning
difficulty with it - we’ve just seen a formal set-up in
on non-null events. But under strong belief, this
which it holds. The resolution of the BI puzzle is
conclusion holds for any information set H which
simply to accept that the BI path may not result.
has a non-empty intersection with E - even if H is
But one can also argue that RCIBR is not the
null under V s initial measure. This is why strong
right condition: it is too weak. In the above exam-
belief is stronger than initial belief.
ple, Bob realizes that he might be ‘surprised’ in the
Let us apply these definitions to Fig. . Does Ann
play of the game - that’s why he has a CPS, not just
initially believe that Bob is rational? Yes. Both of
an ordinary probability measure. If he realizes he
Ann’s types initially believe Bob is rational. Type f
might be surprised, should he abandon his
initially assigns probability 1 to the rational pair
( I n , t b ) . Type u a initially assigns
 In In
Out Out Out Out Out

2 1 4 2n - 3 2n
1 4 3 2n 2n -1
 In Across
Out Out Down

Tb tb
1 [0] Battigalli Ta ta 1 [0] formulate
0 [1] and Siniscalchi 0 [1] 0 a[0]general A c r o s s , and we get BI again. Asheim ( ) for
result of this kind. They consider a complete CPS-mulates a general such result.
based type structure, which contains, in a certain Another strand of the literature on BI employs
sense, every possible type for each player (a knowledge models rather than belief models. As
complete type structure will be uncountably pointed out in Example , players’ beliefs don’t have
infinite), and prove: F i x a c o m p l e t e to be correct in any sense. For example, a type
C P S - b a s e d might even assign probability 1 to a strategy- type
t y p e
s t r u c t u r e . I f t h e r e pair for another player different from the actual one.
i s
R C S B R a t t h e s t a t e Knowledge as usually formalized is different, in that
(s1,
t 1 , . . . , s n , C ) , t h e n if a player knows an event E , then E indeed
t h e
s t r a t e g y p r o f i l e happens.
( s 1 , . . . ,
s " ) i s e x t e n s i v e - f o r m Aumann ( ) formulates a knowledge-based
r a t i o n a l i z a b l e . epistemic model for PI trees. In his set-up, the
C o n v e r s e l y , i f condition of common knowledge of rationality
t h e
p r o f i l e (s1,..., s n ) implies that the players choose their BI strategies.
i s
e x t e n s i v e - f o r m Stalnaker ( ) finds that non-BI outcomes are
r a t i o n a l i z a b l e , possible, under a different formulation of the same
t h e n
t h e r e i s a s t a t e (s1, if1,..., s " , condition. The explanation lies in differences in
C ) a t w h i c h t h e r e how counterfactuals are treated. These play an
i s
R C B R . important role in a knowledge-based analysis, when
we talk about what a player thinks at an information
The extensive-form rationalizability strategies
set that cannot be reached given what he knows.
(Pearce, ) yield the BI outcome in a PI game (under
an assumption ruling out certain payoff ties; Halpem ( ) provides a syn
Battigalli, ), so the Battigalli and Siniscalchi thesis in which these differences can be understood.
analysis gives epistemic conditions for BI. See also the exchange between Binmore ( ) and
Aumann (
There are other routes to getting BI in PI games. ), and the analyses by
Asheim ( Samet (
) develops an epistemic ), Balkenborg and Winter ( ), and
analysis using the propemess concept (Myerson, ). Halpem ( ).
Go back to Example . The propemess idea says that Aumann (1998) provides knowledge-based
Bob’s type t b should view (A c r o s s , t " ) epistemic conditions under which Ann plays O u t
as infinitely more likely than { D o w n , f ) in Centipede. The conditions are weaker than in his
since A c r o s s is the less costly ‘mistake’ for(1995) paper, and the conclusion weaker (about
outcomes not strategies). There is an obvious
parallel between this result and the belief- based
AB A 3
result on Centipede we stated above (also about
outcomes). More generally, there may be an
analogy between counterfactuals in knowledge
2 1 0 models and extended probabilities in belief models.
2 1 0 But, for one thing, completeness is crucial to the
belief-based approach, as we have seen, and an
Epistemic Game Theory: Complete Information, Fig. analogous concept does not appear
4.2

Epistemic Game Theory:

Complete Information,
Fig. 4.3

Out In Out Down Across

Sb Sa
 3 2 1 0

3 3,3 0,4 0,2 0,0

2 4,0 2,2 0,2 0,0

A
1 2,0 2,0 1, 1 0,0

0 0,0 0,0 0,0 0,0

Epistemic Game Theory: Complete Information, Fig.

5.1

unit. Figure is an associated type structure (with

one type for each player).

The rational strategy-type pears are R‘J = {0,1,2,3}

x { f 1 } and R\ = {0,1,2,3} x {t6}. Since both types
assign positive probability only to a rational
strategy-type pair for the other player, we get R am =
R'f and Rbm = R\ for all
m. In particular, there is RCBR at the state (3, f, 3,
tb).
But a price of 3 is inadmissible (as is a price of
0). The LA set is just {(1,1)}, where each firm
charges the lowest price above cost. (This is a
plausible scenario: while pricing at cost is inad-
missible, competition forces price down to the first
price above cost.)
A tool to incorporate admissibility is
l e x i c o g r a p h i c
p r o b a b i l i t y s y s t e m s
(L P S ’ s ), introduced and axiomatized by
Blume et al. ( , ). An
LPS specifies a sequence of probability measures.
The interpretation is that the first measure is the
player’s primary hypothesis about the true state. But
the player recognizes that his primary hypothesis
might be mistaken, and so also forms a secondary
hypothesis. This is his second measiue. Then his
tertiary hypothesis, and so on. The primary states
can be thought of as infinitely more likely than the
secondary states, which are infinitely more likely
than the tertiary states, and so on. Stahl ( ),
Stalnaker ( ), Asheim
( ), Brandenburger et al. ( ), and Asheim
and Perea ( ), among other papers, use LPS’s.
Epistemic Game Theory: Complete Information, Fig. 5.2

12
Sb

Epistemic Game Theory: Complete Information, Fig. 5.3

Example 5.2 (Bertrand Contd) Figure is a implies x k > y k for some k < /.) A strategy-type
type structure for Bertrand (Fig. ) that now pair (.v', f ) is rational (in the lexicographic
specifies LPS’s. sense) if s ' is maximal under this ranking.
So (3, f ) and (3, l h ) are irrational. All
Each player has a primary hypothesis which assigns choices give each player an expected payoff of 0
probability 1 to the other player’s charging a price under the primary measure. But a price of 2 gives
of 0. But each player also has a secondary each player an expected payoff of 2 under the
hypothesis that assigns equal probability to each of secondary measure, as opposed to an expected
the three remaining choices for the other player. payoff of 1 from a price of 3. Conceptually, we
This measure is shown in parentheses. Note that want (3, t a ) and (3, l h ) to be irrational
every state (that is, strategy-type pair) gets positive (because a price of 3 is inadmissible).
probability under some measure. But states can also What does each player think about the other’s
be ruled out, in the sense that they can be give rationality? For this, we again need an LPS-based
infinitely less weight than other states. definition. An early candidate in the literature was:
What about epistemic conditions? Are the Say player i believes event E at the 1st level if
players rational in this situation? Does each think E gets primary probability 1 under /’s LPS
the other is rational? And so on. (Borgers, ; Brandenburger, ). A stronger concept is:
To answer, we need a definition of rationality Say i assumes E if all states not in E are
with LPS’s. Fix strategy-type pairs ( s ' , / ' ) infinitely less likely than all states in E , under /’s
and i ) for player i , where i is now associated LPS (Brandenburger, Friedenberg and Keisler,
with an LPS. Calculate the tuple of expected 2006). In other words, a player who assumes E
payoffs to i from s ' , using first the primary recognizes E may not happen, but is prepared to
measiue associated with t ' , then the secondary ‘count on’ E versus not-/?.
measiue associated with t ' , and so on. Calculate In Fig. , type f doesn’t lst-level believe (so
the corresponding tuple for r . If the first tuple certainly doesn’t assume) the other player is
lexicographically exceeds the second, then s ' is rational. Likewise with l b . Again, this is right
preferred to f . (If* = x n ) andy = (v, conceptually.
..........................................................................
y „ ) ,
then .r lexicographically exceeds y if y, > ,v,
Conditions for Iterated Admissibility Bob’s strategies infinitely less likely than another if
the first is eliminated on an earlier round of IA than
Once again we can parallel Definition and define the second. Ewerhart gives an analysis of IA
inductively rationality and wth-order lst-level couched in terms of provability (from mathematical
belief of rationality (RwlBR) at a state of a type logic).
structure, and rationality and common lst-level
belief of rationality (RC1BR). Likewise, one can
define rationality and mth-order assumption of Strategic Versus Extensive Analysis
rationality (RwzAR), and rationality and
common assumption of rationality (RCAR). Kohlberg and Mertens ( , Section 2.4) argued
What do these conditions yield? that a ‘fully rational’ analysis of games should be
In fact, just as we saw in sections “ invariant - that is, should depend only on the fully
and reduced strategic form of a game. (This is the
” that neither RCIBR not RCSBR yields BI, so strategic form after elimination of any - pure -
neither RCIBR nor RCAR yields IA. RCIBR is strategies that are duplicates or convex
characterized by the W concept (Dekel and combinations of other strategies.) In this, they
Fudenberg, ), that is, the set of strategies that remain appealed to early results in game theory (Dalkey, ;
after one round of deletion of inadmissible strategies Thompson, ) which established that two trees
followed by iterated deletion of strongly dominated sharing the same reduced strategic form differ from
strategies. RCAR is characterized by the self- each other by a (finite) sequence of elementary
admissible set concept (Brandenburger, Friedenberg transformations of the tree, each of which can be
and Keisler, 2006). Self-admissible sets may be argued to be ‘strategically inessential’. Kohlberg
viewed as the weak-dominance analogue to Pearce ( and Mertens added a fourth transformation
) best-response sets. involving convex combinations, to get to the fiilly
But while the IA set is one self-admissible set in reduced strategic form.
a game, there may well be others. To select the IA In decision theory, invariance is implied by (and
set, a completeness assumption is needed, similar to implies) admissibility. (Kohlberg and Mertens, ,
section “ Section 2.7, gave the essential idea. See
Fix a complete LPS-based type structure. If Brandenburger, , for the decision- theory argument.)
there is RmAR at the state (s1, t1,..., sn, C), then the If we build up our game analysis using a decision
strategy profile (v1,..., sn) survives (m + 1 ) rounds of theory that satisfies admissibility, we can hope to
iterated admissibility. Conversely, if the profile get invariance at this level too. LPS-based decision
(s1,..., s") survives (m + 1 ) rounds of iterated theory satisfies admissibility. Indeed, IA, and also
admissibility, then there is a state (s1, t1,..., sn, tn) at the S ' W and self- admissible set concepts, are
which there is RmAR (Brandenburger, Friedenberg invariant in the Kohlberg-Mertens sense. The
and Keisler, 2006). extensive-form rationalizability concept (section “
This result is stated for RmAR and not RCA- R. ”) is not.
See the next section for the reason. Of course, for a There does appear to be a price paid for invari-
given game, there is an m such that IA stabilizes ance, however. The extensive-form conditions of
after m rounds. RCSBR and (CPS-based) completeness are con-
IA yields the BI outcome in a PI game (again sistent (in any tree). That is, for any tree, we can
ruling out certain payoff ties; Marx and Swinkels, ), build a complete type structure and find a state at
so, understanding IA gives, in particular, another which RCSBR holds. But Brandenburger et al. (
analysis of BI. ) show the strategic-form conditions
Related analyses of IA include Stahl ( ) of RCAR and (LPS-based) completeness are
and Ewerhart ( ). Stahl uses LPS’s and inconsistent (in any matrix satisfying a non-
directly assumes that Ann considers one of triviality condition).
 A possible interpretation is that rationality, even Aumann, R. 1987. Correlated equilibrium as an expression of
as a theoretical concept, appears to be inherently Bayesian rationality. Econometrica 55: 1-18.
Aumann, R. 1995. Backward induction and common
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Kohlberg-Mertens notion of a ‘fully rational’ Z: 6-19.
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Aumann, R. 1998a. On the centipede game. Games and
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analysis of scenarios (we have seen several in this sufficient epistemic condition for playing backward
survey) that are ‘a long way from’ these theoretical induction. Journal of Mathematical Economics 27: 325-
limits. Under the epistemic approach to game 345.
Basu, K. 1990. On the existence of a rationality definition for
theory there is not one right set of assumptions to extensive games. International Journal of Game Theory
make about a game. 19: 33—44.
Battigalli, P. 1997. On rationalizability in extensive games.
Journal of Economic Theory 74: 40-61.
See Also Battigalli, P., and M. Siniscalchi. 1999. Hierarchies of
conditional beliefs and interactive epistemology in
► ipistemic Game Theory An Overview dynamic games. Journal of Economic Theon’ 88: 188-
► ipistemic. Game Theory: Beliefs and Types 230.
► ipistemic. Game Theory: .complete Battigalli, P., and M. Siniscalchi. 2002. Strong belief and
forward-induction reasoning. Journal of Economic
Theoty 106: 356-391.
► A. . .
Ben Porath, E. 1997. Rationality, Nash equilibrium, and
► Nash Equilibrium, Refinements of
backward induction in perfect information games.
Review of Economic Studies 64: 23^16.
Bemheinr, D. 1984. Rationalizable strategic behavior.
Econometrica 52: 1007-1028.
Bicchieri, C. 1988. Strategic behavior and counterfactuals.
Synthese 16: 135-169.
This survey is based on Brandenburger ( ). I am
Bicchieri, C. 1989. Self-refuting theories of strategic inter-
grateful to Springer for permission to use this mate-
action: A paradox of common knowledge. Erkenntnis 30:
rial. I owe a great deal to joint work and many
69-85.
conversations with Robert Aumann, Eddie Dekel,
Binmore, K. 1987. Modelling rational players I. Economics and
Amanda Friedenberg, Jerry Keisler and Harbome
Philosophy 3: 179-214.
Stuart. My thanks to Konrad Grabiszewski for
Binmore, K. 1996. A note on backward induction. Games and
important input, John Nachbar for very important
Economic Behavior 17: 135-137.
editorial advice, and Michael James for valuable
Blume, L., A. Brandenburger, and E. Dekel. 1991a. Lexi-
assistance. The Stem School of Business provided
cographic probabilities and choice under uncertainty.
financial support.
Econometrica 59: 61-79.
Blume, L., A. Brandenburger, and E. Dekel. 1991b. Lexi-
cographic probabilities and equilibrium refinements.
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Abstract
In a game of incomplete information some of the
players possess private information which may
be relevant to the strategic interaction. Private
information is modelled by a t y p e
 s p a c e , in which every type of each player strategies s = ( s , ) , <= / € S 11, <= /S, of
is associated with a belief about the basic issues the players. (In the particular case in which k is
of uncertainty (like payoffs) and about the other associated with a payoff matrix, that is, the game is
players’ types. At a B a y e s i a n such that each player has finitely many strategies,
e q u i l i b r i u m each type chooses a the payoffs i f ( s ) to the players / e /appear in
strategy which maximizes its expected payoff the entry of the matrix corresponding to the
given the choice of strategies by the other combination of strategies 5 = (s,), s / . ) As usual,
players’ types. Bayesian equilibrium payoffs are the set of strategies S , of player i e I may be a
often inefficient relative to the equilibrium complex object by itself. For instance, it may be the
payoffs that would result had the players been set of mixed strategies over some set of pure
fully informed. strategies S ( f The payoff function of player i in
Keywords the state of nature k is uf : S —> M.
Bayesian equilibrium; Bayesian strategies; Obviously, different types of a player may want
Common knowledge; Epistemic game theory': to choose different strategies. Thus, a B a y e s -
incomplete information; Games with incomplete i a n s t r a t e g y of player i in a game of
information; Private information incomplete information specifies the strategy a ,(/,)
e S , that the player chooses given each one of her
types/, e T j .
JEL Classifications Given a profile of Bayesian strategies a =
C7 ( r i j : T j —> S j ) j s / of the players, the
expected payoff of player i of type /, is
A game of incomplete information is a game in
which at least some of the players possess private
information which may be relevant to the strategic U i ( a , t i ) = ^ 2 uf (<r,■(/,'), <T_,-
interaction. The private information of a player may
be about the payoff functions in the game, as well (/)) x X i ( l i ) ( k , l ,)
as about some exogenous, payoff-irrelevant events. where ox,(/ ,) = ( a f t f f j / ,. If there is a
The player may also form beliefs about other continuum of states of nature and types, the sum
players’ beliefs about payoffs and exogenous becomes an integral:
events, about their beliefs about the beliefs of
others, and so forth. Ui(a, ti) = JKxT_Uk (o;(/;), G-i(t-i))dXi(ti)
Harsanyi ( -8 ) introduced the idea that (k,l i)
such a state of affairs can be succinctly described by
a t y p e s p a c e . With this formulation, (In this case, the expected payoff function U t ( a ,
T , denotes the set of player /’s t y p e s . Each t j ) is well defined if the Bayesian strategies qy :
type t , e 7} is associated with a belief X , { t , ) 7)
e A ( K x T _ , ) about some basic space of S j are measurable functions and if the payoff
uncertainty, K , and the combination 7' , of the function f - . K x S ^ R is measurable as well;
other players’ types. The basic space of uncertainty we omit the details of this technical requirement).
K is called the space of s t a t e s o f We assume that the players are expected payoff
n a t u r e , and Q = K / II, s { T h where 7 maximizers. Thus, player i prefers the Bayesian
is the set of players, is called the space of strategy a over o' if and only if U , { a , /,) >
s t a t e s o f t h e w o r l d . C7,(cr', t j ) for each of her types t j e T , . It
A type space models a game of incomplete follows that given a Bayesian strategy profile o_, of
information once each state of nature k e K is the other players, the Bayesian strategy o, is a
associated with a payoff matrix of the game, or, b e s t r e p l y of player i if for any other
more generally, with a payoff function u k t for strategy o' of hers, t/,((o„ o_,), t j ) >
each player i c I . This payoff function specifies U i ( ( < j ' , o_,), t , ) for each of her
the player’s payoff uf (,v) for each combination of
types t t e T t . A B a y e s - N a s h has invested in the first period, investor f s
e q u i l i b r i u m or a B a y e s i a n payoff in the state of nature k is
e q u i l i b r i u m is a profile of Bayesian 3
strategies a * = (cr,*),- e / such that cr,* is a best iM'wait' ,■) = —k.
reply against cr_;* for every player? e I. I\ / ^
A simple, discrete variant of an example by
• If the investor n e v e r invests, her payoff is 0
Gale ( ) may clarify these abstract definitions.
irrespective of the state of nature:
There are two investors i = 1,2 and three
possible states of nature k e K = {—1, 0, 1} . (‘never’ ,■) = 0 .
Each investor i only knows her own type
Blow will the different types behave at a Bayes-
t i e T i = {-1 0 , -6 , -2 ,2 ,6 ,1 0 }. ian equilibrium? The type t , = 10 assesses that
by investing immediately her expected payoff is
Every type t t of investor i believes that all of
the other investor’s types t j e T j , j / i , are U i ( ‘ i m m e d i a t e l y ' , 10) = ;xO
equally likely, so that each of them has probability + ;X 1 = ^
Moreover, every type t t believes that the state of 6 66
nature is k = 1 when t t + t j > 0 ; that
(immediate investment yields 0 in case t j = —1 0 ,
the state of nature is k = 0 when?,- + t j 0 ; and
and yields 1 in case t j = — 6 , — 2 , 2 , 6 , 10). This
that the state of nature is k = — 1 when?,- +
is higher than }, the maximum payoff she could
t j < 0 . Formally, the belief of type t t e 7} is
possibly get by waiting for the second period, and
defined by
higher than the payoff 0 of never investing. So at a
Bayesian equilibrium
X,(ti)(k,tj) = \\k has ^ same sign as U + t,
{0 otherwise of (1 0 ) = 'immediately', i = 1 ,2 .
Next, the expected payoff to the type t - i =
The investors cannot communicate their types to 6 from immediate investment is
one another. They can invest in at most one of two
1 1 4
available investment periods. Each investor has U i { ' i m m e d i a t e l y ',6 ) = -x (— 1)
three relevant strategies: invest +—x0+—
6 6 6
i m m e d i a t e l y , in the first period;
w a i t to the second period and invest only if the
other investor has invested in the first period; or
n e v e r invest. The payoff of each of the
(immediate investment yields 1 unless t j = —
investors depends on the state of nature k c K
1 0 , in which case the payoff is — 1 , or t j = —
{ 1,0,1} and on her own investment strategy, but not
6 , in which case the payoff is 0). So investing
on the investment strategy of the other investor. The
immediately is preferred for her over never
payoffs are as follows:
investing. But how about waiting until the second
• Investing i m m e d i a t e l y when the period? That’s an inferior option as well, since the
state of nature is k yields investor i a payoff of types t j = — 1 0 , — 6 , — 2 will never invest
k in the first period (this would yield them a negative
expected payoff). So only the positive types t j =
2,6,10 could c o n c e i v a b l y invest
u\ (‘ immediately’ ,•) = k
immediately, with overall probability reaching at
(The • stands for the investment decision of the most |. So waiting to see if they invest yields to the
type t , = 6 an expected payoff not higher | x { = |,
• If investor i chooses to wait to the second period which is smaller than { . We conclude that the
and invest only if the other investor preferable strategy of t j = 6 at equilibrium is
 < 7 * (6 ) = ‘i m m e d i a t e l y ’, i 1,2. of the players are not completely aligned. For
example, a potential seller of an object would like to
What about t , = 2? Iimnediate investment strike a deal with a potential buyer at a price which
yields her is as high as possible, while the potential buyer
2 1 3 would like the price to be as low as possible. That’s
Vi(‘immediately’, 2 ) = — x (—1) + — x 0 + — why the traders might not volunteer to communicate
6 66
honestly their private valuations of the object, even
if they are technically able to do so. Still, in case the
buyer values the object more than the seller, they
(— 1 is the payoff when t j = - 1 0 , 6; 0 would both prefer to trade at some price in-between
is the their valuations rather than forgoing trade
payoff when = — 2 ; the payoff is 1 otherwise). altogether. Therefore, the traders would
However, given that the types /, = 6,10 invest nevertheless like to avoid a complete lack of
immediately at equilibrium, and that the negative communication. Myerson and Satterthwaite ( )
types t j = — 1 0 , — 6 , — 2 do not invest phrase general conditions under which no
immediately, the type t , = 2 figures out that by Bayesian equilibrium of any trade mechanism is
waiting and investing only if the other investor has ever fully efficient due to this tension between
invested first would yield her an expected payoff interests alignment and interests mismatch. Under
these conditions, even if the traders are able to
, , 2 3 1 1 communicate their private information, at no
U i ( w a i t ,2) > — x —
= ->- 6 4 4 Bayesian equilibrium does trade take place in all
6
instances in which there exist gains from trade.
(| is the probability assigned by t , = 2 to the event In the above variant of Gale’s example we were
that /, c {6 , 1 0 } and hence j invests immediately, able to find the unique Bayesian equilibrium using
and | is the payoff from the second period iterative dominance arguments. We have iteratively
investment). Thepreferred strategy of /, 2 at crossed out strategies that are inferior for some
equilibrium is therefore types, which enabled us to eliminate inferior strat-
egies for other types, and so forth. As in games of
a*(2 ) = ‘wait’, i = 1 ,2 .
complete information, this technique is not appli-
We can now compute inductively, in a similar cable in general, and there are games with incom-
way, that also plete information in which a Bayesian equilibrium
is not the outcome of any process of iterative elim-
of(—2 ) = ‘w a i t ’ , i = 1 ,2 of (—6 ) =
ination of dominated strategies (Battigalli and
‘ w a i f , i
Siniscalchi ; Dekel et al. ).
= 1,2
Games with incomplete information are
and that discussed in many game theory textbooks (for
example, Dutta ; Gibbons ; Myerson ; Osborne ;
of (1 0 ) = ‘never', i = 1 ,2 . Rasmusen ; Watson ). Aumann and Heifetz ( ),
Notice that the equilibrium in the example is Battigalli
inefficient. For instance, when the pair of types is and Bonanno ( ) and Dekel and Gul ( )
(/i , t 2 ) = (2 , 2 ) the investment is profitable, are advanced surveys.
but both investors wait to see if the other one
See Also
invests, and thus end up not investing at all. In this
case, behaviour would become efficient if the ^ ED IS term c Gsinc' liicorv AJO. Overview
investors could communicate their types to each
other. Indeed, they would have been happy to do so,
because their interests are aligned.
Obviously, there are other strategic situations
with incomplete information in which the interests
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case (prediction) or from a particular case to a
learning. European Economic Review 40: 617-628.
Gibbons, R. 1992. Game theoiy for applied economists. pattern which subsumes it (explanation). Prediction
Princeton: Princeton University Press. and explanation are thus two sides of the only
Harsanyi, J.C. 1967-8. Games with incomplete epistemic coin, experience generalized. The
information played by Bayesian players, parts I III.
economic world and economic knowledge are then
Management Science 14: 159-182,320-334,486-502.
Myerson, R. 1991. Game theoiy: Analysis of conflict. construed on this natural science model.
Cambridge, MA: Harvard University Press. This very basic empiricism needs
Myerson, R., andM. Satterthwaite. 1983. Efficient supplementing in two ways, if it is to carry con-
mechanisms for bilateral trading. Journal of viction. One is to give theory a more explicit role,
Economic Theory 29:265-281.
Osborne, M. 2003. Introduction to game theory. Oxford: which it plainly has in the practice of economics,
Oxford University Press. without undermining the claims of prediction to be
Rasmusen, E. 1989. Games and information: An introduc- the only test of truth. A neat source is Friedman (
tion to game theory. Oxford: Basil Blackwell.
), who associates economic theory with ‘a
Watson, J. 2002. Strategy: An introduction to game theory.
New York: W.W. Norton. language’ and ‘a body of substantive hypotheses’.
The former is ‘a set of tautologies’ and ‘its function
is to act as a filing system’. The latter is ‘designed
to abstract essential features of a complex reality’.
Whether the right features have been abstracted and
included in the filing system depends solely on thee
Epistemological Issues in Economics
success of the resulting predictions. This echoes the
Shaun Hargreaves-Heap and Martin Hollis Logical Positivists’ distinction between analytic
statements, whose truth relies on the meaning of
terms and tells us nothing about the world, and
synthetic statements, whose truth depends on the
facts. Friedman’s ‘substantive hypotheses’ serve to
Economics has raised such high hopes with its link pure theory (the ‘filing system’) to the world,
sophisticated techniques that the lack of agreed while making sure that empirical facts wear the
findings sets a puzzle. It will be suggested here that trousers.
this lack of agreement reflects an epistemological
puzzle, partly of how to recognize a causal
 The other supplement is Popper’s ( ) Economics is full of illustrations of the Quine-
account of science as conjectures and refutations. Duhem hypothesis. The ‘money supply’ or ‘the
Reflecting that circular theories, like those of Freud general price level’ are not brute facts. There are a
and Marx, are always confirmed by experience in number of different definitions of the money supply
the eyes of their holders, he weakens the claim of and ways of aggregating prices, and the choice of
empirical confirmation as a test of truth. Instead, it one rather than another will reflect theoretical
is falsifiability which separates science from considerations. The economist works with
pseudo-science. Formally, if hypothesis H implies descriptions of data which already have theoretical
observation O , then O does not prove H , but order built into them, and this seems inescapable.
n o t - 0 refutes H . So a genuinely scientific Likewise, the joint testing of hypotheses is
theory must state possible empirical conditions in notoriously recognized in economics to be
which it would be refuted. A causal law is an complicated by the role of c e t e r i s
empirical hypothesis of sufficient scope and gen- p a r i b u s conditions. Predictions are always
erality, which has risked refutation. In Popper’s own issued subject to certain c e t e r i s
eyes, he has made a radical break with traditional p a r i b u s clauses, and if the prediction is
empiricism by undermining the value of induction. falsified, the economist is often able to claim that
However, epistemologically, claims to knowledge this is because the c e t e r i s p a r i b u s
still face the same old test and the facts of conditions were violated, particularly when, as in
observation are still trumps. (This paragraph refers consumer theory, there are unobservable variables
to Popper’s best-known, classic account and not to like preference orderings or utility functions to
his more recent writings.) reckon with. So we find that empirical tests in
Later philosophy of science has raised serious economics are often indecisive. Few neoclassical
difficulties for this empiricist approach to judging a economists, for example, seem willing to forsake
theory. The Quine-Duhem hypothesis has it that a the homogeneity assumption (the absence of money
scientific theory is a web, which includes obser- illusion) in consumer theory despite its frequent
vation sentences and which can only be understood ‘falsification’. Indeed, it looks rather as if, despite
as a whole. Quine ( ), evoking Duhem the common gestures of respect for Popper,
( ), argues that traditional empiricism relies economics is full of those circular theories which
on two untenable dogmas. One is that our five are always confirmed by experience in the eyes of
senses supply us with ‘unvarnished news’ as an their holders. The Quine-Duhem hypothesis is
objective and independent test of hypotheses. The descriptively plausible.
other is that meaningful statements divide cleanly This conclusion would not surprise Kuhn ( ),
into analytic and synthetic (as defined above). Both who argues that even the natural sciences
dogmas are to be rejected. Our beliefs form a have not progressed in the way expected by an
‘seamless web’, a ‘field of force which touches empiricist methodology. Instead, their history is
experience only at the edges’. At the moment of best understood as a discontinuous series of para-
testing they ‘face the tribunal of experience digms. By ‘paradigms’ he usually seems to mean
together’ and, in assessing the verdict, we always the definitive current practices of the dominant
have a choice of what to accept, revise or reject scientific community and sometimes a more loosely
(including our own observations). In place of a specified set of currently shared presuppositions or
single hypothesis H implying an unvarnished world views. Paradigms rise and fall for many
observation O , we have a set H y H ^ ... etc. reasons, but empirical testing is never decisive.
linked to another theory-laden set O y O i ... etc. Rather, paradigms simply acquire more and more
What we do about it, when we find that we cannot anomalies as contrary empirical evidence
keep both sets, may be governed by criteria like accumulates, and it is only when a new paradigm
parsimony, elegance or fertility, whose epistemic surfaces, which can incorporate the anomalies, that
warrant is open to question and is far removed from the anomalies become regarded as counter-
any which relies on there being brute facts. examples. A paradigm shift then occurs.
Feyerabend ( ) has continued this
process of dismantling empiricism, until it is unclear the humanities seek to understand by reconstructing
whether theory choice can be a rational process at the actors’ world from within. The crux is the idea
all. This can be read as an invitation to a sociology that the agent’s own point of view matters in the
of knowledge approach. If there is no good social world in a way which does not hold for the
intellectual reason behind theory selection, then we natural sciences. Unlike the natural world, the social
must study the social pressures on and within the is n o t an ordered realm independent of our
scientific communities, which influence the concepts, beliefs, hypotheses and conjectures about
evolution of theory. In economics one might cite the it. Our beliefs influence our actions and hence the
suspicion in some quarters that the dominance of outcomes we observe in any empirical
neoclassical economics owes much to its apparent investigation, whereas subatomic particles have no
support for a free enterprise system and that its beliefs to affect outcomes in the natural world. This
mathematical sophistication is best understood as an sets a puzzle for an empiricist methodology, which
exclusionary device typical of a closed profession. seeks the causal laws governing an independent
But a step into the sociology of knowledge is not the realm. How is the social scientist to investigate the
only option. world from within and to relate these findings to the
Lakatos ( ) tries to reaffirm the core of demands of objectivity?
Popper by accepting that the units at stake are whole Weber’s answer is that some of his work is to be
research programmes rather than single hypotheses, done by a process of ‘ v e r s t e h e n ’ - a
and that the core of the research programme is often key term from the German idealist, ‘hermeneutic’
defended against falsification by suitable (interpretative) tradition. The guiding thought is that
adjustments to the auxiliary hypotheses or what turns behaviour into action is its inward
‘protective belt’. A research programme is to be meaning and that institutions similarly are mean-
judged, however, by whether these revisions to the ingful practices. But ‘meaning’ is an elusive con-
protective belt are progressive or degenerating. cept, which threatens to let in more subjective
Degenerating ones are a d h o c and cover only variety than a social scientist can welcome. Weber
the anomaly which has precipitated the adjustment, tries to render v e r s t e h e n more precise by
whereas progressive ones provide additional and stressing the rationality of action seen through the
novel areas of application for the theory. The actor’s eyes. He borrows the neoclassical economic
progressive/degenerative distinction sounds a concept of rational action. To the objection that real
promising way of reintroducing empirical criteria actions are not always rational, even when seen
into the evaluation of a theory, but in practice this from within, he replies that, by establishing what
designation, like falsification earlier, is prone to would be fully rational, one can identify departures
vary with the eyes of the beholder. What looks from the ideal type as e x p l a n a n d a .
progressive from one theoretical perspective can V e r s t e h e n is not the only method,
become a d h o c when viewed from another. however. The social sciences seek both adequacy at
For a setting to these developments the reader might the level of meaning and adequacy at the causal
usefully consult Harre ( ); for a level, with the ‘causal level’ said to be one of
chart of the options, Chalmers ( ); and for a statistically significant correlations.
robust post-empiricist philosophy of science, Hesse V e r s t e h e n is thus finally less of an
( ). alternative to e r k l d r e n and more of a
Recent philosophy of science thus makes it heuristic device; but an interesting line has been
unsurprising that economic methodologies inspired opened.
by empiricism are alive with controversy. But there Among examples of the use of
are other sources of methodological inspiration. v e r s t e h e n Weber cites pure
Weber (1922) draws an appealing but cloudy mathematics. This suggests a more ambitious
distinction between explaining ( e r k l d r e n ) thought, one which finds echoes in economics itself.
and understanding ( v e r s t e h e n ) . Von Mises ( , ) pre
Natural sciences seek to explain by means of causal sents economics as the science of human action and
laws; economic theory as the construction a
p r i o r i
of ideal types of rational allocation. This yields an ends as well as of means. An ideally rational
element of a p r i o r i knowledge contrary to allocation of resources is the one which a just or
empiricism. Similarly, Hayek ( ) and the new good society would display, and an ideally rational
Austrians appeal to Kant and a p r i o r i choice is, in the last analysis, a moral choice. A
knowledge when making their commitment to a switch to a Kantian epistemology may breach the
methodological individualism grounded in the positive/normative distinction and restore eco-
preconditions of the possibility of free choice. nomics to the position of a moral science.
Although a shift to a Kantian epistemology of A challenge to the positive/normative distinction
pure reason would create more problems than it opens up deep epistemological questions. But some
answers, it could have interesting implications. economists are willing to take the plunge, inspired
Consider, for example, Arrow-Debreu general by Rawls ( ). By defining a just soci
equilibrium theory. It is not plausibly regarded ety as one whose allocation of resources rational
either as a set of empirical hypotheses or as a mere agents would agree upon in advance of knowing
filing system. Its proponents would not accept a what they would each get out of it personally,
sociology-of- knowledge suggestion that it belongs Rawls connects economic rationality to moral
to the initiation rites of the profession. It functions choice. That makes it possible to ask precise ques-
very much as an ‘ideal type’, used forjudging tions about, for instance, the rationality of prefer-
economic performance and making policy ences and which kind of preferences should be
recommendations. What claim has to be made for it, satisfied in cases of conflict. The hope might be said
if it is to be a reliable benchmark for performance? to be an a p r i o r i , normative science with
A Kantian reply is that it has to lay claim to truth, in implications both for efficiency and for moral
the sense of stating correctly what would be the advance. This is to take seriously the thought that to
outcome of a fully rational allocation of resources know what would be ideally rational is to know
throughout an economy. As in mathematics, the how to do better.
Kantian adds, a p r i o r i truths are hard to Rawls’s epistemological novelty lies in the use
come by but are nonetheless what theory aims for. of a thought-experiment, inviting readers to think
Arrow-Debreu general equilibrium theory makes themselves into the shoes of fully rational, self-
sense on no other terms. interested agents, who do not yet know whether
This is, of course, a contentious approach even they themselves will gain or lose from any
to pine mathematics. It is doubly so for economics, arrangement proposed. Their knowledge of what
owing to the role of rationality in its ‘ideal types’. would be rational comes from a proof that each
Not everyone would accept that Arrow-Debreu does best to settle for equal basic rights and a
general equilibrium theory embodies an ideally maximum distribution of goods. The proof is con-
rational allocation. Whether it does depends in part troversial, but Rawls has certainly given economists
on how ‘rationality’ is defined. It is standardly new thoughts, especially in welfare economics, and
given an instrumental definition, with a rational a new line of defence against the charge that pure
allocation being one which adopts the most efficient theorizing about reflective equilibria is only a
means to a given end. One reason for this definition parlour game.
is that it is believed to keep on the safe side of the The article began by suggesting that the lack of
positive/ normative distinction and so to preserve many results in economics comparable to the major
the basic parts of economic theory from value discoveries in natural science reflected puzzles
judgements. This does not satisfy advocates of other about causal laws and the value of seeking them.
approaches, especially political economists, who Some of the puzzles are general for all sciences;
allege that Arrow-Debreu general equilibrium witness the unfinished arguments started by Quine,
theorem has ideological commitments. A Kantian Kuhn and others. An initial empiricism seems
comment would be that ‘ideal type’ rationality is peculiarly difficult to uphold in economics,
bound to involve the rationality of however, because one is trying to predict what will
be done by agents, who themselves have
beliefs and whose world depends on their Kuhn, T.S. 1970. The structure of scientific revolutions,
expectations. 2nd edn. Chicago: University of Chicago Press.
Lakatos, I. 1978. The methodology of scientific
That makes rationality an epistemologically research programmes. In Philosophical papers, Vol.
important yet special concept in economics. But it is I, ed. J. Worral and G. Currie, Cambridge: Cam-
unlikely to be a gateway to a simple rationalist bridge University Press.
epistemology. Whereas an ‘ideal type’ of lfiction- Lipsey, R.G. 1980. Introduction to positive economics.
London: Weidenfeld & Nicolson.
less motion is simply a limiting case with a zero Popper, K.R. 1963. Conjectures and refutations: The
coefficient of friction, an ‘ideal type’ of rational growth of scientific knowledge. London: Routledge &
choice is not an abstraction from normal behaviour Kegan Paul.
but a solution to a theoretical problem with a likely Quine, W. 1961. Two dogmas of empiricism. In From a
logical point of view, ed. W. Quine. Cambridge, MA:
normative dimension. Even if economics is still Harvard University Press.
regarded as the search for a different kind of causal Rawls, J. 1971. A theory of justice. Cambridge, Mass.:
law, rather than as an alternative to causal thinking, Belknap Press of Harvard University Press.
this difference in kind is great enough to set von Mises, L. 1949. Human action. London: William
Hodge.
epistemological problems. Changes in belief change
—. 1960. Epistemological problems of economics.
the course of economic events and introduce Princeton: Princeton University Press.
discontinuities, which make ideal types of rational Weber, M. 1921. Economy and society’, 1968. New
action unlike timeless models of causal regularities. York: Bedminster Press.
Rational belief is part of the concept of rationality.
So the normative element of the concept of
rationality will remain important for economics,
even if only for prediction. Equal Rates of Profit

Christopher Bliss
See Also

The concept of equality, or its opposite inequality,

implies a comparison, and a comparison must be
based on the consideration of a population of cases.
Therefore equality or inequality has different
implications according to the definition of that
population. This general observation applies in
Bibliography particular to rates of profit.
Three different types of comparison of rates of
Chalmers, A.F. 1976. What is this thing called science? St profit will be examined:
Lucia, Queensland: University of Queensland
Press. (i) We may compare the rates of profit in terms
Duhem, P. 1914. The aim and structure of physical theory, of a fixed n u m e r a i r e , particularly
1954. Princeton: Princeton University Press.
Feyerabend, P.K. 1975. Against method: An outline of an money, which can be obtained over a certain
anarchistic theory of knowledge. London: New Left period of time from investment of funds in
Books. different lines of activity. We shall refer to
Friedman, M. 1953. On the methodology of positive
equality in this sense as s e c t o r a l
economics. In M. Friedman, Essays in positive
economics, Chicago: University of Chicago Press. e q u a l i t y of rates of profit. Or,
Harre, R. 1972. The philosophies of science. Oxford: (ii) We may compare the rate of profit obtainable
Oxford University Press. Hayek. over a certain period of time in terms of one
Hayek, F.A. 1960. The constitution of liberty. Chicago:
n u m e r a i r e with that obtainable over
University of Chicago Press.
Hesse, M. 1980. Revolutions and reconstructions in the the same period of time in terms of another
philosophy of science. Brighton: Harvester Press. n u m e r a i r e .
 In a famous chapter of his G e n e r a l highest return. Indeed in some cases an arbitrage
T h e o r y (Keynes , Ch. 17), Keynes condition alone suffices to demonstrate that rates of
employs the term ‘own rates of interest’ to profit must be equal.
describe these rates of return in terms of We shall refer to a state of the economy in
different n u m e r a i r e s , and we which all possibilities of profitable arbitrage have
shall borrow the same term and call equality been put into effects, which is a kind of short-period
of the rates of return in different numeraires equilibrium, as an a r b i t r a g e
o w n r a t e s equality Finally, e q u i l i b r i u m . It has sometimes been
(iii) We may compare the rate of profit obtainable claimed that profit (where what is intended is a part
in terms of the fixed n u m e r a i r e , of profit distinct from a normal rate of return) is
which may again be money, during one period essentially a phenomenon of disequilibrium. On this
of time with that obtainable during another account an arbitrage equilibrium would not only
later period of time. This comparison include exhibit equal rates of profit, all rates of profit would
the historically important question of the long- equal zero. Only the normal rate of return would be
term trend of the rate of interest, whether it realised in an arbitrage equilibrium.
will tend to constancy, to increase, or to To argue about terminology where weighty
decline and, if not constant, what will be its issues are involved shows poor judgement. Even if
eventual limit. We shall refer to equality in profit is defined to be an excess of return to capital
this sense as t e m p o r a l above the return generally available, and even if we
e q u a l i t y of rates of profit. (In exclude temporary rents, it remains to show that no
common with many writers, particularly in the sector can enjoy a permanent profit advantage
past, we ignore in the present discussion against which arbitrage is for some reason
distinctions between the rate of interest and powerless. If, on the other hand, profit is taken to
the rate of profit. The main cause of a include temporary rents it is evident that there is
persistent difference between the two must be really no case for equality. Hence the only
sought in the uncertainty from which our interesting question to decide is whether rates of
analysis abstracts.) profit defined as net returns to capital divided by the
values of capital employed (on average or at the
While it is convenient to have discussions of margin) are equal in an arbitrage equilibrium.
respectively sectoral, own-rate and temporal
equality of rates of profit collected together in one
article, it will be clear that these are distinct notions Sectoral Equality of Rates of Profit
and that the investigation of the conditions required
for another. Nowhere is the power of arbitrage, together with its
limitations, better illustrated than in the case of
comparisons of profit rates across sectors. The
The Theory of Profit desire of every investor to obtain the highest pos-
sible rate of return may reasonably be assumed to
An argument concerning equality of rates of profit equalize the equivalent rates of return on different
might depend importantly on which theory of the
bonds. Will not a similar principle ensure the
rate of profit is invoked. Such is inescapably the equalization of rates of profit in different activities,
case where temporal equality of rates of profit is
be they regions or industries?
concerned. However a good deal of our argument The answer depends on two important points.
concerning sectoral and own rate equality of rates of
First, we must decide how to compare two rates of
profit is independent of the exact theory of the return, what are the principles of equivalence?
determination of rates of profit in general. This
Secondly, arbitrage may encounter obstacles. This
unexpected possibility might be realized because is tme even where bonds are concerned,
equality of rates of profit depends above all upon
arbitrage, the tendency for capital to seek the
p 11 P 12 '■Pi, ■ ' ' P i t
P l P 22 ' ' Pi, ■ ' ' (1)
\ P 2 T
P N 2 ' ■ ' '
P m' P n , ■ P n t

As problems raised by infinite price systems

need not concern us here, we suppose that the prices
only extend forward to period T . If we imagine
that good 1 is money, it will be seen that the money
rate of interest in period 1 for a /-period loan may be
calculated as follows. One unit of present money
costs p n and one unit of money bought now for
delivery in period / costs p u . Hence one unit of
money surrendered now buys P i f p u units of
money at t. This corresponds to a rate of interest
equal to p \ \ l p \ t — 1 , or ( p ii — p u ) !
p u - What was denoted above by the term the
money rate of interest can equally be designated the
own rate of interest on money, in this case for a t-
period loan.
The money rate of interest measures the extra
money obtainable by postponing payment as a
proportion of the payment deferred. This notion
generalises to any good. We may for example
measure the extra wheat obtainable by postponing
delivery as a proportion of the quantity of wheat
delivery deferred. Suppose that wheat prices occupy
the second row of (Eq. ) above. Then the / period
own rate of interest for wheat will be equal
top 2 \ l p 2 t ~ h or ( p 2 \ - P i t ) !
P n , which is exactly analogous to the expression
of the money rate of interest already derived.
Turning from the rows of (Eq. ), which corre-
spond to different goods, consider the columns,
which correspond to different periods of time. It is
easily shown that if the columns are proportional to
each other, which is the same as saying that relative
prices are the same in all periods, then the own rate
of interest for a given duration of loan is the same
for all goods. Suppose that the own rate
of interest for good 1 for a deferment from period 1 Stationarity of the real economy is sufficient
to period t is rjt. Then, as we have already seen: for stationarity of a price system that will
support production activities, but does not
imply that any such price system will be
r\t= {Pn-P\,)/P\, (2) stationary. Indeed it is an implication of the
multiplicity of price systems and interest rates
However, by assumption: which goes under the name of ‘double-
switching’. That prices which support sta-
Pi,/Pu=Pn/Pu (3) tionary production will frequently be neither
unique nor themselves stationary. Their non-
So that: uniqueness is an immediate implication of
double-switching. The existence of non-
(Pn-Pu)/Pi, = (Pu -Pit)/Pit (4) stationary price systems for these equilibria E
follows when we note that the average of two
systems of equilibrium prices must themselves
Or, be equilibrium prices. However the average of
r\t = r\t (5) two price systems based on different rates of
interest produces a rate of interest variable
Here, constancy of relative prices implies over time, and varying relative prices.
equality of own rates of return, as required. Con- The importance of these findings may be
versely, variations in relative prices will be questioned because the price system is required to
reflected in differences in own rates of return. support not only production (supply) but also
Under what circumstances is it reasonable to consumption (demand). This will make the obser-
assume constancy of relative prices over time? We vation of non-unique prices, and in particular of a
shall certainly require the assumption that the history including double-switching, much less
economy is stationary in some sense. Suppose for probable than a considering of the production side
example that as time passes timber becomes more alone might suggest.
and more scarce relative to demand as forests are It remains to briefly mention Keynes’s use of
depleted or demand grows. Then we would expect own rates of interest in his G e n e r a l
the price of timber to rise through time relative to T h e o r y , if only to point out that it is not in
other goods. Similarly, technical progress, unless it fact particularly germane to the present discussion
be of the simplest labour-augmenting kind, will of equality of own rates of interest. Keynes’s
typically imply changes in relative prices. The extraordinary argument is concerned with the
transistor, the microchip and other innovations, to comparison of money rates of return at the margin
cite another example, have certainly caused electric to accumulating various assets, which is something
goods to become relatively cheaper. like the question of sectoral equality.
Consider therefore a stationary state, which may We may imagine that as the various assets are
be growing economy, but which is stationary in the accumulated the money rates of return to further
sense that in each period it is technically exactly the accumulation for each of them is forced down, and
same as in every other period, except perhaps for that the quantities accumulated are such that these
scale. As the economy is essentially the same at marginal returns on all assets are equalized. If we
every moment of time, it makes intuitive sense to could conceive of the elasticity of the money rate of
suppose that relative prices might be the same at return for each asset to the stock accumulated
each moment of time, and this intuition is valid in (which we may call the return-stock elasticity) as a
so far as it can be shown that any development of value independent of other accumulations, which
the economy which is stationary, in the sense just Keynes in effect does, then assets with low return-
described, may be supported by a price system stock elasticities will accumulate rapidly relatively
which is itself stationary, in the sense that relative to assets with higher return-stock elasticities.
prices are invariant over time3. Keynes’s argument claims that money is eventually
the asset with the lowest return-stock elasticity, and
that this has the implication that, in an economy
with a limited supply of money, the money rate of
return
(which of course is the own rate of interest of Let partial derivatives be denoted by subscripts
money) wi 1 1 eventually rise to a level which dis- so that, for example, the marginal product of capital
courages the further accumulation of real assets. is denoted F ^ K , L , t ) . We denote the
rate of profit by r , so that:

Temporal Equality of Rates of Proit r= FK(K,L, t). (7)

We now turn to the equality, or inequality as the Time derivatives are shown by a dot over the
case may be, of the rates of profit which prevail at variable concerned. Differentiating F ^ K , L ,
different moments of time. There is a longer tradi- t )
tion among economic theorists, which goes back to totally with respect to time we obtain an expression
the classical writers, of explaining the long-run for die time rate of change of the rate of profit as:
tendency for the rate of profit to fall. This was
largely a response to a supposed fall in the rate of r = FKK ■ K + FKL ■ L + FKU (8 )
interest which the classical economists ‘took to be
an indisputable fact’. For these older theories the Hence for constancy of the rate of profit we
reader is referred to entries on Adam Smith, Marx, must have:
Mill, Ricardo and Say. Here we consider only a
modem view of the problem. A justification for FKK ■K + FKL'L+Fk, = 0. (9)
this division of labour may be sought in the fact
that modem theories of the rate of profit are radi- which on rearrangement yields:
cally different from classical views.
The main source of the difference between FKK-K FKL-L Fk,
modem and classical theories (which in this con- —= °, (1 0 )
tK rK rK
text should be taken to exclude Marx) is that the
former treat technical progress as having regular where k and l are respectively the logarithmic
and continuous effects on the economy, where the rates of growth of capital and labour. Now (Eq. )
latter typically do not. Thus the characteristic can be expressed more simply as:
classical argument for a falling rate of profit is
stagnationist in nature. The decline in the rate of oK-k+aL-l + y = 0 ; (1 1 )
profit is part of the grinding to a halt of a previ-
ously progressive economy. In contrast, the mod- where c > K and are respectively the elasticity of
em neoclassical approach locates the explanation the marginal product of capital with respect to K
of a falling rate of profit in the character of a and L , and y is the proportional change in the
technical progress conceived as an indefinitely marginal product of capital due to the passage of
continuing process. time alone. We know that F k ( K , L , l ) is
To demonstrate the theoretical issues involved homogeneous of degree zero in K and L . Hence:
we first show when a declining rate of profit
would arise in a neoclassical model with aggre- + oL = 0, (12)
gate capital and a constant saving propensity, and
then discuss some of the shortcomings of that and (Eq. ) reduces to:
model as an account of capital accumulation.
Let output, Y, depend upon the input of o K - ( k - l ) + y = 0. (13)
labour, L, and a capital stock which is homoge-
This last expression has an intuitive interpreta-
neous with the output flow, K, according to a
tion. As a* is the elasticity of the marginal product
constant returns production function as:
of capital witli respect to capital, it will be negative,
(6) ft is weighted by k - 1 , the rate of growth of capital
per unit of labour, which will be positive under
Y = F(K,L, t).
normal economic growth. Thus n K ■ ( k - ► and Profit
1) measures the rate at which capital accumulation ► jurplus ach to Value ribution
is pushing down the rate of profit due to the ► mics
substitution of capital for labour at constant
technical knowledge. The second term represents Bibliography
the rate at which technical progress is tending to
raise the rate of profit at constant factor proportions, Bliss, C.J. 1975. Capital theory and the distribution of
which must be positive term if technical progress is income. Amsterdam: North-Holland.
beneficial. Now, unsurprisingly, (Eq. ) says that, for Harcourt, G.C. 1972. Some Cambridge controversies in the
theory of capital. Cambridge: Cambridge University
the rate of profit to remain constant, these two Press.
effects must exactly offset. Hay, D.A., and D.J. Morris. 1979. Industrial economics:
As it is known that a production function with Theory and evidence. Oxford: Oxford University
aggregate capital cannot be derived rigorously Press.
Keynes, J.M. 1936. The general theory of employment,
except for simple or special production technolo- interest and money. London: Macmillan.
gies, it may reasonably be asked how fare the above Schumpeter, J. 1954. History of economic analysis. New
account, of a downward pressure on the rate of York: Oxford University Press.
profit due to accumulation being offset by an Sraffa, P. 1960. Production of commodities by means of
commodities. Cambridge: Cambridge University
upward pressure due to technical progress,
generalizes. In particular, is it generally true that
accumulation with constant technical knowledge
exerts a downward pressure on the rate of profit? Equality
Given the enormous literature on the theory of
capital which has been produced in recent years, it James S. Coleman
is perhaps surprising that this question remains
relatively under investigated. Many discussions of
capital accumulation simply beg the question by
assuming that the rate of interest would fall contin-
Abstract
uously through time. Indeed double-switching is
‘Equality’ is used to mean equality before the
most at variance with the traditional neoclassical
law, equality of opportunity, and equality of
view of capital accumulation when that assumption
result, among other things. These types of
is made. However there is no guarantee of a con-
equality are not necessarily mutually compatible.
tinuous fall of the rate of profit through time, and
Equal distribution of benefits is often taken to be
the demand side of the economy is likely to prohibit
‘natural’ (by Rawls, for example), partly because
a return to a previous and lower income state.
envy is ubiquitous. In welfare economics the
On the other hand, linear models of the type that
presumed diminishing marginal utility of money
have been used to illustrate simple stories of capital
implies that equality of incomes maximizes
accumulation can lead to quite eccentric time pro-
welfare, but if interpersonal utility comparisons
files of consumption being associated with the accu-
are impossible no such presumption can be
mulation of capital (where this is defined simply as
made. As well, the interdependencies between
an increase in long-term consumption). Hence there
individuals in terms of welfare are such that
is no possibility in general of ruling out erratic
enforced equalization is likely to reduce overall
developments in die rate of interest over time.
welfare.

See Also Keywords

Berlin, L; Coleman, J. S.; Edgeworth, F. Y.;
► Capital Perversity Efficiency vs. equality; Envy; Equality; Equality
before the law; Equality of opportunity; Equality
of result; Inequality; Input-output
 analysis; Interdependencies of welfare; Inter- What is ordinarily meant by equality under the
personal utility comparisons; Liberty; Marginal law has to do with (b), (c), and (d): that the
utility of money; Nozick, R.; Optimal taxation; normative or legal constraints on actions depend
Pigou, A. C.; Progressive taxation; Property only on the nature of the action, and not on the
rights; Rawls, J.; Robbins, L. C.; Welfare identity of the actor. That is, the law treats persons
economics in similar positions similarly, and does not dis-
criminate among them according to characteristics
irrelevant to the action.
JEL Classifications What is ordinarily meant by equality of oppor-
D6 tunity has to do with (a), (b), and (c): that the
processes through which persons come to occupy
The very use of the term ‘equality’ is often clouded positions give an equal chance to all. More partic-
by imprecise and inconsistent meanings. For ularly, this ordinarily means that a child’s oppor-
example, ‘equality’ is used to mean equality before tunities to occupy one of the positions (a) do not
the law (equality of treatment by authorities), depend on which particular adults from set (b) are
equality of opportunity (equality of chances in the that child’s parents. What is ordinarily meant by
economic system), and equality of result (equal equality of result has to do with (a.ii): that the
distribution of goods), among other things. These rewards given to the position occupied by each
different meanings often conflict, and are almost person are the same, independent of the activity.
never wholly consistent. See Hayek ( , p. 85, , pp. These three conceptions, equality under the law,
62-4) for a dis equality of opportunity, and equality of result can
cussion of equality before the law and equality of also be seen as involving different relations of the
result, and Rawls ( ) for a discussion of State to the inequalities that exist or spontaneously
equality of opportunity within a theory of dis- arise in ongoing social activities. Equality before
tributive justice. Elsewhere I have discussed the the law implies that the laws of the State do not
difference between equality of opportunity and recognize distinctions among persons that are
equality of result in education (Coleman ). See also irrelevant to the activities of the positions they
Pole ( ) for a detailed examination occupy, but otherwise make no attempt to eliminate
of the changing conceptions of equality in Amer- inequalities that arise. Equality of opportunity
ican history. implies that the State intervenes to insure that
Some order can be brought into the confusion inequalities in one generation do not cross gener-
among the different uses of the term ‘equality’ by ations, that children have opportunities unaffected
first conceiving of a system that constitutes an by inequalities among their parents. Equality of
abstraction from reality. The system consists of: result implies a continuous or periodic intervention
and redistribution by the State to insure that the
(a) a set of positions which have two properties: inequalities which arise through day-today activities
are not accumulated, but are continuously or
(i) when occupied by persons, they generate periodically eliminated.
activities which produce valued goods and The relations between the first two kinds of
services; equality differ according to how close a society is to
(ii) the persons in them are rewarded for these a legally minimalist society or a legally maximalist
activities, both materially and symbolically; society. In a society that is legally minimalist,
equality before the law is compatible with a high
(b) a set of adult persons who are occupants of degree of inequality of opportunity - depending on
positions; the distribution of opportunity provided by other
(c) children of these adults; institutions in society, such as the family. In a
(d) a set of normative or legal constraints on legally maximalist society, in which many functions
certain actions. of traditional institutions have
been taken over by institutions that are creatures of This quotation describes a view with which
the State (e.g., functions of the family taken over by Berlin does not necessarily identify himself. In the
the public school), equality before the law implies a same paper, he states that ‘equality is one value
high degree of equality of opportunity. Only in a among many ... it is neither more nor less rational
society in which the law was far more intrusive than than any other ultimate principle ... rational or
found anywhere, and children were taken from their nonrational’ It is, however, the position implicitly
families to be raised ‘with equal opportunity’ by the taken by John Rawls in his T h e o r y o f
State, could it be said that equality before the law J u s t i c e , for the book is addressed to the
would coincide with equality of opportunity. question, ‘When can inequalities (of result) be
The relation between equality of opportunity regarded as just?’ Rawls’s answer can be
E
and equality of result is somewhat different, for it paraphrased as ‘Only those inequalities are just
implies two different kinds of interventions of the which make the least well off person better off than
State. Equality of opportunity implies intervention that person would be (other things being equal) in
to provide each person with resources that give the absence of the inequalities.’
equal c h a n c e s to obtain the material and Whether equality of result is ‘natural’ or not, and
symbolic rewards that arise from productive activ- whether the position of Berlin and Rawls is correct
ity, while equality of result implies intervention in or incorrect, would appear to depend on how the
the distribution of these rewards, to provide each distribution of goods occurs: If goods are initially
person with equal a m o u n t s . The two the property of a single central source (e.g., ‘the
concepts become indistinguishable only when the State’), then Berlin’s position and that of Rawls
State intervenes to insure that each position (in appear correct. If all rights and resources originate
( a ) above) provides the same set of material with the State (or with the king, as in early political
and symbolic rewards; and in such a circumstance, theory), than an equal distribution has some claim to
‘opportunity’ loses meaning altogether. be seen as natural. (If, for example, the revenue
from oil discovered on public lands is a major
component of GNP, as in some Middle Eastern
Is Equality 'Natural'? states, equal distribution constitutes a natural point.)
But if goods are seen to arise from the activities of a
There are certain philosophical positions that take set of independent actors each with certain initial
equality of result as a ‘natural’ point, from which property rights, and each with a certain amount of
all others are deviations. Isaiah Berlin probably zeal and skill, ‘equality’ (meaning equality of result)
states this as well as any other is hardly natural, and is inconsistent with the
No reason need be given for ... an equal distribution distribution of property rights including rights to the
of benefits for that is ‘natural’, self evidently right
and just, and needs no justification, since it is in fruits of one’s own activity.
some sense conceived as being self justified ... The
assumption is that equality needs no reasons, only
inequality does so; that uniformity, regularity, Equality, Envy and Resentment
similarity, symmetry, ... need not be specially
accounted for, whereas differences, unsystematic The idea of equality as ‘natural’ appears also to
behavior, changes in conduct, need explanation and,
as a mle, justification. If I have a cake and there are
derive in part from the ubiquity of envy and
ten persons among whom I wish to divide it, then if I resentment in society, with the demand for ‘equal-
give exactly one tenth to each, this will not, at any ity’ as an expression of these feelings which carries
rate automatically, call for justification; whereas if I legitimacy. A number of sociologists have pointed
depart from this principle of equal division I am
expected to produce a special reason. to this connection. For example, Simmel writes
It is some sense of this, however latent, that makes (1922, translated in Schoeck , pp. 236-7):
equality an idea which has never seemed intrinsically Characteristically, no one is satisfied with his posi-
eccentric ... ( , p. 131). tion in relation to his fellow beings, but everyone
 wishes to achieve a position that is in some way an But normative economics, that is, welfare eco-
improvement. When the needy majority experiences
nomics, makes up for the absence of ‘equality’ from
the desire for a higher standard of living, the most
immediate expression of this will be a demand for positive economic theory, for the idea of equality of
equality in wealth and status with the upper ten result is a part of the very atmosphere surrounding
thousand. welfare economics. The question of what policies
Simmel follows with an anecdote: at the time of will maximize social welfare is not often answered
the 1848 revolution, a woman coal-carrier remarked directly in terms of equality in the distribution of
to a richly dressed lady, ‘Yes, madam, everything’s valued goods, but the idea seems always to hover
going to be equal now; / shall go in silks and you’ll nearby. The most direct expression of the central
carry coal.’ importance of equality in welfare economics was
Helmut Schoeck, in an extensive examination of probably that of Pigou ( ); see also
the role of envy in society, argues that (Bergson ( , ch. 9) who rea
social philosophers have largely failed to see how soned that because money, like everything else, had
little the individual is concerned with being equal to declining marginal utility, and thus a dollar was
someone else. For very often his sense of justice is
worth much less to a person when he had a million
outraged by the very fact that he is denied the
measure of inequality which he considers to be right others than when it was the only one he had, then
and proper ( , p. 234). the maximum of social welfare could only be
achieved when incomes were made equal. (Neither
Feelings of envy and resentment constitute a
Pigou nor any other welfare economist followed
challenge to the existing distribution of r i g h t s
this implication with actual policy rec-
in society, between those held collectively and those
ommendations for equality of income, thus raising
held individually. In particular, it is a challenge to
the question: if the criterion is correct, then why not
the existence of individual property rights. The
recommend implementing it?)
centrality of property rights for conceptions of
The rock on which Pigou’s argument is often
equality is seen most clearly in neoclassical eco-
regarded as foundering is that of interpersonal
nomic theory, which assumes a distribution of
comparison of utility. To move from the relative
property rights among a set of independent actors,
importance for one person of a dollar when he is
accompanied by a free market. (See Meade , for a
rich and when he is poor to its relative importance
discussion of property rights and the market in
to different persons is a move which, as has been
relation to equality.) It is to economic theory that I
often reiterated, cannot be justified on positive
now turn.
grounds. Perhaps the most widely quoted statement
to this effect is that of Lionel Robbins ( ):
But, as time went on, things occurred which began to
shake my belief in the existence between so
complete a continuity between politics and economic
The Role of 'Equality' in Economic Theory analysis ... I am not clear how these doubts first
suggested themselves; but I well remember how they
The concept of ‘equality’ has no place in positive were brought to a head by my reading somewhere - I
economic theory. In this it is unlike the concept of think in the work of Sir Henry Maine - the story of
‘liberty’, for economic theory is predicated on the how an Indian official had attempted to explain to a
high-caste Brahmin the sanctions of the Benthamite
assumption of liberty, that is, free choice (subject
system. ‘But that,’ said the Brahmin, ‘cannot
only to resource constraints) among alternative possibly be right I am ten times as capable of
actions. There is, in the concept of free choice, happiness as that untouchable over there.’ I had no
however, something closer to the idea of equality sympathy with the Brahmin.
But I could not escape the conviction that, if I chose
before the law than to equality of opportunity, and
to regard men as equally capable of satisfaction and
closer to the latter than to equality of result. Equal- he to regard them as differing according to a
ity of result implies a distribution process that is the hierarchial schedule, the difference between us was
antithesis of the market. not one which could be resolved by the same
 methods of demonstration as were available in other The matter can also be seen as a problem in
fields of social judgement ... ‘I see no means,’ Jevons input-output economics: What current allocation of
had said, ‘whereby such comparison can be
accomplished.’ resources among productive activities (i.e., among
positions in the system as described earlier) will
Edgeworth expressed the same point, ‘The achieve some desired distribution of final
Benthamite argument that equality of means tends consumption? If the aim is to maximize the sum of
to maximum happiness, presupposes a certain final consumption (‘maximizing welfare’?), it is
equality of natures; but if the capacity for happiness quite unlikely that either the current allocation
of different classes is different, the argument leads necessary to achieve that, or the distribution of final
not to equal, but to unequal distribution’( , p. consumption itself, will approach equality. Even if
114). the desired final distribution is equality, and even if
Such arguments are ordinarily taken as conclu- that is achievable within the system of activities, it
sive within the domain of economics, and with their is highly unlikely that the allocation at time 0
acceptance, the very programme of welfare necessary to achieve that at time t will be equal.
economics - not to speak of the foundations for a And it may well be that the only distribution at time
policy designed to bring equality - is emasculated. 0 that would achieve equality at time / would do so
A philosopher might argue, of course, that there at a low level of welfare, with each having less than
is no logical difference between the comparison of if there were inequality at time / resulting from a
utilities of two persons and the comparison of different distribution at time 0 . If Pareto
utilities of one person at two different times. optimality is taken as a self-evident necessary
Neither, by this argument, is warranted. See, for condition for optimal policies, then because of the
example, Parfit ( ). processes described above, a criterion of equal
However, Pigou’s conclusion has, quite apart distribution (either initially or subsequently) would
from problems of interpersonal comparison of violate the condition. This suggests that Rawls’s
utility, another deficiency. It assumes that each question was misdirected, and should have been
person is an island, and contributes nothing to the ‘when (assuming non-violation of constitutional
welfare of others, nor has his welfare contributed to rights) is e q u a l i t y of distribution justified?’
by others. Yet is is the essence of social and and should have been answered, ‘Only when there is
economic systems that there is interdependence, that no unequal distribution that would subsequently
one person’s activities do affect the welfare of make each better off.’
others, whether intended or not. One person spends Thus even if Pigou’s point that maximizing
money on loud radios that cause disturbance, while welfare requires equalizing marginal utilities is
another plants flowers that others enjoy. Or one uses accepted, and noncomparability of utilities is
income for training which is productive, benefiting ignored, the policy implication of equalizing
general welfare, while another uses income on drink incomes appears shortsighted in the extreme.
and becomes alcoholic, requiring public-expense Another way of seeing so is by use of Robert
hospitalization. Nozick’s Wilt Chamberlain example, an example
But if this is so, then maximization of welfare designed to argue against theories of distributive
one time period into the future would require that justice which, like that of Rawls, use the resulting
these interdependencies be taken into account distribution of goods (‘end state theories’, to use
Maximization would occur only if resources were Nozick’s term) as a criterion.
distributed among persons in accordance with the
Now suppose that Wilt Chamberlain is greatly in
positive impact of their activities on those events demand by basketball teams, being a great gate
which bring welfare to others. But in general per- attraction. (Also suppose contracts run only for a
sons do not capture the Ml benefits of their welfare- year, with players being free agents.) He signs the
following sort of contract with a team: In each home
generating activities, nor do persons pay the full
game, twenty five cents from the price of each ticket
costs of their welfare-diminishing activities. of admission goes to him. (We ignore the question of
whether he is ‘gouging’ the owners, letting them
 look out for themselves.) The season starts, and that have progressive taxation. But this taxation
people cheerfully attend his team’s games; they buy may lead to underprovision of welfare-generating
their tickets, each dropping a separate twenty five
cents for their admission price into a special box
activities. That is, efficiency may be sacrificed to
with Chamberlain’s name on it. They are excited achieve some distributional goals. The potential
about seeing him play; it is worth the total admission conflicts between efficiency and equality are
price to them. Let us suppose that in one season one discussed in the literature on optimal taxation (e.g.,
million persons attend his home games, and Wilt
Chamberlain winds up with $250,000, larger even
Atkinson and Stiglitz , part II). (A device which is
than anyone else has. Is he entitled to this income? informally used in social systems to reduce the
(Nozick , p. 161) disincentive effect of regimes of taxation and
redistribution that shift incomes in the direction of
Thus as Nozick points out, an equal distribution equality is the attachment of social stigma to the
at one point will lead to an unequal distribution at a receiving of income thus redistributed, for example,
later point, due to the very system of activities stigma associated with being ‘on welfare’. The
through which persons satisfy their interests. existence of this stigma constitutes a means of
There are only three ways to prevent this, all of informally reconstituting the differential incentives
which, carried to their limit, can be shown to reduce that are reduced by redistribution.)
welfare. One is to prevent the economic exchange All three approaches to preventing inequalities
through which persons spend their quarters as they from arising out of equality give, at their extreme,
see fit, for such exchanges may lead to a large the same result: elimination of the very system of
accumulation in the hands of the Wilt activities that generates welfare in the first place;
Chamberlains. for it is these activities which not only generate
A second is to attack the system of activities welfare, but also transform equality at one time into
itself, the system which generates that matrix of inequality at a later time.
coefficients that transform equality into inequality - Thus it becomes clear that the source of
that is, shutting down professional basketball, which inequalities is embedded in the very matrix of social
redistributes income from those with low incomes and economic activities through which individuals
to those with high incomes. The third way is to increase the welfare of themselves and one another.
allow the exchange, but then to tax the high If, through technology for example, this matrix
incomes back down to equality. This effectively changes in such a way that individuals’ satisfaction
eliminates the activity, because if income is an ofwants is more concentrated in a few hands (e.g.,
incentive to carry out the activity that is paid for, by the invention and development of television),
the Wilt Chamberlains lose all incentive to carry the then inequalities will necessarily increase.
activity. More generally, the degree of inequality seems
Indeed, unless there is a perfect positive corre- related to the degree of interdependence in this
spondence of those activities which are intrinsically matrix of social and economic activities. In a social
pleasurable with those which produce benefits for system that has very low interdependence (e.g., a
others, and a perfect negative correspondence with social system composed largely of subsistence
those that produce harm for others, the absence of farmers, a condition that was once the case for
any extrinsic incentives wi 11 lower the welfare for nearly all societies), the welfare of each in future
all. The more interrelated the activities of periods depends largely on his own initial
individuals, the greater the reduction in social distribution of resources (including zeal and skill).
welfare when extrinsic incentives are absent. If that distribution is near equality, then near
It is true that taxation which is not carried to the equality is perpetuated into the future, modified
limit, but is merely ‘progressive’, does not eliminate only by random events. More important, even if the
the incentive for activities that bring high income, initial distribution is unequal, the low
for these activities continue in societies interdependence of the system of activities
means that these inequalities (also modified by slowly than interdependence of activities, then
random events) are merely carried forward into the (except for unlikely configurations of the activity
future. In a system with a high degree of matrix) there will be a decrease in equality of result
interdependence, however, there are a great many among lineages of persons. If equality of
configurations which constitute ‘inequality- opportunity increases more rapidly than the increase
generating’ activity structures. In such activity in interdependence of activities, there will be an
structures, initial distribution of equality will lead to increase in equality of result among lineages, even
highly unequal distributions. This inequality in turn with a decrease in equality of result within
will lead in the next generation to inequality of generations.
opportunity, constrained only by random processes Altogether, there has been little investigation of
or explicit policies towards non-inheritance of the matters discussed above, that is, just how the
position, i.e., toward equality of opportunity. (In a structure of social and economic activities itself
system in which attention to basketball was directed affects inequalities. Such investigations would lead
not to televised professional teams, but to games of toward taking work on equality partly out of the
the local high school, both the material and realm of normative theory, bringing it partly into the
nonmaterial rewards among basketball player would realm of positive theory.
be more equally distributed. There would be greater
equality of results, which would arise not through a
change in the set of persons ( b ) , the distribution
See Also
of children (c), or the normative and legal con-
straints (d ), but only through a change in the
distribution of positions.)
Does this mean that there tends to be a negative
relation between the interdependence of activities in Bibliography
a social system (and thus the total social product)
and the equality with which the activities of the Atkinson, A.B.., and J.E. Stiglitz. 1980. Lectures on public
economics. New York: McGraw-Hill.
system distribute the product? If so, tins is a
Becker, G., and N. Tonies. 1986. Inequality, human capital,
discouraging result for those who would prefer a and the rise and fall of families. In Approaches to social
social system in which incomes are not increasingly theory, ed. S. Lindenberg, J. Coleman, and S. Nowak.
unequal, for it specifies an opposition between two New York: Russell Sage.
goals both regarded as desirable. Bergson, A. 1966. Essays in normative economics.
Cambridge, MA: Harvard University Press.
This question has two parts, a within-generation Berlin, I. 1961. Equality. In Justice and social policy, ed. F.A.
part and a between-generation part. Within genera- Olafson. Englewood Cliffs: Prentice Hall.
tions, it appears likely that there is a negative rela- Coleman, J. 1975. What is meant by ‘an equal educational
tion, that increased interdependence does, except in opportunity’? Oxford Review of Education 1 (1): 27-29.
Edgeworth, F.Y. 1897. Papers relating to political economy,
unlikely activity structure, increase inequality. It is 1925. London: Macmillan for the Royal Economic
possible that this negative relation is responsible for Society.
the rise in redistributive actions of governments as Hayek, F.A. 1960. The constitution of liberty. Chicago:
interdependence of economic activities increases. University of Chicago Press.
Hayek, F.A. 1976. Law, legislation and liberty. Vol. 2.
Between generations, the answer would appear Cambridge: Cambridge University Press.
to hinge largely upon the relative rates of increase Meade, J.E. 1964. Efficiency, equality and the ownership of
of interdependence of activities and of equality of property. London: Allen & Unwin.
opportunity (i.e., non-inheritance of position). The Nozick, R. 1974. Anarchy, State and Utopia. New York:
Basic Books.
latter can occur through regression to the mean as Parfit, D. 1984. Reasons and persons. Oxford: Oxford
well as through explicit policy intervention (see University Press.
Becker and Tomes , for a discussion). If equality of Pigou, A.C. 1938. Economics of welfare. 4th ed. New York:
opportunity increases more Macmillan.
Pole, J.R. 1978. The pursuit of equality in American his- toiy.
Cambridge: Cambridge University Press.
Rawls, J. 1971. A theory of justice. Cambridge, MA: Harvard Equality of opportunity is to be contrasted with
University Press. equality of outcome. While advocacy of equality of
Robbins, L. 1938. Interpersonal comparisons of utility.
Economic Journal 48: 635-641.
outcome has been traditionally associated with left-
Schoeck, H. 1969. Envy: A theory of social behavior. wing political philosophy, equality of opportunity
New York: Harcourt, Brace and World. has been championed by conservative political
Simmel, G. 1962. Soziologie. 2nd ed. Munich: Duncker & philosophy. Equality of outcome does not hold
Humblot.
individuals responsible for imprudent actions that
may, absent redress, reduce the values of the
outcomes they enjoy, or for wise actions that would
raise the value of the outcomes above the levels of
Equality of Opportunity others’. Equality of opportunity, in contrast, ‘levels
the playing field’ so that all have the potential to
John E. Roemer
achieve the same outcomes; whether in the event
they do depends upon individual choice.
This traditional political alignment was upset by
Ronald Dworkin ( , ) who posed the
Abstract question: if one is egalitarian, then what should one
Whereas the ethic of equality of outcome does seek to equalize, welfare or resources? He argued,
not hold individuals responsible for actions that first, that equalizing welfare (outcome) was
may create inequality of outcomes, equality of undesirable, even if interpersonal comparisons of
opportunity ‘levels the playing field’ so that all welfare could be made, because doing so would fail
have potential to achieve equal outcomes; to hold individuals accountable for their
inequalities of outcome that then transpire are preferences. The issue of ‘expensive tastes’ was
not compensable at the bar of justice. The important for Dworkin; he argued that, if a person
influences on the outcome a person experiences were glad he possessed an expensive taste, or
comprise c i r c u m s t a n c e s (for identified with it, as opposed to viewing it as an
which he should not be held responsible) and addiction - a taste he would prefer not to have - then
e f f o r t (for which he should be). Equal- society owed him no extra resources to satisfy it.
opportunity policy compensates persons for their Dworkin argued that egalitarians should advocate
disadvantaged circumstances, ensuring that, the equalization of resources, as opposed to
finally, only effort counts in achieving outcomes, but his conception of what comprised
outcomes. resources was broad. Resources consisted in not
Keywords only transferable goods and wealth but internal
Affirmative action; And parameters of disad- talents as well. The question became: what
vantage; Compensation; Distribution; And effort allocation of t r a n s f e r a b l e resources
vs circumstances; Dworkin, R.; On equality; On would count as equalizing the e n t i r e
insurance market; Educational finance; b u n d l e of resources across persons, that is,
Efficiency; And equity; Equality of opportunity; would count as appropriately compensating
Vs equality of outcome; Equality of outcome; individuals for their endowment of non-transferable
Vs equality of opportunity; Vs equality of resources? Dworkin’s answer was to construct a
resources; And compensation; And efficiency; kind of market for contingent claims behind a thin
Income-tax regime; Insurance market; Dworkin veil of ignorance in which traders knew their prefer-
on; Meritocracy; Property rights; And ences (importantly, over risk) but not what
welfarism; Welfarism; Sen on; And property resources they would come to have in the (actual)
rights; Sen, A.; And welfarism world. The desirable tax scheme, in the world,
would mimic the allocation of transferable
resources that would be implemented at the
JEL Classifications
D63
equilibrium in this market for contingent claims, Following Ameson and Cohen, Roemer (
after the birth lottery occurred (see Roemer eh. 7, ) proposed a model that would attempt to
for a formal model). capture the insights of this philosophical discussion
Dworkin’s contribution, importantly, attempted and permit one to compute, for a given situation, the
to integrate the issue of responsibility into policy that constituted the ‘equal opportunity’
egalitarian theory - which amounted to taking the policy. He separated the influences on the outcome
most important tool of the political right and a person experiences into c i r c u m -
harnessing it for use by the political left. In s t a n c e s and e f f o r t : circumstances
Dworkin’s theory, individuals are held responsible are attributes of the person’s environment for which
for their preferences, and this is implemented he should not be held responsible, and effort is the
through the insurance market behind the veil of choice variable for which he should be held
ignorance, where traders representing persons use responsible. An equal-opportunity (EOp) policy is
their persons’ preferences to enter into insurance an intervention (such as the provision of resources
contracts. But persons are not held responsible for by a state agency) that makes it the case that all
their resources, including internal talents, and the those who expend the same degree of effort end up
families into which they are bom, and this is with the same outcome, regardless of their
implemented through allowing the traders behind circumstances. Thus, EOp ‘levels the playing field’
the veil to insure against bad luck in the birth lottery in the sense of compensating persons for their
in so far as the distribution of these resources is deficits in circumstances, ensuring that, finally, only
concerned. effort counts with regard to outcome achievement.
Several years later, G. A. Cohen ( ) and A more precise formulation follows. Suppose
Richard Ameson ( ) criticized Dworkin’s the there is an o b j e c t i v e for whose
ory. Cohen argued that ‘Dworkin’s cut’ between acquisition a planner wishes to equalize
preferences and resources, was, for the purpose of opportunities; this might be a wage-earning
ethics, the wrong way to separate characteristics. capacity, a life expectancy, or an income level.
Suppose a person developed champagne tastes Denote the achievement of the objective as a
because she grew up in an aristocratic family in function u ( o c , x ; /?) where a is the
which she was never exposed to beer. Was it correct (scalar) level of effort expended by the person, x is
to later deny her the resources to buy champagne to the policy of the planner, and /i is the vector of
achieve the level of welfare that beer drinkers could circumstances of the person, u is monotone
achieve more cheaply? Or suppose that a person, increasing in the argument a - thus, effort enhances
who grew up in a disadvantaged home that lacked the acquisition of the objective. Nevertheless, effort
resources, developed no ambition to develop his may be subjectively costly for the individual: thus,
talents; indeed, he was satisfied with his u is not to be thought of as the usual economist’s
unambitious tastes. Should he likewise be held utility function, in which effort is costly. For
responsible, even though his tastes were the example, w might be the wage- earning capacity a
consequence, at least in part, of an indigent person comes to have, where a is the number of
childhood? years of schooling and f j measures family
Ameson argued that Dworkin was right to argue background, natural talent, and so on. The policy x
against taking the ‘equalisandum’ as welfare, but can be chosen from some feasible set of policies
said that replacing it with ‘resources’ was wrong - X : it might, for example, be the distribution of a
rather, it should be replaced with o p p o r - resource possessed by the planner. The set of
t u n i t y f o r w e l f a r e . What did it individuals with a given value of f j is called a
mean, then, to equalize opportunities for welfare? In ‘type’.
what sense did this differ from ‘equalizing Suppose that, for each ordered pair (x, ( j )
resources’ a la Dworkin? Ameson sfruggled to there ensues a distribution of effort in type f j
formulate an alternative, but did not succeed in denoted by its cumulative distribution function
proposing one that was clearly feasible. F ( a ; x , f j ) . The distribution of effort,
classically, would result from the maximization of a
preference order by
the individuals of the type, one in which effort is a vector (x|, . . . , x „ ) such that X p t x t
differentially costly for those individuals. Typically, = x . We have as data, as well, the distribution
these distributions F differ across types ( [ ! ) . functions F f \ x , f i ) . For this general
By hypothesis, individuals are not to be held specification, there will generally not exist a
responsible for their type. We now ask how one feasible policy satisfying ( ).
should interpret the stricture to choose a policy that Some alternative is therefore required. One may
equalizes the values of the objective a t c o n - proceed as follows. We desire to equalize the values
s t a n t e f f o r t l e v e l s across of v across different /5’s, at each n . As a second-
types. The problem is that the best, we desire to maximize the minimum value of v
d i s t r i b u t i o n of effort in a type is a across different /5’s, at each n . Thus, define
characteristic of the type and, if individuals are to
be compensated for their types, they should likewise
be compensated for the characteristics of those dis-
tributions. For example, if a disadvantaged type has
a distribution of effort with a low mean, that itself
should be taken into account in the compensation We define a policy x to be e f f i c i e n t if
scheme. Roemer’s solution was to propose that the
d e g r e e of a person’s effort should be there is no x' eX s.t(in)((S>(n;x!) > 0 (7 c;x)),
measured by her r a n k in the effort distribution (2)
of her type. Thus, define the rank n by
where the inequality sign in ( ) is understood to
n = F(a; x, ft) mean that, for some value(s) of n , there is strict
inequality. We are interested only in efficient pol-
and define the ‘ indirect’ objective function icies. There may, however, be many, even a con-
tinuum, of these; and the theory, thus far, gives us
v ( n \ x , f i ) = no way of choosing among them.
To see this, let us consider a special case in
u ( F ~ l
( n ; x , f } ) , x ; f } ) . which effort responses within types are insensitive
to the policy: thus, we may write those distributions
Then .r is an equal-opportunity policy just in
as F ( a ; f t ) . Suppose that there are just
case it equalizes the value of objective across types
two types, [ 1 1 and [ 1 = 2 , indicating the
at every degree of effort, that is:
level of
education of parents; each type comprises one-half
in <E [0, 1]VjS, flv{n\xffi) = v{n\x,fl). (1)
the population. The Department of Education has
Here, the process by which the effort distribu- one unit per capita of an educational resource to be
tions F emerge is black-boxed; of course, in actual invested in children. A p o l i c y is an ordered
applications, the black box would be unpacked with pair ( y , 2 —y), indicating the per capita
the specification of utility functions that individuals investment in children of the two types. Suppose
maximize to derive their efforts. that u ( a, y ; ( j ) = a° y c f j b is the
In general there will be no policy which equal- value of the objective (perhaps, the child’s future
izes opportunities in the sense of ( ). For example, wage) where y is the amount of educational
let u be wage-earning capacity, a be years of resource invested in the child. We will denote a
schooling, f t be the educational level of the indi- policy by the value of its first component, y . Then
vidual’s parents, and .r be investment in the edu-
0(jc;y)= min [ ( F - \ 7 i - , l ) ) a y c , ( F - l ( n ; 2 Y ' 2 b ( 2 - y f ] ,
cation of the individual by the state. Suppose
policies can be targeted to types, and there is a per (3)
capita social endowment of x for education.
Suppose we partition the population into a finite set
of types, {/?7| i = 1 , . . . , / ? } where the population
frequency of type i is p , . A feasible policy is
 approach is distinguished from classical social-
J= (4) choice theory in being n o n - w e l f a r i s t .
Welfarism is the view that only the set of vectors of
outcome (welfare) possibilities matters for the social
Now define decision. To be precise, if we represent individual
preferences over social alternatives by utility
F-\n- 2) functions, then the choice of a social alternative
,M
'F-\n, 1) should depend only upon the information that is
r\v,2) recoverable from the utility possibilities sets of the
(5) possible societies. In this sense, welfarism is a
consequentialist view. Sen ( ) criticized the
welfarist postulate for ignoring the issue of civil
Then any policy rights (the right not to be beaten by another, for
instance); Roemer ( ) criticized it, with regard
to the theory of distributive justice, for ruling out
ye 1 + (%blcMalc ’ 1 + aflcm?lc (6) any theories which mention property rights. The
equal-opportunity approach says that one cannot
is efficient, and this interval comprises exactly the judge the goodness of a social outcome by knowing
only the distribution of outcomes; one must also
efficient policies. Thus, there is a continuum of
know h o w h a r d p e o p l e t r i e d
efficient policies.
in order to evaluate that goodness - in other words,
There has been no general agreement concerning
one must know the correlation of effort with
how to narrow the set of efficient policies to a
achievement to pass judgement on the fairness of a
single choice - in other words, how to rank efficient
distribution scheme. Put this way, it is clear that the
policies from the equal- opportunity viewpoint.
equal-opportunity approach formalizes a view that
Roemer ( ) proposed
is held quite generally by citizens in many countries,
to choose a single policy by solving the problem:
to judge from opinion surveys. In judging how just
*1 schemes of distribution are, the proverbial man on
max <$>(n;x)dn; (7) the street usually wants to know if reward is
Jo
‘proportionate’ to effort expended. Knowing only
the distribution of outcomes does not suffice.
Van de Gaer ( ) proposed to solve Several empirical studies have applied these
ideas. In Roemer et al. ( ), the authors asked:
in a set of 11 OECD countries, what income-tax
max min v(n;x, fi)dn. (8) regime would equalize opportunities for income
■v f >
acquisition among workers? All workers in a
country were assumed to have a quasi-linear utility
Each of these proposals is somewhat arbitrary'.
function over income and labour, with a constant
Fleurbaey and Maniquet ( ) summarize the
labour-supply elasticity with respect to the marginal
axiomatic approach to the problem, to which they
tax rate (or the wage). The sole circumstance was
and others have made substantial contributions. I
taken to be the level of education of the mother of
believe that appeal to the equal- opportunity
the worker. Young male workers were partitioned
principle as such cannot resolve the issue; we must
into three types, according to whether their mothers
bring additional ethical considerations to bear.
had low, medium, or high levels of education. The
How does the theory of equal opportunity fit
set of policies, X , was taken to be the set of
into social choice theory? There are a number of
feasible affine income tax regimes, that is, ones
ways one may answer this question; I believe the
postulating constant marginal tax rates
most salient point is that the equal-opportunity
 Observed marginal EOp marginal
Country income-tax rate income tax rate
Belgium .53 .54
Denmark .44 0
advantaged type would be maximized with a lump-
France .31 .58
.36 .71 sum tax to finance public goods, and no other
Great transfer payments. This comes about precisely
Britain
Italy .23 .82 because the p r e - f i s c distributions of
Netherlands .53 .47 income across the three types of worker are already
Norway .39 0 very close in these countries. In the other countries
Spain .38 .61 in the sample, these pre-fisc distributions are
Sweden .52 0 sufficiently far apart that positive marginal tax rates
United .24 .65 will, despite their incentive effects, increase the
States average post-fisc income of the least advantaged
West .36
0 type.
Germany Should one conclude from Table that, from the
equal-opportunity viewpoint, marginal income
taxation should be abandoned in northern Europe?
Hardly, for the division of workers into only three
types is quite coarse. There are many other
circumstances besides the education of the mother
Source: Roemer et aL ( ) for which society might wish to compensate
citizens. Indeed, the article under discussion studies
and a lump-sum payment to all. The objective was as well a typology for four of the countries (where
the post-fisc income (not utility) of the individual. data exist) into six types, where workers are typed
Using the EOp objective of ( ) turns out to be not only by three maternal education levels but also
equivalent to choosing that income-tax regime by two levels of native ability, as measured by
which maximizes the average post-fisc income of performance in IQ tests. It turns out that a positive
the least advantaged type, those whose mothers did marginal EOp tax rate is then recommended for
not complete secondary school. Table summarizes Sweden, although Denmark retains its zero tax rate!
the observed marginal tax rates in the countries of (With a sufficiently low labour-supply elasticity,
the sample and the equal-opportunity tax rates, so this result, too, would be changed.)
computed, under the assumption that the (male) Income taxation may not be the instrument of
labour-supply elasticity with respect to taxation is choice to equalize opportunities for income; one
- .06. naturally thinks of using educational finance policy
Countries can be partitioned into three groups: as a method for compensating children from
those for which observed tax rates are much greater disadvantaged families. Betts and Roemer ( )
than the EOp tax rate (West Germany, Denmark, partitioned American male workers who were
Sweden and Norway), those for which the observed attending secondary school in the late 1960s into
and EOp tax rates are approximately the same four types, defined by four levels of maternal
(Belgium and the Netherlands), and those for which education. They took w a g e - e a r n i n g
observed tax rates are much lower than the EOp tax c a p a c i t y as the objective and state
rates (Italy, Spain, France, the United States and educational investment in the child as the policy
Great Britain). The pattern is not particularly instmment, and asked: What distribution of
surprising given common perceptions of the depth educational finance would have equalized
of income-transfer programmes in these countries. opportunities for wage-earning capacity among
A comment upon the countries in the first cate- these four types of worker? Wage elasticities with
gory is in order. To say that the EOp tax rate is zero respect to educational investment were computed
in the northern European countries means that, with for the four types using data from the US Panel
the postulated labour-supply effects of taxation, the Studies on Income Dynamics (PSID). Based on the
average post-fisc income of the least assumption of a per capita educational budget of
$2500, the recommended allocation is presented in
Table .
Parental ed’n
< 8 years 8 < ed < 12 years 12 years > 12 years
EOp investment $5360 $3620 $1880 $1100
Type of worker
LB HB LW HW
Equality of Opportunity,
EOp investment Table 2 EOp allocation $16,260
$8840 of investment with per capita$2610
budget of $2500 per student
$679per annum

Source: Betts and Roemer ( )

Equality of Opportunity, Table 3 EOp allocation of educational investment, four types, race x maternal education

Source: Betts and Roemer ( )

In other words, equal-opportunity investment education, is in most places less equitable even than
would allocate almost five times as much to the the equal-resource policy would be: that is, usually
most disadvantaged type of student as to the most more is invested in the public education of
advantaged type. Interestingly, we computed that advantaged children than in that of disadvantaged
the average wage of workers under this allocation children.
would have risen by 2 . 6 per cent over the observed I have earlier distinguished between the equal-
average wage. In other words, there is no observed opportunity approach and the more classical wel-
trade-off between equity and ‘efficiency’. farist approach in welfare economics. A second
The authors computed that if the allocation of important distinction is between equal opportunity,
Table had been implemented there would have been as a concept of equity, and meritocracy. Consider
very little change in the fraction of black workers the problem of admissions to university or
who would have risen above the bottom quintile of professional school. The equal-opportunity
the wage distribution. They proceeded to compute approach would suggest admitting the highest-
the EOp policy for a different typology of workers effort candidates from each of a set of types,
into four types, defined as: distinguished by their levels of advantage in back-
ground. The meritocratic approach would suggest
LB: low maternal education, black admitting those who are most likely to be high
HB: high maternal education, black achievers. EOp focuses upon fair treatment
LW: low maternal education, white a m o n g t h e p o o l o f
HW: high maternal education, white c a n d i d a t e s , while meritocracy has a
double focus: treating the candidates fairly but also
considering the quality of services those candidates
The results are presented in Table . will, in the future, provide to society at large. (On
For this typology, the investment ratios are huge. the other hand, meritocracy is n o t concerned
Moreover, the total wage bill would fall by 2 per with candidates’ effort in its measurement of fair
cent under the allocation of Table , showing that an treatment, but only with their ability to perform.)
equity-efficiency’ trade-off does exist with respect Thus the two approaches are in conflict.
to this typology. Clearly, the quality of services provided to
At the least, the calculations of Betts and society at large must count - the unadorned EOp
Roemer demonstrate that there is a large difference approach cannot in general be the right one. Gen-
between an e q u a l - r e s o u r c e erally speaking, society should follow a mixture of
p o l i c y , which invests the same amount in equal-opportunity and meritocratic policies. To
all children, and an e q u a l - calibrate the right mixture would require, as well as
o p p o r t u n i t y p o l i c y , which data to calculate the relevant elasticities, a general
invests in children in such a way as to attempt theory of justice for society at large, in which
compensation for differential social circumstances. account is taken not only of fairness to those
The United States, with its system of locally competing to occupy social positions but
financed public
of the welfare of those who eventually consume the of effort expended, increases the probability of
products those individuals will produce. In the US admission by the s a m e a m o u n t across
debate around affirmative action, one can hear all types of student. One can say, that is, that
different emphases. With respect to school admis- equalizing rewards to effort is the necessary and
sions, most citizens seem concerned with fairness to sufficient condition for decentralizing the social
the candidates, although there is a dispute as to problem of equalizing opportunities across the
what traits should or should not count in judging board into policy formation at the sectoral level.
fairness; but, with respect to employment, many Whether or not Calsamiglia’s insight will be
believe meritocratic principles are primary. Thus, important in policy design depends upon the degree
race-based affirmative action policies in universities to which individuals are involved in inter-sectoral
are under challenge for focusing on the wrong effort allocation decisions.
parameters of disadvantage (which, many argue,
should be ones of social class, not race), while
affirmative-action employment policies are chal-
lenged for paying insufficient attention to compe- See Also
tence in employing workers.
In the applications discussed above, the
policymakers - whether fictitious ones in the minds ► :: : .. income and Wealth
of scholars or actual ones in social institutions -
have generally contemplated only the effects of
policies in a single sector, whether it be in Bibliography
education or employment. Calsamiglia ( ) has Ameson, R. 1989. Equality and equal opportunity for welfare.
posed the following problem. Suppose Philosophical Studies 56: 77-93.
individuals are competing for positions in several Betts, J.. and .1. Roemer. 2003. Equalizing opportunity
through reform. In Schools and the equal opportunity
sectors simultaneously (in her example, for problem, ed. P. Peterson and L. Woessmann. Cambridge,
admission to a university and to an athletic team), MA: MIT Press.
and the admissions officer in each sector is Calsamiglia, C. 2005. Decentralizing equality of opportunity
attempting to design an equal-opportunity policy and issues concerning the equality of educational
opportunity. Ph.D. dissertation. New Haven: Department
for the candidates in his sector alone. Thus, the
of Economics, Yale University.
university admissions officer knows the abilities Cohen, G. 1989. On the currency of egalitarian justice. Ethics
and circumstances and efforts of candidates for 99: 906-944.
university, and the athletic coach knows the same Dworkin, R. 1981a. What is equality? Part one: Equality of
welfare. Philosophy & Public Affairs 10: 185-246.
information as it applies to performance in her
Dworkin, R. 1981b. What is equality? Part two: Equality of
sector. Each designs a l o c a l equal-opportunity resources. Philosophy & Public Affairs 10: 283-345.
admissions policy for his own sector. When will the Fleurbaey, M., and F. Maniquet. 2004. Compensation and
combination of policies equalize opportunities responsibility. In Handbook of social choice and welfare,
ed. K. Arrow, A. Sen, and K. Suzumura, vol. 2.
g l o b a l l y ? The tension here is that
Amsterdam: North-Holland.
policies in each sector will, if not properly Roemer, J. 1993. A pragmatic theory of responsibility for the
designed, distort the efforts of candidates in other egalitarian planner. Philosophy & Public Affairs 22: 146-
sectors. Calsamiglia demonstrates that, under 166.
Roemer, J. 1996. Theories of distributive justice. Cambridge,
suitable conditions, locally designed EOp policies
MA: Harvard University Press.
aggregate into a global EOp policy if and only if Roemer, J. 1998. Equality of opportunity. Cambridge, MA:
they e q u a l i z e r e w a r d s t o Harvard University Press.
e f f o r t across types in each sector. For Roemer, J., R. Aaberge, U. Colombino, J. Fritzell, S. Jenkins,
I. Marx, M. Page, E. Pommer, J. Ruiz- Castillo, M.J. San
example, assigning disadvantaged students who are
Segundo, T. Tranaes, G. Wagner, and I. Zubiri. 2003. To
applying to law school ‘extra points’ to compensate what extent do fiscal regimes equalize opportunities for
them does n o t equalize rewards to effort as income acquisition among citizens? Journal of Public
between them and more advantaged students: Economics 87: 539-565.
rather, one requires a policy which, for each unit
Sen, A. 1979. Utilitarianism and welfarism. Journal of The equation of exchange (often referred to as the
Philosophy 76: 463-489. quantity equation) is one of the oldest formal
Van de Gaer, D. 1993. Equality of opportunity and investment
in human capital. Ph.D. dissertation. Leuven: Catholic relationships in economics, early versions of both
University of Leuven. verbal and algebraic forms appearing at least in the
17th century. Perhaps the best known variant of the
equation of exchange is that expressed by Irving
Fisher ( ):

Equation of Exchange MV = PT. (1)

Michael D. Bordo Equation represents a simple accounting identity for

a money economy. It relates the circular flow of
money in a given economy over a specified period
of time to the circular flow of goods. The left-hand
side of Eq. stands for money exchanged, the right-
Abstract
hand side represents the goods, services and
One of the oldest formal relationships in eco-
securities exchanged for money during a specified
nomics, the equation of exchange, as a basic
period of time. M is defined as the total quantity of
accounting identity of a money economy, dem-
money in the economy, T as the total physical
onstrates that the sum of expenditures must
volume of transactions, where a transaction is
equal the sum of receipts. It is useful both as a
defined as any exchange of goods, including
classification scheme for analysing the under-
physical capital, services and securities for money,
lying forces at work in a money economy and as
P is an appropriate price index representing a
a building block or engine of analysis for
weighted average of the prices of all transactions in
monetary theory and in particular for the quan-
the economy. Finally, to make the stock of money
tity theory of money. It can also be regarded as a
comparable with the flow of the value of trans-
building block for a macro theory of aggregate
actions ( P T ) , and to make the two sides of the
demand and supply, and used to construct a
equation balance, it is multiplied by V , the trans-
theory of nominal income.
actions velocity of circulation, defined as the aver-
age number of times a unit of currency turns over
Keywords (or changes hands) in the course of effecting a given
Briscoe, J.; Caimes, J. E.; Cash balance year’s transactions.
(Cambridge) approach; Circular flow of income; An alternative variant of the equation of
De Foville, A.; Equation of exchange; Equation exchange is the income version by Pigou ( ).
of societary circulation; Fisher, I.; Friedman, M.; Empirical difficulties in measuring an index of
Hadley, A. T.; Kemmerer, E. W.; Keynes, J. M.; transactions, and the special price index related to it,
Lang, J.; Law, J.; Levasseur, E.; Lloyd, H.; led, with the development of national income
Lubbock, J.; Mill, J. S.; Naive quantity theory; accounting, to the formulation of Eq.
Newcomb, S.; Nominal income; Norton, J. P.;
Pantaleoni, M.; Pigou, A. C.; Quantity equation; MV = PY (2)
Quantity theory of money; Rau, K. H.; Ricardo,
D.; Senior, N. W.; Stocks and flows; Thornton, where Y represents national income expressed in
H. ; Transactions velocity of circulation; constant dollars, P the implicit price deflator and V
Turner, S.; Velocity of circulation; Walras, L. the income velocity of circulation defined as the
average number of times a unit of currency turns
over in the course of financing the year’s final
activity.
JEL Classifications
E4
 Equations and differ from each other because the must equal the sum of receipts. The left-hand side
volume of transactions in the economy includes of the equation shows the market value of goods
intermediate goods and the exchange of existing and services purchased (dollar value of goods
assets, in addition to final goods and services. Thus exchanged) and the money received. The equation
vertical integration and other factors which affect also relates the stock of money to the circular flow
the ratio of transactions to income would also alter of income by multiplying M by its velocity.
the ratio of transactions velocity to income velocity. Finally, the equation is usefiil in creating
A third version of the equation of exchange, the definitional categories - M , V , P , T -
Cambridge cash balance approach (Pigou ; Marshall amenable both to empirical measurement and to
; Keynes ), converts the flow of spending into units theoretical analysis.
comparable to the stock of money The equation of exchange is best known as a
building block for the quantity theory of money.
M = kPY (3) The traditional approach has been to make
behavioural assumptions about each of the variables
where k = 1 /Fis defined as the time duration of
in the equation, converting it from an identity to a
the flows of goods and services money could
theory. The simplest application, dubbed the ‘naive
purchase, for example, the average number of
quantity theory’ (Locke ) treated V and T in Eq.
weeks income held in the form of money balances.
as constants, with P varying in direct proportion to
Equations and are arithmetically equivalent to
M .
each other but they rest on fundamentally different
A more sophisticated version (Fisher ) treats
notions of the role of money in the economy. Both
each of M , V a n d T as being normally
Eqs. and view money primarily as a medium of
determined by independent sets of forces, with V
exchange and the quantity of money is represented
as determined by slowly changing factors such as
as continually ‘in motion’ - constantly changing
those affecting the payments process and the
hands from buyer to seller in the course of a time
community’s money holding habits.
period. Equation views money as a temporary abode
The Cambridge cash balance approach, based on
of purchasing power (an asset) forming part of a
Eq. , views the quantity theory as encompassing
cash balance ‘at rest’. Consequently, the items
both a theory of money demand and money supply.
included in the definition of money in the
In this approach the nominal money supply is
transactions and income versions of the equation of
determined by the monetary standard and the
exchange are assets used primarily to effect
banking system while the nominal quantity of
exchange - currency and checkable deposits,
money demanded is proportional to nominal
whereas the cash balance approach includes, in
income, with k the factor of proportionality,
addition to these items, non-checkable deposits and
representing the community’s desired holding of
possibly other liquid assets.
real cash balances, k in turn is determined by
The equation of exchange is usefiil both as a
economic variables such as the rate of interest in
classification scheme for analysing the underlying
addition to the factors stressed by the Fisher
forces at work in a money economy and as a
approach. The price level (value of money) is then
building block or engine of analysis for monetary
determined by the equality of money supply and
theory and in particular for the quantity theory of
demand.
money.
The equation of exchange can also be regarded
As a classification scheme, the equation as a
as a building block for a macro theory of aggregate
basic accounting identity of a money economy
demand and supply (Schumpeter ). If we view
demonstrates the two-sided nature of the circular
/V/Fas aggregate demand and T or Tas aggregate
flow of income - that the sum of expenditures
supply, then P would be determined in the familiar
Marshallian way.
Finally, the equation can be used to construct a
theory of nominal income. According to this
approach (Friedman and Schwartz ), nominal writers Briscoe ( ) and Lloyd ( ) both
income is determined by the interaction of the expressed a rudimentary version of Eq. , unfor-
money supply and a stable demand for real cash tunately omitting a term for velocity. Turner ( )
balances. The decomposition of a given change in formulated the equation without breaking
nominal income into a change in the price level and P T into separate components. The most complete
in real output is determined in the short run by early statement of the equation was by Sir John
inflation (deflation) forecast errors and in the long Lubbock ( ), who not only included all the
run by the natural rate of output. items of the equation but (preceding Fisher) dis-
The equation of exchange both as a classifica- tinguished between the quantities and velocities of
tion scheme and as a building block for the quantity hard currency, bank notes and bills of exchange.
theory of money can be traced back to the earliest Similar complete algebraic statements of the
development of economic science. equation were made by the German writers Lang (
The pre-classical writers of the 17th and 18th ) and Rau ( ); the Italian Pantaleoni
centuries viewed the equation in both senses. Locke ( ); the Frenchmen Levasseur ( ), Walras
( ), Hume ( ) and Cantillon ( ) and de Foville ( ); and the Americans
(1735) each organized his approach to monetary Newcomb ( ), Hadley ( ), Norton ( )
issues using the equation. Locke had a clear state- and Kemmerer ( ). Of this group Newcomb
ment of the naive quantity theory assuming both V presented the clearest statement. Newcomb started
and T to be immutable constants. Hume followed with the concept of exchange as involving the
Locke but made a clear distinction between long- transfer of money for wealth. Summing up all
run statics and short-run dynamics. In the long run exchanges in the economy he arrived at his equation
the price level would be proportional to M but, in of societary circulation:
the short run or transition period, changes in M
would produce changes in T . Cantillon had a VR=KP
clear understanding of the relationship between the
(4)
stock of money and the circular flow of income.
Indeed, he was the first to define explicitly the where V represents the total value of currency, R
concept of velocity of circulation, viewing V not as the rapidity (velocity) of circulation, K the volume
a constant but as a variable influenced in a stable of real transactions, P a price index.
way by both technological and economic variables. The clearest and best known algebraic expres-
Furthermore, like Hume, Cantillon distinguished sions of the equation were by the neoclassical
between the long-run equilibrium nature of the economists Irving Fisher ( ) and A.C. Pigou
quantity theory and short-run disequilibrium. Both ( ). Fisher ( , pp. 15-17), directly follow
Locke and Hume viewed the equation from the ing Newcomb, defined the equation of exchange as
perspective of money ‘at rest’ forming a cash a statement, in mathematical form, of the total trans-
balance whereas Cantillon viewed money as action: effected in a certain period in a given com-
continuously in ‘motion’. munity___[I]n the grand total of all exchanges for a
year, the total money paid is equal to the total value
John Law ( ) understood the equation of
of goods bought. The equation thus has a money side
exchange but used it to derive a link between and a goods side. The money side is the total money
changes in the quantity of M and changes in T . paid, and may be considered as the product of the
The classical economists Thornton,et al. quantity of money multiplied by its rapidity of
circulation. The goods side is made up of the
followed the Locke/Hume/Cantillon tradition of the
products of quantities of goods exchanged multiplied
quantity theory of money using a verbal version of by their respective prices.
the equation of exchange in their monetary analysis.
Algebraic versions of the equation first appeared This statement expressed as in Eq. or in an
in the 17th and 18th centuries (see Marget ; expanded version distinguishing between currency
Humphrey ). The British and deposits payable by check,

MV + M'V' = PT
where M ' is defined as checkable deposits and V Briscoe, J. 1694. Discourse on the late funds .... London.
their velocity, Fisher then used to analyse the forces Cantillon, R. 1755. In Essai sur la nature du commerce en
general, ed. H. Higgs. London: Macmillan, 1931;
determining the price level. reprinted New York: Augustus M. Kelley, 1964.
Fisher’s approach followed the ‘motion’ theory Fisher, I. 1911. The purchasing power of money. New York:
tradition of Cantillon with velocity determined pri- Macmillan.
marily by technological and institutional factors. In Fisher, I. 1922. The purchasing power of money, 2nd ed.
Reprinted New York: Augustus M. Kelley, 1963.
contrast, Pigou ( ) and other writers in the Foville, A. de. 1907. La monnaie. Paris.
Cambridge tradition, Marshall ( ) and Keynes Friedman, M. 1956. The quantity theory of money - A
( ), followed the ‘rest’ approach of Locke and restatement. In Studies in the quantity theory of money,
Hume, expressing the equation as ed. M. Friedman. Chicago: University of Chicago Press.
Friedman, M., and A..I. Schwartz. 1982. Monetary trends in
the United States and the United Kingdom: Their relation
1 /P = kR/M
to income, prices and interest rates, 1867-1975. Chicago:
University of Chicago Press for the NBER.
(6 ) Hadley, A.T. 1896. Economics. New York.
Hicks, J.R. 1935. A suggestion for simplifying the theory of
where R represents total resources enjoyed by the money. Economica 2: 1-19.
community, A; the proportion of resources the com- Holtrop, M.W. 1929. Theories ofthe velocity of circulation of
munity chooses to keep in the form of titles to legal money in earlier economic literature. Economic Journal
39 (January): 503-524.
tender, M the number of units of legal tender and Hume, D. 1752. Of money. In Essays, moral, political and
P a price index. For Pigou the fundamental literary, vol. 1 of Essays and treatises, a new edition,
difference between his approach and that of Fisher Edinburgh: Bell and Bradfiite; Cadell and Davies, 1804.
was that by focusing Humphrey, T.M. 1984. Algebraic quantity equations before
attention on the proportion of their resources that Fisher and Pigou. Federal Reseive Bank of Richmond
people choose to keep in the form of titles to legal Economic Review 70 (5): 13-22.
tender instead of focusing on the ‘velocity of circu- Kemmerer, E.W. 1907. Money and credit instruments in their
lation’ ... it brings us ... into relation with volition - relation to general prices. New York: H. Holt & Co.
an ultimate cause of demand - instead of with Keynes, J.M. 1923. A tract on monetary reform. Reprinted,
something that seems at first sight accidental and London: Macmillan for the Royal Economic Society,
arbitrary. ( 17, p. 174, emphasis added) 1971.
Keynes, J.M. 1936. The general theory of employment,
The Cambridge cash balance version of the equa- interest and money. Reprinted, London: Macmillan for
the Royal Economic Society, 1973.
tion of exchange, by focusing on the demand for
Lang, J. 1811. Grundlinien der politischen Arithmetik.
money and volition rather than emphasizing Kharkov.
mechanical aspects of the circular flow of money, Law, J. 1705. Money and trade considered with a proposal
can be viewed as the starting point for the Keynes- for supplying the nation with money. New York: Augustus
Kelley, 1966.
ian approach to the demand for money (Keynes ),
Levasseur, E. 1858. La question de Tor: les mines de
for modem choice theoretic approaches to money Californie et <TAustralie. Paris.
demand (Hicks ) and for the modem quantity theory Lloyd, H. 1771. An essay on the theory of money. London.
of money (Friedman ). Locke, J. 1691. The works of John Locke, Vol. 5. London,
1823.
Lubbock, J. 1840. On currency. London.
Marget, A.W. 1942. The theory of prices. New York:
See Also Prentice-Hall.
Marshall, A. 1923. Money, credit and commerce. London:
► T : (1835-.;:9) Macmillan. Reprinted, New York: Augustus M. Kelley,
►" C:/ c 7; 1965.
Newcomb, S. 1885. Principles of political economy. New
York: Harper & Brothers.
Bibliography

Bordo, M.D. 1983. Some aspects of the monetary economics

of Richard Cantillon. Journal of Monetary Economics 12:
234-258.
 Statistical studies in the New York
Norton, J.P. 1902. have undergone some quite profound modifications
money market. New York: Macmillan. over that period.
Pantaleoni, M. 1889. Pure economics. Trans. T.B. Bruce,
London: Macmillan, 1898. At the most elementary level, ‘equilibrium’ is
Pigou, A.C. 1917. The value of money. Quarterly Journal of spoken about in a number of ways. It may be
Economics 32 (November), 38-65. Reprinted in Readings in regarded as a ‘balance of forces’, as when, for
Monetary Theoty, Edited by F.A. Lutz and L.W. Mints for the
example, it is used to describe the familiar idea of a
American Economic Association, Homewood: Irwin,
1951.
balance between the forces of demand and supply.
Pigou, A.C. 1927. Industrialfluctuations, 2nd ed. London: Or it can be taken to signify a point from which
Macmillan, 1929. there is no endogenous ‘tendency to change’:
Rau, K.H. 1841. Grundsatze der Volkswirtsaftslehre, 4th ed. Leipzig stationary or steady states exhibit this kind of
and Heidelberg.
Schumpeter, J.A. 1954. History of economic analysis. New York:
property. However, it may also be thought of as that
Oxford University Press. outcome which any given economic process might
Turner, S. 1819. ^4letter addressed to the right Hon. be said to be ‘tending towards’, as in the idea that
Robert Peel with reference to the expediency of competitive processes tend to produce determinate
the resumption of cash payments at the period
fixed by law. London.
outcomes. It is in this last guise that the concept
Walras, L. 1874-7. Elements d'economie politique pure. Lausanne: seems first to have been applied in economic
Corbaz. theory. Equilibrium is, as Adam Smith might have
put it (though he did not use the term), the centre of
gravitation of the economic system - it is that
configuration of values towards which all economic
Equilibrium (Development of the magnitudes are continually tending to conform.
Concept) There are two properties embodied in this orig-
inal concept which when taken into account begin
Murray Milgate
to impart to it a rather more precise meaning and a
well-defined methodological status. Into this cat-
egory enters the formal definition of ‘equilibrium
conditions’ and the argument for taking these to be
Keywords a useful object of analysis.
Ceteris paribus; Equilibrium; Expectations; There are few better or more appropriate places
Game theory; General equilibrium; Inter- to isolate the first two properties of ‘equilibrium’ in
temporal equilibrium; Long-mn equilibrium; this original sense than in the seventh chapter of the
Natural and normal conditions; Partial equilib- first book of Adam Smith’s W e a l t h o f
rium; Short-run equilibrium; Stationary state; N a t i o n s . The argument there consists of
Steuart, J.; Temporary equilibrium two steps. The first is to define ‘natural conditions’:
There is in every society ... an ordinary or average
rate of both wages and profits____When the price of
any commodity is neither more nor less than what is
JEL Classifications sufficient to pay ... the wages of the labour and the
BO profits of the stock employed ... according to their
natural rates, the commodity is then sold for what
From what appears to have been the first use of the may be called its natural price. (Smith , I.vii, p. 62)
term in economics by James Steuart in 1769, down The key point here is that ‘natural conditions’ are
to the present day, equilibrium analysis (together associated with a general rate of profit - that is,
with its derivative, disequilibrium analysis) has uniformity in the returns to capital invested in
been the foundation upon which economic theory different lines of production under existing best-
has been able to build up its not inconsiderable practice technique. In the language of the day, this
claims to ‘scientific’ status. Yet despite the
persistent use of the concept by economists for over
2 0 0 years, its meaning and role
property was thought to be the characteristic of the ‘statements of tendency’, or Taws’, or ‘principles’
outcome of the operation of the process of ‘free in the economic literature of the 18th and 19th
competition’. centuries. It is worth emphasizing that there was no
The second step in the argument captures the implication that these general tendencies were
analytical status to be assigned to ‘natural either swift in their operation or that they were not
conditions’: subject at any time to interference from other
obstacles. Like sea level, ‘natural conditions’ had
The natural price ... is, as it were, the central price, to
an unambiguous meaning, even if subject to
which the prices of all commodities are continually
gravitating. Different accidents may sometimes keep innumerable cross-currents.
them suspended a good deal above it, and sometimes To put it another way, the distinction between
force them down even somewhat below it But ‘general’ and ‘special’ cases (like its counterpart,
whatever may be the obstacles which hinder them
the distinction between ‘equilibrium’ and ‘dis-
from settling in this center of repose and
continuance, they are constantly tending towards it equilibrium’), refers neither to the immediate
(I.vii, p. 65) practical relevance of these kinds of cases to actual
existing market conditions, nor to the prevalence,
This particular ‘tendency towards equilibrium’ was frequency, or probability of their occurrence. In
held to be operative in the a c t u a l economic fact, as far as simple observation is concerned, it
system at any given time. It is not to be confused might well be that ‘special’ cases would be the
with the familiar question concerning the stability order of the day. John Stuart Mill expressed this
of competitive equilibrium in modem analysis. idea especially clearly when he held that the
There the question about convergence to conclusions of economic theory are only applicable
equilibrium is posed in some ‘in the a b s t r a c t ’, that is, ‘they are only
h y p o t h e t i c a l state of the world where true under certain suppositions, in which none but
none but the most purely competitive environment general causes - causes common to the w h o l e
is held to prevail. It is also essential to observe that c l a s s of cases under consideration - are taken
in defining ‘natural conditions’ in this fashion, into account’ (Mill , pp. 144-5). Marshall, of
nothing has yet been said (nor need it be said) about course, understood their application as being
the forces which act to determine the natural rates subject not only to this qualification (which he
of wages and profits, or the natural prices of spoke about in terms of ‘time’), but also to the
commodities. It will therefore be possible to refrain condition that ‘other things are equal’ ( , I.iii,
from discussing the t h e o r i e s offered by p. 36). There will be cause to return to this matter
various economists for the determination of these below.
variables in most of what follows. Treatment of To unearth these regularities, one had to inquire
these matters may be foimd elsewhere in this behind the scene, so to speak, to reveal what
dictionary. Similarly, there will be no discussion otherwise might remain hidden. Adam Smith had
here of existence or uniqueness of equilibrium (see set out the basis of this procedure in an early essay
existence of general equilibrium). on ‘The Principles which Lead and Direct
‘Natural conditions’ so defined and conceived Philosophical Enquiries’:
are the formal expression of the idea that certain
systematic or persistent forces, regular in their Nature, after the largest experience that common
observation can acquire, seems to abound with
operation, are at work in the economic system. events which appear solitary and incoherent... by
Smith’s earlier idea, that ‘the co-existent parts of representing the invisible chains which bind together
the universe ... contribute to compose one immense all these disjointed objects, [philosophy | endeavours
and connected system’ ( , VII.ii, to introduce order into this chaos of jarring and
discordent appearances. (Smith , p. 45)
1. 37), is translated in this later formulation
into an analytical device capable of generating
conclusions with a claim to general (as opposed to a
particular, or special) validity. These general con-
clusions were customarily referred to as
central organizing category around which economic they associated these conditions with the outcome
theory was to be constructed. It is no accident that of a specific process common to market economies
the formal introduction of the concept into (free competition) and utilized them in the
economics is associated with those very writers constmction of a general economic analysis of
whose names are closely connected with the market society. Earlier applications of ‘natural
foundation of ‘economic science’. It could even be order’ arguments were little more than normative
argued that its introduction marks the foundation of pronouncements about some existing or possible
the discipline itself, since its appearance divides state of society. They certainly made no ‘scientific’
quite neatly the subsequent literature from the many use of the idea of systematic tendencies, even if
analyses of individual problems which dominated these might have been involved. This is particularly
prior to Smith and the Physiocrats. apparent in the case of the ‘natural law’
Cementing this tradition, Ricardo spoke of fix- philosophers, but is also true of the early liberals
ing his ‘whole attention on the permanent state of like Locke and Hobbes. Even Hume, who to all
things’ which follows from given changes, intents and purposes had in his possession all of the
excluding for the purposes of general analysis building blocks of Smith’s position, drew back from
‘accidental and temporary deviations’ ( , the one cmcial step that would have led him to
p. 88). Marshall, though substituting the terminol- Smith’s ‘method’ - he was just not prepared to
ogy ‘long-run normal conditions’ for the older admit that thinking in terms of regularities, however
‘natural conditions’, excluded from this category useful it might prove to be in dispelling theological
results upon which ‘accidents of the moment exert a and other obfuscations (and thus in advancing
preponderating influence’ ( , p. vii). ‘human understanding’), was anything more than a
J.B. Clark followed suit and held that ‘natural or convenient and satisfying way of thinking. The
normal’ values are those to which ‘in the long run, question as to whether the social and economic
market values tend to conform’ ( , p. 16). world was actually governed by such regularities, so
Jevons ( , p. 86), Walras ( -7, p. 380), central to Smith and the Physiocrats, just did not
Bohm-Bawerk ( , vol. 2, p. 380) and Wicksell concern Hume.
( , vol. 1, p. 97) all followed the same Yet the earlier normative connotations of ideas
procedure. like ‘natural conditions’, ‘natural order’, and the
Not only was the status of ‘equilibrium’ as the like, quite rapidly disappeared when the terminol-
centre of gravitation of the system (the benchmark ogy was appropriated by economic theory. Nothing
case, so to speak) preserved, but it was defined in was ‘good’ simply by virtue of its being ‘natural’.
the manner of Smith. The primary theoretical object This, of course, is not to say that once the
of all these writers was to explain that situation theoretical analysis of the natural tendencies
characterized by a uniform rate of profit on the operating in market economies had been completed,
supply price of capital invested in different lines of and the outcomes of the competitive process had
production. Walras, whose argument is quite been isolated in abstract, an individual theorist
typical, stated the nature of the connection might not at that stage wish to draw some
forcefully: conclusions about the ‘desirability’ of its results (a
uniformity of ... the price of net income [rate of normative statement, so to speak). But such
profit] on the capital goods market ... [is one] condition
statements are not implied by the concept of
by which the universe of economic interests
is governed. ( 774-7, p. 305) equilibrium - they are value judgements about the
characteristics of its outcomes.
From an historical point of view, the novelty of
Indeed, contrary to the view sometimes
these arguments which were worked out in the 18th
expressed, even Smith’s use of deistic analogies and
century by Smith and the Physiocrats is not that
metaphors in the T h e o i y o f M o r a l
they recognized that there might be situations which
S e n t i m e n t s , where we read about God
could be described as ‘natural’, but that as the creator of the ‘great machine of the universe’,
and where we encounter for the first time the
famous ‘invisible
hand’, is no more than the extraneous window- to an imaginary stationary society in which no one
dressing which surrounds a well-defined theoretical conducts the daily business of life.
argument based upon the operation of the so-called On this question, as might be expected, Marshall
‘sympathy’ mechanism. Thus, as W.E. Johnson vacillated. The thrust of his argument (as well as
noted when writing for the original edition of those of his major contemporaries, with the
Palgrave’s Dictionary, ‘the confusion between important exception of Pareto ) seems to imply that
scientific law and ethical law no longer prevails’, such a property was not essential to his purpose, but
and he observes that ‘the term normal has replaced as was his habit on so many occasions, in a footnote
the older word natural’ - to be understood by this he qualified that position ( , p. 379, n.l). In the
terminology as ‘something which presents a certain final analysis, the
empirical uniformity or regularity’ (Palgrave , p. answer seems to have depended rather more on the
139). explanation given for the determination of
While ‘natural conditions’ or ‘long-run normal equilibrium values, than upon the concept of equi-
conditions’ represent the original concept of librium proper. It was not until the 1930s that the
‘equilibrium’ utilized in economic theory, John issue seems to have been resolved to the general
Stuart Mill’s Political Economy seems to have been the satisfaction of the profession. But then its ‘reso-
source from which the actual term equilibrium lution’ required the introduction of a new definition
gained widespread currency (though, like so much of equihbrium (the concept of intertemporal
else, it is also to be found in Cournot’s Recherches). equihbrium) due in the main to Hicks.
More significant, however, is the fact that in Mill’s However, some further embellishments and
hands the meaning and status of the concept modifications were worked upon the concept of
undergoes a modification. While maintaining the equihbrium before the 1930s. Here, two develop-
idea of equihbrium as a long- period position, Mill ments stand out. The first concerns the distinction
introduces the idea that the equilibrium theory is between partial equihbrium analysis and general
essentially ‘static’. The relevant remarks appear at equihbrium analysis. The second concerns a trend
the beginning of the fourth book: that seems to have developed consequent upon
We have to consider the economical condition of Marshall’s treatment of the element of time, which
mankind as liable to change ... thereby adding a
led him to his threefold typology of periods
theory of motion to our theory of equilibrium - the
Dynamics of political economy to the Statics. (Mill (‘market’, ‘short’, and ‘long’ - we shall leave to one
,IV.i, p.421) side the further category of ‘secular movement’).
Since he retained the basic category of ‘natural and The upshot of this trend which is decisive, is that it
normal conditions’, Mill’s claim had the effect of became common to speak of the possibility
adding a property to the list of those associated with of‘equilibrium’ in each ofthese Marshallian periods.
the concept of equilibrium. However, over the The analytical basis for partial equihbrium
question of whether this additional property was analysis was laid down in 1838 by Cournot in his
Recherches. Mathematical convenience, more than
necessary to the concept of equilibrium, there was
to be less uniformity of opinion. Indeed, this matter methodological principle, seems to have been
gave rise to a debate in which at one time or another responsible for his adopting it (see, for example, , p.
(until at least the 1930s) almost all theorists of any 127). Though this small volume failed to exercise
repute became contributors. The problem was a any widespread influence on the discipline much
simple one - are natural or long-period normal before the 20th century, it was known and read by
conditions the same thing as the ‘famous fiction’ of Marshall (who spoke of Cournot as his ‘gymnastics
the stationary or steady state. Much hinged upon the master’), from whose Principles the popularity of
answer; a ‘yes’ would have limited the application partial equihbrium analysis is largely derived
of equilibrium (though it would be remiss to overlook Auspitz,
Lieben and
von Mangoldt). Unlike the case of Cournot, how- concerned. This view would accord, incidentally,
ever, it would be difficult to argue that Marshall with the fact that the great disputes over the relative
came across the method in anything other than a merits of these two modes of analysis (for example,
roundabout way (though some have argued that its that between Walras on the one hand, and Auspitz
principal attraction for him lay in its facility in and Lieben on the other) were fought over the
allowing him to express his theory in a manner specification of demand and cost functions.
which required little recourse to mathematics). Another modification to the concept of equi-
When Marshall first introduced the idea of librium that has become more significant in recent
assuming ‘other things equal’ in the literature also makes an appearance in Marshall;
P r i n c i p l e s , the c e t e r i s though it is not carried as far as it has been in recent
p a r i b u s condition which is taken as the literature. The second, third and fifth chapters of the
hallmark of the partial equilibrium approach, he fifth book of Marshall’s P r i n c i p l e s set
seems to have done so not in order to justify the out the conditions for the determination of what he
procedure of analysing ‘one bit at a time’, but in calls the ‘temporary equihbrium’, the ‘short-run
order to make a quite different point - that a long- equilibrium’ and the ‘long-run equilibrium’ of
run normal equilibrium would only a c t u a l l y demand and supply. The last of these categories, as
emerge if none but the most general causes were Marshall makes perfectly clear in the text,
allowed to operate without interference (see, for corresponds to Adam Smith’s ‘natural conditions’ (
example, , pp. 36,366, and 369-70). In other words, , p. 347). The first two are to a greater or
the ‘other things’ that were being held ‘equal’ were lesser degree ‘more influenced by passing events,
the given data of the theory and the external and by causes whose action is fitful and short lived’
environment - if the data remained the same and the (p. 349). What is striking about Marshall’s
external environment was freely competitive, then a terminology is the fact that situations which from an
long-run normal equilibrium would result. Indeed, analytical point of view would traditionally have
Walrasian general equilibrium holds ‘other things been regarded as ‘deviations’ from long- period
equal’ in this sense. To put it another way, in normal equilibrium (that is, disequilibria) are
Marshall’s initial argument nothing was sa id about explicitly referred to as different cases of
the possibility of assuming the interdependencies ‘equihbrium’. This trend has taken on an entirely
between long-run variables themselves to be of new significance in recent literature, and has had
secondary importance, as is customary in partial dramatic consequences for the meaning and status
equilibrium analysis. of the concept of equilibrium in economic theory.
This latter requirement of Marshallian analysis, But just as important in comprehending this
the idea of the negligibility of indirect effects when development is the introduction of the notion of
one looks at individual markets ( , intertemporal equilibrium into theoretical discourse.
p. 677ff), seems to have sprung from his habit of The notion of intertemporal equilibrium
presenting equilibrium t h e o r y in terms of (introduced by Hayek, Lindahl and Hicks in the
p a r t i c u l a r market demand and supply inter-war years and developed in the 1950s by
curves (with their attendant notions of Malinvaud, Arrow and Debreu) warrants special
representative consumers and firms). It is here, in consideration since ‘equilibrium conditions’ under
fact, that Marshall’s presentation of demand and this notion are defined quite differently from
supply theory differs so markedly from its ‘natural’ or ‘long-run normal’ conditions.
presentation by Walras. To the extent that this is so, Intertemporal equilibrium defines as its object the
it would seem to be better to recognize that the idea determination of n t market-clearing prices (for n
of ‘partial’ versus ‘general’ equilibrium has more to commodities over / elementary time periods
do with the presentation of a particular theory, and commencing from an arbitrary short-period
Marshall’s propensity to consider markets one at a
time, than it has to do with the abstract category of
equilibrium with which this discussion is
starting point). The chief implication of this defi- of argument, Walrasian equilibrium and, say, con-
nition of equilibrium conditions, and that which sets jectural equilibrium compete with one another not
it apart from long-run normal conditions, is that not for the title ‘general’ (since, in the traditional sense
only will the price of the same commodity be at least, there is no such category), but for the title
different at different times but also that the stock of ‘significant’. Furthermore, at any given time they
capital need not yield a uniform return on its supply are competing for this title with as many other
price. models as are available to the profession.
This fundamental change in the concept of It seems to be the case that the status of equi-
equilibrium did not mean that intertemporal equi- librium in economic analysis has come full circle
librium positions were immediately divested of the since its introduction in the late 18th century. From
status that had been given to ‘equilibrium’ ever being derived from the idea that market societies
since Adam Smith. In certain circles they continued were governed by certain systematic forces, more or
to be regarded as positions towards which the less regular in their operation in different places and
economic system could actually be said to be at different times, it now seems to be based on an
‘tending’ (or as benchmark cases). opinion that nothing essential is ‘hidden’ behind the
However, once the s e q u e n t i a l many and varied situations in which market
character of this equilibrium concept came to be economies might actually find themselves. In fact, it
better understood, it became apparent that there seems that these many cases are to be thought of as
could be no ‘tendency’ towards it - at least not in being more or less singular from the point of view
the former meaning of that idea. One was either in of modem theory. From being the central organizing
it, in which case the sequence was ‘inessential’, or category around which the whole of economic
one was not, in which case the sequence was theory was constructed, and therefore the ultimate
‘essential’ (see Hahn , p. 16). And the probabilities basis upon which its practical application was pre-
overwhelming suggested the latter. Attention was missed, equilibrium has become a category with no
thus turned to the individual points in the sequence; meaning independent of the exact specification of
the temporary equilibria, as Hicks had dubbed them the initial conditions for a n y model. Instead of
(applying the terminology of Marshall in a new being thought of as furnishing a theory applicable,
context). A whole new class of cases, as Mill would have said, to the whole class of cases
disequilibrium cases from the point of view of frill under consideration, it is increasingly being
intertemporal equilibrium, began to be examined. regarded by theorists as the solution concept
The discipline has now accumulated so many relevant to a particular model, applicable to a
varieties that it is impossible to document them all limited number of cases. The present fashion for
here. Instead, two broad features of this replacing economic theory proper by game theory,
development may be noted here, the first an approach which could be regarded by no less a
concerning the role that expectations were thereby theorist than Professor Arrow as contributing only
enabled to play, the second the common designation ‘mathematical tools’ to economic analysis not many
now uniformly applied to all such cases: years ago ( , p. 113), seems to exem
‘equilibrium’. plify the trend of modem economics.
When equilibrium is interpreted as a solution
concept in the sense that a l l solutions to a l l
models (for which solutions exist) enjoy equal See Also
analytical status and differ only in that they become
‘significant’, as von Neumann and Morgenstem put ► Arrow-Debreu Model of General Equilibriun
it, when they are ‘similar to reality in those respects ► v : . T
which are essential in the investigation at hand’ ( ► Conjectural Equilibria
, p. 32), it is some ► General Equilibrium
times said that economics has availed itself of a ► Temporary Equilibrium
very powerful notion of equilibrium. On this line
Bibliography Walras, L. 1874-7. Elements of pure economics. Trans, and ed.
W. Jaffe from the definitive edition of 1926. London:
Arrow, K.J. 1968. Economic equilibrium. In International Allen & Unwin, 1954.
encyclopedia of the social sciences, as reprinted in The Wicksell, K. 1901. Lectures on political economy, 2 vols., ed. L.
collected papers of Kenneth J. Arrow, vol. 2. - Cambridge, Robbins. London: Routledge and Kegan Paul, 1934.
MA: Harvard University Press.
Clark, J.B. 1899. The distribution of wealth. London: Macmillan.
Cournot, A.A. 1838. Researches into the mathematical principles of
the theory of wealth. Trans. N.T. Bacon with an introduction
by I. Fisher, 1897; 2nd ed. London/New York:
Macmillan. 1927.
Garegnani, P. 1976. On a change in the notion of equilibrium Equilibrium: An Expectational Concept
in recent work on value. In Modern capital theory, ed. M.
Brown et al. Amsterdam: North-Holland. Edmund S. Phelps
Hahn, F.H. 1973. On the notion of equilibrium in economics.
Cambridge: Cambridge University Press.
Hicks, J.R. 1939. Value and capital, 2nd ed. Oxford: Clarendon
Press, 1946.
Jevons, W.S. 1871. Theory of political economy. Edited from the
2nd edition (1879) by R.D.C. Black. Harmondsworth:
Penguin, 1970. Economic equilibrium, at least as the term has
Marshall, A. 1890. Principles of economics, 9th (variorum) traditionally been used, has always implied an
edition, taken from the text of the 8th edition, 1920. outcome, typically from the application of some
London: Macmillan.
inputs, that conforms to the expectations of the
Marshall, A. 1919. Industry and trade, 2nd ed. London:
Macmillan. participants in the economy. Many theorists, espe-
Mill, J.S. 1844. Essays on some unsettled questions of political cially those employing the ‘economic man’ pos-
economy, 2nd ed. 1874; Reprinted. New York: Augustus tulate, have also required the further condition for
M. Kelley.
equilibrium that every participant be optimizing in
Mill, J.S. 1848. Principles of political economy. 1871 (Reprinted
1909), 6th ed. London: Longmans, Green & Company. relation to those correct expectations. However it is
Palgrave, R.H.I., ed. 1899. Dictionaiy of political economy, vol. 3. the former condition, correct expectations, that
London: Macmillan. appears to be the essential property of equilibrium
Pareto, V. 1909. Manual of political economy.
at least in the orthodox use of the term. Economic
Trans, from the French edition of 1927 and ed. A.S.
Schwier and A.N. Page. New York: Augustus M. Kelley, equilibrium is therefore not defined in the same
1971. terms as physical equilibrium. The rest positions or
Ricardo, D. 1817. The principles of political economy and taxation. damped oscillations of pendulums cannot be
Edited from the 3rd edition of 1821 by P. Sraffa with the economic equilibria nor disequilibria since pen-
collaboration of M. Dobb, vol. 1 of The works and
correspondence of David Ricardo, dulums have no expectations.
11 vols. Cambridge: Cambridge University Press, 1951- Yet it is natural and obvious that the first appli-
73. cations of the equilibrium idea identified some
Smith, A. 1759. The theoiy of moral sentiments. Edited by D.D. position of rest, or stationary state, as being the equi
Raphael and A.L. Macfie from the 6th edition of 1790.
Oxford: Oxford University Press, 1976. librium in the problem at hand. Undoubtedly the
Smith, A. 1776. An inquity into the nature and causes of the wealth term equilibrium, referring to an ‘equal weight’ of
of nations, 2 vols., ed. E. Cannan. London: Methuen, 1961. forces pushing capital or what-not i n as pulling
Smith, A. 1795. Essays on philosophical subjects. Edited by it o u t , owes its origins to the balance of forces
W.P.D. Wrightman and J.C. Bryce. Oxford: Oxford
University Press, 1980. prevailing in a stationary situation. But there can
von Bohm-Bawerk, E. 1899. Capital and interest, 3 vols. also be a s e q u e n c e of positions in which
Reprinted. South Holland: Libertarian Press. 1959. there is a new balance with each new position.
von Neumann, J, and Morgenstem, O. 1944. Theoiy of games There was no reason why equilibria might exist
and economic behaviour, 3rd ed. Princeton: Princeton
University Press, 1953.
only among stationary states or balanced- growth
paths.
Once efforts began to extend economic theory to
the case of moving equilibrium paths the
expectational meaning of equilibrium began to be mathematical standpoint has a human, or real,
explicit. Two of the pioneers here are Myrdal and interpretation. One might say, semi-jocularly, that
Hayek. In his 1927 book on price determination and pendulums have no economic equilibria since their
anticipations (in Swedish) Myrdal addresses the motions, unlike those of trapeze artists, are not a
two-way interdependency arising in a dynamic function of expectations, if they have any.
analysis of an on-going economy: present In the postwar period the notion of equilibrium
disturbances influence future prices and turns up in contexts quite different from that of the
anticipations of future disturbances affect present inter-war economic theorists. In game theory, begun
prices (the latter relation being MyrdaTs main by von Neumann and Morgenstem, the term
subject). In a 1928 article (in German) on what he equilibrium is used to refer to the theoretical
called intertemporal equilibrium, Hayek drew the solution to the policies, or play, of two or more
analogy between intertemporal trade and inter- players in strategic interaction. If the model pos-
national (or interspatial) trade: prices of the same tulates optimizing, or expected-utility- maximizing,
thing at two different places or times are not behaviour by all players, as game theorists’ models
generally equal, though they may be pulled up or invariably do, the equilibrium necessarily has the
down together. In a 1929 article (in Swedish) feature that no player can do better acting alone; but
Lindahl studied what is considered to be the first lying behind this feature is the essential property
mathematical model of intertemporal equilibrium. that each player has correctly expected the strategy
This literature is surveyed in Milgate ( ). of the others and hence optimized relative to those
The English-speaking world was slow to take up conect expectations.
the new line of research. In his G e n e r a l In the late 1960s the notion of equilibrium
T h e o r y of 1936, Keynes speaks grandly of begins to take root in the new territory of non-
having shown the existence of an (implicitly classical markets - markets without costless and
moving) equilibrium with underemployment, and he thus complete information. An economy may have
does argue that the expectation of falling wages and markets - the resort hotel market is perhaps a
thus prices makes the slump worse, which suggests suitable example - in which there are costs in the
he had an expectational notion of equilibrium in acquisition or processing of information about
mind; but he gives no clues as to what he means by prices (and perhaps product specifications) so that
equilibrium, so both the nature and the basis of his arbitrage tendencies are delayed and the classical
claim are left unclear. The new topic of law of one price operates only with a lag. One well-
intertemporal equilibrium and the explicit expec- known portrait of such a market imagines that the
tational treatment of equilibrium make their English national market is composed of Phelpsian islands
debut in Hicks’s V a l u e a n d lacking current-period information about one
C a p i t a l in another’s prices. Another image visualizes each
1939. (In the same year Harrod’s expectational firm as an island unto itself with its own stock of
notion of ‘warranted growth’, alias equilibrium, and customers, who are not knowledgeable about the
the translation of Lindahl’s writings appear.) Hicks policies (and perhaps even the whereabouts or
makes clear the analytical problem that the analyst existence) of other firms. In such non-Walrasian
and the economic agents alike must solve to find markets the prevailing prices can be (and usually
equilibrium: in view of the dependence of future are) supposed to be marketclearing: no buyer or
endogenous variables, such as next period’s price, seller is subjected to rationing (sometimes called
on present actions of firms and households, and the non-price rationing by overfastidious writers).
dependence of such actions on expectations of those However the market will be in
future variables, what expectation would cause the e q u i l i b r i u m if and only if the prices
actual outcome to coincide with the expectation? (and other variables) reflect correct expectations on
For example, if the actual price P is a function/of the part of suppliers and buyers about the prices
the expected price P e find the value of P e such
that P e = f ( P e ) . Thus the fixed- point
character of equilibrium from a
prevailing elsewhere - at other islands or other statistically optimal forecasts conditional upon his
firms; otherwise there is disequilibrium. particular information set. This is equilibrium with
An economy may also have markets - one may a qualification.
think of labour markets or markets for rental In surveying the meaning of equilibrium
housing - in which, although information is Grossman has remarked that, in Hicks, ‘perfect
immediate, the wage or rental setters have to make foresight is an equilibrium concept rather than a
decisions of some durability, however short-lived, condition of individual rationality’. A similar
and without advance information about the similar comment applies, with even greater weight, to
decisions of the other firms. In such quasi- statistical equilibrium and to its rational-
Walrasian markets there may be reasons - having to expectations variant. The agents of equilibrium
do with incentives, or efficiency - why wages tend models are not simply rational creatures; they have
to exceed and rentals lie below the market-clearing somehow come to possess fantastic knowledge. The
level. Yet the market will be in equilibrium premise raises obvious problems of
e q u i l i b r i u m in the case (if such exists) knowledge: why should it be supposed that all the
in which no wage setter or rental setter experiences agents have hit upon the true model, and how did
surprise at the corresponding decisions being made they manage to estimate it and conform to it more
simultaneously (or perhaps somewhat later within and more closely? There has always been a strand
the period of the commitment) by the other wage or of thought, running from Morgenstem in the 1930s
rental setters; otherwise the market must be in to Frydman in the present, that holds that we cannot
disequilibrium, however long or brief (see Phelps et hope to understand the major events in the life of an
al. ). economy, and perhaps also its everyday behaviour,
Thus the analogy between intertemporal equi- without entertaining hypotheses of disequilibrium.
librium and interspatial equilibrium, which was
drawn by Hayek and others in their analysis of the
former, now seems deeper than it could have at first.
The expectational meaning of equilibrium, which is
so unavoidably clear in the context of intertemporal
See Also
equilibrium, where future prices are generally
expected future prices, turns out to be just as natural
and inevitable in the interspatial context as soon as
one gives up the Active device of the Walrasian
auctioneer and thus admit that there are ‘other’
prices elsewhere, about which there must be
►
expectations, not merely a single market-wide price. ►
The 1970s witnessed the formal analysis of
equilibrium in terms of expectations, or forecasts, of
the probability distributions of prices. Lucas, Bibliography
adopting the device of separate market-clearing
islands, analysed a model in which there is non- Frydman, R., and E.S. Phelps (eds.). 1983. Individualforecasts
and aggregate outcomes. Cambridge: Cambridge University
public, or local, information (later called
Press.
asymmetric information), namely local prices, and Grossman, S.J. 1981. An introduction to the theory of rational
these price observations are used to update people’s expectations under asymmetric information. Review of
conditional forecasts of the currently unobserved Economic Studies 54: 541-560.
prices elsewhere. There may exist a Hayek, F.A. 1928. Das intertemporale Gleichge-
wichtssystem der Preise und die Bewegungen des
r a t i o n a l - e x p e c t a t i o n s Geldwertes. Weltwirtschafiliches Archiv 28(1): 33-76.
equilibrium in which everyone knows and uses the Hicks, J.R. 1939. Value and capital. Oxford: Clarendon Press.
correct c o n d i t i o n a l expectations of the Keynes, J.M. 1936. General theory of employment, interest and
unobserved prices - that is, the money. London: Macmillan.
Lindahl, E. 1929. Prisbildningproblemets upplaggning fran stochastic general equilibrium (DGSE)
kapitalteoretisk synpunkt Ekonomisk Tidskrift 2. models; Equilibrium-correction models;
Lucas Jr., R.E. 1972. Expectations and the neutrality of
money. Journal of Economic Theory 4(2): 103-124. Error-correction models; Forecast failure;
Milgate, M. 1979. On the origin of the notion of GARCH processes; Linear-quadratic models;
‘intertemporal equilibrium’. Economica 46(1): 1-10. Partial equilibrium; Stationarity; Unit roots;
Morgenstem, O. 1935. Vollkommene Voraussicht und
Vector autoregressions
wirtschaftliches Gleichgewicht. Zeitschrift fur
Nationalokonomie 6(3): 337-357.
Myrdal, G. 1927. Prishildningsprohlemet och For Under -
ligheten. Uppsala: Aknqvist and Wiksell. JEL Classifications
Phelps, E.S., et al. 1970. Microeconomic foundations of C32
employment and inflation theory. New York: W.W.
Norton.
von Neumann, J., and O. Morgenstem. 1944. The theory of
games. Princeton: Princeton University Press. Introduction

An equihbrium is a state from which there is no

inherent tendency to change. Since we deal with
stochastic processes, the equilibrium is the expected
Equilibrium-Correction Models value of the variable in an appropriate
representation, since that is the state to which the
David F. Hendry process would revert in the absence of further
shocks. Then, we define an equilibrium- correction
model (EqCM) as one ( a ) which has a well-
defined equihbrium, and (b) in which adjustment
takes place towards that equihbrium. A key aspect
Abstract
of an EqCM is that deviations from its expected
The equilibrium-correction class of econometric
value are attenuated, and eventually eliminated if
models is surprisingly large, and includes
no additional outside influences impinge. As such,
regression equations, autoregressive-error
equilibrium-correction models are a very broad
models, autoregressive distributed-lags, simul-
class, comprising all regressions, autoregressions,
taneous equations, autoregressive conditional
autoregressive-distributed lag (ADL) models, linear
heteroskedastic processes and generalized
simultaneous equations, vector autoregressions
ARCH, vector autoregressions and dynamic
(VARs), vector equilibrium-correction systems
stochastic general equihbrium systems, among
based on cointegration (VEqCMs), dynamic
others. Moreover, its properties are relatively
stochastic general equihbrium systems (DSGEs),
generic for all members. Following an historical
autoregressive conditional heteroscedastic
overview of its origins in error corrections and
processes as in Engle ( ) (ARCH), and
control mechanisms on the one hand and
generalized
cointegration on the other, its properties are
ARCH (GARCH, see Bollerslev ) processes among
described, leading to an explanation as to why
others. Their formulation (in levels or differences)
the ubiquitous class of equilibrium- correction
determines the equihbrium to which they converge
models is prone to forecast failure in processes
(level or steady state). For example, a random walk
that are non-stationary from location shifts.
without drift is a non-stationary process in levels,
but is stationary in differences (its non-integrated
representation), and has an expectation of zero, so
Keywords the differences equihbrium corrects to zero.
Adjustment costs; Autoregressive distributed- We first address the broad nature of the
lag models; Autoregressive-error models; equilibrium-correction class in section “
Cointegration; Common factors; Control
mechanisms; Differencing; Dynamic
 ”, then review the Ay, = p'Az, - (;y,_j - P0 ~ P'z>-1) + £t (3)
history of equilibrium-correction model formulation
where the feedback coefficient is — 1. Then ( ) is
in section “ ”, and con
an EqCM where the equilibrium-correction term is
sider its links to cointegration in section z
a yt OVi - P o - P ' t - \ )■ Notice that
differencing is a linear transformation, not an
The roles of cointegration and equilibrium correc-
operator, in any setting beyond a scalar time series.
tion in economic forecasting are examined in sec-
The existence of ( ) does not require that v r and
tion “
z, are stationary, provided the linear combination is;
”, in particular the non-robustness of
and could hold, for example, for growth rates rather
EqCMs to location shifts in the underlying equi-
than the original levels if y , and z, were
libria, and consequently their proneness to forecast
differences of those original variables.
failure. Section “ ” concludes.
Autoregressive-Error Models as
The Equilibrium-Correction Class Equilibrium- Corrections
Even extending a static regression like ( ) by (say) a
Often it is not realized that the model being used is first-order autoregressive error as in:
a member of the equilibrium-correction class, so
this section establishes that the models listed above y, = Po + P'zt + ut where u, = put , + e, (4)
are indeed in the EqCM class. The properties of the
leads to:
class are partly specific to the precise model, but
primarily generic, as section “ yt = Po + P'zi + p(y, I Pn P'zt i) + £t
” empha-
sizes. We consider six cases. or:

Regression as an Equilibrium-Correction Ay, = P'Az,

Model + (P ~ 1)(T;-I — Po ~ P' z t-1) + £ I (3)
Consider a conditional linear equation of the form showing that the common-factor model class (see
in ( ) for t = 1;...; T . Sargan ; Hendry and Mizon ) is also a restricted
equilibrium-correction mechanism, constrained by
k £
yt Po i P, i, i + t
z the impact effects (from Az,) being the same as the
1=1 long-run effects (from zM).
= Po + P'zt + £t (1)
ADLs as Equilibrium-Correction Models
with s , ~ IN [0, of] (normally and independently A first-order autoregressive distributed-lag (ADL)
distributed, mean zero, variance of) independently model is:
of the past and present of the k regressors { z t } .
Then: yt = Po + P'\zt + Pi}’/-1 + P'izt-\
+ s , where s t ~ IN [0, erf]. (6)
my, -Po -/?'z,)M = 0 (2)
The error on ( ) is an innovation against the
defines the conditional equilibrium, where adjust- available information, and its serial independence is
ment to that equilibrium is instantaneous as entailed
part of the definition of the model, whereas
by ( ). Re-expressing ( ) in differences (Ax, = x ,
normality and homoscedasticity are just for con-
— X [ _ \ for any x ) and lagged deviations
venience. The condition \ [ 1 2 \ < 1 is needed to
from ( ) delivers the (isomorphic) EqCM
formulation:
ensure a levels’ equilibrium solution: Ericsson ( Ay, = g y + 0\ (Az, 6)
) provides an extensive discussion. We con
sider ( ) for both stationary and integrated {z,}, the + ( p 2 - 1 ) ( y , ~ i -xiz,_!-/t)
+ «/. (11)
latter denoting that some of the z, have unit roots in
their levels representations, but are stationary in Re-specifying deterministic terms as in ( ) plays
differences. an important role in EqCMs, both by helping to
First, under stationarity, taking expectations in ( orthogonalize the regressors, and because of the
) where E[y,] = y and E[z,] = z V/. pernicious effects of shifts in /y a topic addressed in
section “
£[(i - 0i)y, -Po- (Pi + P 3 )%\ = 0 (7) ”. It is so well known that the
standard error of the mean of an IID random
so:
variable is the standard deviation of the data divided
by the square root of the sample size that it hardly
bears reiterating: except that it is somehow almost
always ignored in this context. The standard error
= K 0 + /c'jZ*. (8) of the intercept in an EqCM equation like ( )
should, therefore, be a t j y / f but is often a
Since many economic theories have long-mn partial
hundred times larger in reported empirical models,
equilibria like ( ), they could be modelled by this
revealing a highly coll inear specification (a similar
class. Transforming ( ) to differences and the
comment applies to VARs). Moreover, a check on
equilibrium-correction term (y — rco — /v:jz) (1
the model formulation follows from using sample
delivers:
means to estimate 8 and /<, then checking that g y
has a sensible value, which may be given by theory
Ay, = 0 ( A z , (for example, no autonomous inflation, so g } , =
+ (02 ~ l)Cy/-i - o -
K

+ £,. (9) 0).

Finally, if 0 2 = 1, ( ) equilibrium corrects in
differences. An autoregression is the special case
The immediate impact of a change in z, ony, is
where 0 \ = 0 3 = 0, so is also an EqCM;
l > \ , and the rapidity with which Ay,
and partial adjustment is another special case where
converges to zero, which is its equilibrium outcome
now 0 s = 0.
under stationarity, depends on the magnitude of (/? 2
—1) < 0; when both changes and e, are zero (their GARCH as an Equilibrium-Correction Model
expectations), ( ) results. As a fourth example, consider a non-integrated
When y, and z, are integrated of order 1 GARCH(1,1) process for e , where E [e^ | /,_ , ]
t
(denoted 1(1)), so are stationary in differences, the = a ) when I _ i denotes past information, and:
t
reformulation in ( ) remains valid provided | / ? | < 1
2

in which case ( y — k 0 — k [ z ) is a cointegration

of = a> + af+1 + d o f j (12)
relation, as discussed in section “ Let
E[Az,] = <5 (say) so E[Ay, ] = k [ 8 = g y
where E [y, — k \ z , ] = /(, then taking with 0 < a < l , 0 < 9 < l and 0 < a + 0 < 1. Let
expectations in ( ) using ( ):
of = e j - v,, where E[v,]= 0, then:
gy = P'\?> + {fi2 - \){n - K0)
e; = co + (a + + v, - 0v,_i (13)
(10)
where the equilibrium is:
and subtracting ( ) from ( ) delivers:
 (unless their polynomial has further unit roots,
making the process doubly integrated, 1(2)).
Finally, for a combination of eigenvalues inside and
Substituting to = (1 (a I 0 ) ) a z from ( ) into on the unit circle, V has reduced rank 0 < r < n
the equation for a j : equal to the number of non-unit eigenvalues, so can
be expressed as T = a f j where a and [ j also
A<T7 = (0- i)(o?+1 - < ? ; ) have rank r . Then n in ( ) can be decomposed
+ a(^+1-a2e). (15) into the unconditional growth rate of x,, denoted y ,
and a/t such that in place of ( ), we have:
Thus, the change in the conditional variance a2
responds less than proportionally (0 < 1) to the Ax, = y + (n, - I„)(Ax, | - y)
previous disequilibrium between the conditional — a(/f'x,_2 ~ f i ) + £t
variance and the long-run variance, perturbed by the
zero-mean discrepancy between the previous (18)
squared disturbance e2 j and the long-run variance
a \ , so the model equilibrium corrects to a \ , so that Iif/fx, j i \ 0 and the system converges to that
consistent with ( ). ARCH is simply a special case. equilibrium when the original variables are 1(1),
hence /fx,_2 is an 1(0) process which equilibrium
VARs as Equilibrium-Correction Models corrects to /(. At the same time, Ax, is an I (0)
The fifth example is an n-dimensional VAR with m process which equilibrium corrects to y , noting
lags and an innovation error e, ~IN„[0, OJ: that f j ' y = 0, whereas x, drifts.
Linear simultaneous equations systems of time
m series are a restriction on a VAR, so are also
X, = 71 + + £, (16) EqCMs.
i = 1
DSGEs as Equilibrium-Correction Models
where the n m eigenvalues of the polynomial |I„ As a final brief example, well-defined general
- Ef=in i L l | in L determine the characteristics of equilibrium systems have equilibria. Using Taylor-
the time series. If all the eigenvalues are inside the series expansions around the steady-state values of
unit circle, ( ) is stationary (when all the param the discretized representation of a system of
eters are constant and the initial conditions also differential equations, Bardsen et al. ( )
satisfy the process). In that case, show that any dynamic system with a steady-state
r (/„ i n,) is invertible and has all its solution has a linear EqCM representation. Thus,
eigenvalues inside the unit circle, so the process they argue that linearizations of DSGEs imply
equilibrium corrects to i// I ’ 1 n . To illustrate for linear EqCM representations. In principle, these
m = 2 , ( ) can be expressed as: could be in terms of changes only, corresponding to
a steady-state path. More usually, level solutions
Ax, = (IIi — I«)Ax,_i -r(x,_2-i/0
result.
+ £, (17)

where E[Ax,] = 0 by stationarity, so E [ x t - Historical Overview

ij / ] 0 is indeed the equilibrium to which x,
converges in the absence of further shocks. Con- Equilibrium-correction models are a special case of
versely, if all the eigenvalues are unity, x, is I (1) the general class of proportional, derivative and
with T = 0 in ( ), so does not equilibrium integral control mechanisms, so have a long ped-
correct in levels, but does so in the differences igree in that arena: for economics examples, see
Phillips ( ), Phillips and Quenouille ( )
and Whittle ( ), with the links summarized
in Salmon ( ). Explicit examples of EqCMs
are presented in Sargan ( ) and were popular- Ar, 1 =
+;+ x , + j + i - x , + j also
ized by Davidson et al. ( ), although they were depends on x t + j , which yields (ignoring the
called ‘error-correction mechanisms’ (ECMs) by end point for simplicity):
those authors. The major developments underlying
cointegration in Engle and Granger ( ) dCH dc,+j | dc, + j + 1
established its isomorphism with equilibrium cor- dxl+j dxl+j dxl+j
rection for integrated processes, leading to an = x,+j - x*+ju(Axt+J) - a(Axt+J+1), (20)
explosion in the application of EqCMs and the
so equating to zero for a minimum for any j , and
development of a formal analysis of vector EqCM
hence for j = 0:
systems in Johansen ( , ). We now
review the two stages linking control mechanisms x, — x* + rxAx, — rxAx,+\ = 0.
with error correction, then that with equilibrium
correction. Expressed as a polynomial in leads and lags in the
operator L (for a / 0):
Error Correction and Control Mechanisms
(L-1 — (2 + or1) +L)x,
Phillips ( , ), in particular, pioneered the
application of control methods for macroeconomic = (L-1 - 12) (1 - hL)x, = - ^. (21)
stabilization, specifically techniques for derivative,
proportional and integral control servomechanisms. The polynomial in ( ) has roots X \ and X 2 with
In this form of control, a target (say an a product of unity (so they are inverses, with X i
unemployment rate of five per cent) is to be inside and X 2 outside the unit circle) and a sum of
achieved by adjusting an instrument (say govern- (2 + a-1). Inverting the first factor ( L ~ l -
ment expenditure), and changes to the instrument, X 2 ) , using { \ I X 2 ) = X i < \ and
its level, and cumulative past errors may need to be expanding the last term as a power series in L ~
included in the rule to stabilize the target. 'expresses x t as a function of lagged .xv and
That approach is a precursor to the well-known current and future values of x * t + k \
linear-quadratic model in which one optimizes a
quadratic function of departures from target tra- l 2
^ (1 + X \ L ~ +X \ L - +•
jectories for a linear dynamic system over a finite (1 - X\L)xt • .)*?
future horizon (see, for example, Holt et al. ;
Preston and Pagan ). For example, consider the 4 OO
quadratic cost function C/, which penalizes the
“ £=0
deviations of a variable x , , from a pre-specified
(22)
target trajectory jx/(j subject to costs of adjustment
from changes Ax, = x , — x t over an Since (1 — X { ) = ii/oefl — X i ) , let:
//-period horizon commencing at time t :

/hk (23)
CH = ^2 c,+j k 0
;=o
H
denote the ‘ultimate’ target (scaled so that the
1“
Xt+i KAX>+JY weights sum to unity as in, for example, Nickell )
=X K
t+j then from ( ) using ( ), for t < H :
(19)
A x , = -(1 -Xi)(x,_i - x ** )
= (1 -iijAtf
To minimize c ,,, at time t + j , differentiate
-(l-21)(x,_1-x,*!1). (24)
with respect to x , - h noting the intertemporal
link that
Thus, x t adjusts to changes in the ultimate target, When E[e,] = 0 and the differenced variables are
and to the previous error from that target, and is an stationary with means E[Au:,] = w and E [Ap t \
EqCM when —1 < < 1. Mistakes in plans, p , then the long-mn steady-state solution to ( ) is:
errors in expectations, and relations between the
ultimate target and its determinants all need to be
w = P o + PlP.
modelled for an operational rule. To hit a moving
target requires a feedforward rule, and the role of
y . ( A x t - j ) 2 in ( ) is to penalize the As formulated, ( ) does not establish any rela-
controller from making huge changes to x , when tionship between the levels w, and p , , hence
doing so. However, it is difficult to imagine real these could drift apart. Since economic agents are
concerned about the level of real wages, w, — p,, E
world adjustment costs being proportional to
changes, which in any case then depend on the Sargan postulated the equilibrium:
specification of x t as logs, levels, proportions or
even changes (see, for example, Nickell ). (w - p ) e , t = ^0 + <5iAp , +
Moreover, the entire class is partial adjustment, as ( 5 ' 2 z , , (27)
) shows.
For 1-period optimization (so H = 0: see, for where z t denotes a vector of additional variables,
example, Hendry and Anderson ), only the end
such as unemployment (n), productivity ( q ) and
point is relevant, so ( ) delivers the planned
political factors. The disequilibrium is:
value ,\f as a function of y' = x * \

,\f - X f — i = —!— ( x * - x,_i) v, =w,—p, - do -diAp, — d'2z, (28)

= p(x*-xl_1). (25)
When the error on the plan is e, x , xf, where and, to re-establish equilibrium whenever the levels
E[xfe,] = 0 under rationality, and x * [ i ' z , drift apart, he used the explicit adjustment equation:
(say), ( ) becomes:

Ax, = p(J}'z, - X , - i ) + £, Aw; = (w-p)e<l_^

= pf!'Az, - p(x,-i - P'z,-i) + £,.
= «v/-i- (29)
This is a partial adjustment again. The static
regression in section “ If a relation like ( ) is well defined with v , being I
” has a more (0) when the levels are I( 1), so the differences are I
restrictive dynamic structure, but otherwise the (0), then w t forms a non-integrated combination
properties of the ADL in section “ with p t and z, so these variables are cointegrated
” can vary over a (see, among many others, Engle and Granger
wide range (see Hendry , ch. 6). ; Phillips and Loretan ; Baneijee,
et al. .).
From Error Correction to Equilibrium A less restricted specification than ( ) entails
Correction including the levels terms (w - p ) , . \ and z,.j
The model in Sargan ( ) was explicitly an (and
ECM for wages and prices ( w t and p t denote their differences), so if contemporaneous vari-
their respective logs), building on previous models ables are excluded:
of wage and price inflation written as:
Aw, = n 0 + TC] A+ 7I2 Aw, - 1
-7r3(vr-£>),_! +7 ^ , - 1
Aw, — P q + ( j , A p t + /i2Aw, I + £,. (26) +
n ' 5 A z t - \ (30)
When 7 i3 / 0, the long-run levels equilibrium Equilibrium-Correction solution to (
) matching ( ) is (<t) 4 7 1 4 /7 1 3 ): and Cointegration

From the ADL to a VAR

E[w-p - p\z\ =f(w,p,i). To complete ( ), a process is needed for { z , } .
Let:
The model in ( ) has both derivative and propor z, \yt_1,zt-\ ~N* [ TI O + n2iy,-i + 7i 22Zwi,G
2 zz ].
tional control (e.g., A p ,_, and (w -p ) t . \ ) (31)
following up Phillips ( , ) (see Salmon ). The
proportional mechanism ensures the disequilibrium Given ( ), the joint distribution is the first-order
adjustment, based on the (possibly detrended) log- VAR:
ratio of two nominal levels (see, for example,
Bergstrom ). The equivalent of g y in section “
(!)b,
” should be p I q in ( ) to avoid having
‘autonomous wage inflation’ independent of all
/ 7111 71 j 2
economic forces. +
The long-run stability of the ‘great ratios’ in \ 7121 ^22
Klein ( ) was often implicitly assumed to
justify such transformations, but had come under (32)
question (see, for example, Granger andNewbold ,
and the discussion in Hendry ), although Hendry Consequently, to match ( ):
and Mizon ( ) had argued
that what mattered was that the errors in ( ) were E[y,|z„y,-i,z,-i] — 7ti0 + 7rny;_i + 7ti2z,_i +<r'12 Q“1(z, - 7120 -
stationary, not that all the variables were stationary.
7t2iy,-l - 7r22Z;-l),
Granger ( ) related the type of model in (33)
( ) to cointegration, and Granger ( ) showed
the important new result that one of Aw, or Ap t so / ? 0 = (7110 - <K7i20), P i = <l>, P 2 =
must depend on the equilibrium correction if w, 1 - 4>'7r2i
andp t were cointegrated: the assumption in ( ) is and
that w, adjusts to the disequilibrium. If both vari- P 3 = ( n i 2 - <t,,Jl2 2 ) when i p = and
ables w , andp t adjust to the disequilibrium, then a j
p , is not weakly exogenous for the [ n ,} (see = (T1 1 — er'i iQr.'cr^. When z t is weakly exoge-
Phillips and Loretan ; Hendry ). It is primarily nous for { p 0 , ... , P ' 3 ) , the model in ( ) can
because of cointegration that equilibrium- be ignored when analysing ( ); also 7 t2i = 0 then
correction models like ( ) have proved a popular ensures the strong exogeneity of z t for
specification. Engle and Granger ( ) showed ( P 0 , . . . ,
that cointegration and proportional EqCM were P'i).
equivalent, linking time-series approaches more Sufficient conditions for stationarity of ( ) are
closely with econometric modelling. Davidson and that all the eigenvalues /., of the matrix of the , 7i, ; j
Hall ( ) also linked VARs as in section are inside the unit circle, but a more realistic setting
” to tar- allows for unit roots in n 2 2 - On that basis, we
get relations as discussed in section “
using
Cointegration
Linear combinations of 1(1) processes are usually I(
cointegration analysis, so we now turn to the topic
1 ) as well: differencing is still needed to remove the
of cointegration in more detail.
unit root. Sometimes integration cancels between
series to yield an 1 (0 ) outcome and
thereby deliver cointegration. Cointegrated pro- = f "10 \
cesses in turn define a ‘long-run equilibrium tra- \hX2,t) V"20 /
jectory’ for the economy, departures from which
induce ‘equilibrium correction’ to move the econ-
omy back towards its path. A rationale for
integrated-cointegrated data is that economic agents
use fewer equilibrium corrections than there are
variables they need to control. We can see that
effect as follows.
which is an EqCM with (.r, , + /? 12x2,i-1 ) stationary.
Consider the bivariate VAR:
Thus, cointegration entails EqCM and vice versa
when the feedback relation is 1(0). However, prior
Xl,t — "10 + "11*1,1-1 + 7112-^2, 1-1 + £l, 1 to Granger ( ) the EqCM literature did
*2,1 = "20 + "21*1,1-1 + 7122-^2, f— 1 + £2 ,1, not visualize a single cointegration relation affect-
(34) ing several variables, and thereby making them
integrated, but instead just took the non-stationarity
of the observed data as due to the behaviour of the
where : : 2 l ) are bivariate independent normal. non-modelled variables. Consequently, system
To determine when the system is 1(1) and if so, cointegration ‘endo- genizes’ data integrability in a
whether or not some linear combinations of vari- consistent way, and so represents a significant step
ables are cointegrated, rewrite (34) as: forward. The extensive literature on cointegration
analysis also addresses most of the estimation and
/Axi,A _ /7i10\ formulation issues that arise when seeking to
V AX , t
2 ) V " 20 /
conduct inference in integrated-cointegrated
processes: much of this is summarized in Hendry
/ (Tin - 1) 7112 \ / *1,1-1 \
(35) and Juselius ( ), to which the interested reader
V "21 (7122 -1 )J
\*2,l-l/ is referred
for bibliographic perspective.

or as (a special case of ( )): Equilibrium Correction and Forecast

Failure
Ax, 7 i I I lx, 1 + e,. (36)
Recent research on the impact of structural breaks,
Three cases are of interest. First n 0, so ( ) is a particularly location shifts, on cointegrated pro-
vector random walk without any levels relation- cesses has emphasized the need to distinguish
ships, and so x, is 1(1) with Ax, being 1(0) and equilibrium correction, which operates successfully
equilibrium correcting to n . Secondly, if II has only within regimes, from error correction, which
full rank, then x, is 1(0) and equilibrium corrects to stabilizes in the face of other non-stationarities (see,
IT-17E. The most interesting case is when n is for example, Clements and Hendry ). The
reduced rank so can be expressed as: assumptions concerning the stationarity, or
otherwise, of the entity to be controlled in section “
” were rarely explicitly stated,
n = a/J, =
(S)(/?n p 12 ), but suggest an implicitly stationary system (or
perhaps steady-state growth). In such a setting,
where we will normalize /?n = 1. Then in ( ):
equilibrium-correction or cointegration relation- which therefore applies to all members of this huge
ships prevent the levels of the variables from class of model, including GARCH (as noted
‘drifting apart’, and so improve the properties of earlier), where the pernicious shift is in the
forecasts. unconditional variance a z in ( ).
Practical work, however, must allow the data To avoid forecast failure, more adaptive
generation process to be non-stationary both from methods merit consideration. One generic approach
unit roots (that is, I( 1) or possibly 1(2 )) and from a
to improving robustness to location shifts is to
lack of time invariance. When data processes are difference the forecasting device (although that may
non-stationary even after differencing and well worsen the impact of large measurement errors
cointegration, equilibrium-correction mechanisms at the forecast origin). Differencing can be before
tend to suffer from forecast failure, defined as a estimation, as in a double-differenced VAR, or
significant deterioration in forecast performance after, as in differencing the estimated EqCM to
relative to in-sample behaviour. Since most eliminate the equilibrium mean and growth
empirical model forms are members of the EqCM intercept. Such devices perform as badly as the
class, this is a serious practical problem. EqCM in terms of forecast biases when a break
To illustrate, reconsider the special case of ( )occurs after forecasts are announced (see Clements
with just one lag, written as: and Hendry ), and have a larger error variance. The
key difference is their performance when
Ax, = y + a(jS'x,_i - / . i ) + £ , . forecasting after a break has already occurred, in
(38) which case the EqCM continues to perform badly
(as shown above in (48)), but a DEqCM becomes
The shift of interest here is V/i* = / i — / i , relatively immune to the earlier break. Taking (47)
where /i denotes the post-break equilibrium mean as an example, an additional difference yields:
(reasonable magnitude shifts in y , a and fi
rarely entail forecast failure). Denote the forecast
A2X7-+I = A(y — A/I*) + ajS'Axy + AET+\
origin as time T , then following a change to // = yV/i* + y/f Ax-, + A s : r \ i
immediately after forecasting, the next outcome is:
so there is no benefit when forecasting immediately
Axr+i = y + K ( f ? x T - /) + &t+ l after the break (as A// = r//), whereas (48) becomes:
= y + a(j8'xj - / d ) + e T + i -
o c V / d * (39)
A-X7’_|_2 = y/i'Ax,. | -|- A;:7.,
where -aV/i is the unanticipated break, and becomes
the mean forecast error for known parameters. since A/< =0. Thus, there is no longer any sys-
Importantly, the 1-step ahead forecast at T + 1 tematic failure. The same comment applies to
using an unchanged model suffers the same double-differenced devices, although Hendry ( )
mistake: shows how to improve these while
retaining robustness.
E [ Axr+2 - (y + a(j8'xr+i - /t))l A further consequence is that, when a location
= — aV,u* (40) shift is not modelled, since most econometric
estimators minimize mis-fitting, the coefficients of
so the shift in the equilibrium mean induces sys- dynamic models will be driven towards unity,
tematic mis-forecasting. The impact on multi-step which induces differencing to convert a location
forecasts of the levels is even more dramatic, as the shift into a ‘blip’. Thus, estimates that apparently
mean forecast error increases at every horizon, manifest ‘slow adjustment’ may just reflect
eventually converging to a(jS'a)_1V/i , which can be unmodelled breaks.
very large (see Clements and Hendry ). Thus,
EqCMs are a non-robust forecasting device in the
face of equilibrium-mean shifts, a comment
 An alternative approach to avoiding forecast relations, and ties together the levels of 1(1) vari-
failure would be to construct a genuine error- ables, eliminating its contribution should not be
correction model, adjusting more or less rapidly to undertaken lightly, hence the suggestion in section
wherever the target variable moves: for example, “
exponentially weighted moving averages do so for ” of using the differenced version of the
some processes. In essence, either the dynamics estimated EqCM for forecasting.
must ensure correction or the target implicit in the
econometric model must move when the regime
alters. This last result also explains why models in See Also
differences are not as susceptible to certain forms of
structural break as equilibrium-correction systems ► ionite
(again see Clements and Hendry ), and in turn helps
to account for many of the findings reported in the
forecasting competitions literature. When the shift Acknowledgment Financial support from the ESRC under
Professorial Research Fellowship RES051270035 is
in question is a change in a policy regime, Hendry gratefully acknowledged, as are helpful comments from
and Mizon ( ) suggest approaches to merging Gunnar Bardsen, Julia Campos, Jennifer Castle, Mike
robust forecasts with policy models. Clements, Soren Johansen and Graham Mizon.

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mean almost anything; this user will adopt a
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that: An expository note. Oxford Bulletin of Economics Although ‘equality’ is less ambiguous than
and Statistics 47: 119-130. ‘equity’, it too has many definitions: Jefferson’s
Phillips, A.W.H. 1954. Stabilization policy in a closed adage that ‘all men are created equal’ clearly does
economy. Economic Journal 64: 290-333.
not mean that they all have the same talents, skills,
Phillips, A.W.H. 1957. Stabilization policy and the time form
of lagged response. Economic Journal 67: 265-277. inherited and acquired wealth; it only means that
they share, or ought to share, certain narrowly
defined legal rights and political powers. However,
in a simple economic model, equality can
be made simple. If we assume that society is But the notion of equity has an obvious disad-
comprised of a certain set of n individuals who vantage, aside from its being founded on that odious
produce among themselves certain quantities of passion. For instance, the economist’s model, which
various goods, we can speak of an equal division of reduces person i to a utility function M,( ) and a
the goods: an allocation that would give each person bundle of goods x,-, ignores the fact that life is full
exactly 1/n of the total of each good. Economists of things not captured in M,( ) or x„ for instance,
would agree that this is equality (at least on the non-transferable attributes like beauty, health and
consumption side). Most would also agree that it is family. Even if the division of economic goods is
an undesirable state of affairs, if for no other reason equitable, i will probably envy j his looks, or his
than that no two people would ever want to good health. This problem was alluded to by Kolm (
consume exactly the same bundle of goods. They
E
). A well-meaning econ
would be equal, but not especially happy. More- omist who follows his equity theory to its bitter end
over, getting society to that equal allocation would will conclude that the beautiful should be disfigured,
require transferring wealth from the more produc- and the well made sick.
tive individuals to the less productive, and the Less obvious disadvantages of the idea of equity
transfer mechanism itself would destroy incentives require references to Pareto efficiency, the
to produce. foundation of modem welfare economics. An
So equality in its extreme form - an equal allocation y is P a r e t o s u p e r i o r to
consumption bundle for every consumer - is an an allocation x if all individuals prefer y to x. (This
obviously unworkable idea, and needs to be weak- assumes, of course, a constant set of individuals who
ened. We shall say in this assay that individual i are making the judgement.) Ify is Pareto superior to
e n v i e s individual j if i would rather have x, the move from x to y is a P a r e t o
j ’ s consumption bundle than his own. m o v e . An allocation x is P a r e t o
Formally, let «,(■) represent individual z’s utility o p t i m a l if there is no y that is Pareto
function, and x t represent his consumption superior to it.
bundle. (For now, production is ignored.) Then i Several authors (e.g. Kolm ) have established
envies j if u , { x j ) > w,(x,). This is now a that in an economy where there is no production,
more- or-less standard usage by economists, who there exist allocations that are both equitable and
have ignored wiser and older counsel, for example, Pareto optimal. To find one, start at the equal
J. S. Mill, who calls envy ‘that most odious and allocation and move the economy to a competitive
anti-social of all passions’ { O n equilibrium. By the first fundamental theorem of
L i b e r t y , ch. 4). Mill would presumably welfare economics, a competitive equilibrium is
not endorse an economic analysis founded on envy. Pareto optimal. Since the equilibrium is based on the
Following Varian ( ) we define an alloca equal allocation, every individual has the same
tion as e q u i t a b l e if under it no individual budget. But if i has the same budget as j , he
envies another; that is, if cannot envy the bundle j buys since he could have
bought it himself. So this theorem creates a link
U i ( x i )> H i ( x j ) for all i and j . between equity and the more traditional, more
fundamental notion of Pareto optimality'.
Obviously, the equal allocation is equitable. But
But it is a weak link. Pazner and Schmeidler (
equity does not share equality’s obvious dis-
) and Varian ( ) consider an economy
advantage of forcing all to consume the same no
with production, where z’s utility depends not only
matter what their tastes. If Adam loves apples and
on his consumption bundle x,-, but also on the
Eve loves oranges, and if God has endowed them
number of hours he works q t . However, produc-
with a total of one apple and one orange, then the
tion attributes are non- transferable. If person i is
equal allocation (half an apple and half an orange
ten times as productive as j , there may be no
for each) is clearly foolish, but the equitable allo-
Pareto optimal distribution of consumption goods
cation (one apple for Adam and one orange for Eve)
and of work hours that is also equitable.
makes good sense.
Equity, Fig. 1 Trader J

Trader I

Think of an economy of which you are a part and But this idea is also unworkable; it is simply too
Luciano Pavarotti is a part. You would have to train airy.
for 10 lifetimes before you could sing an aria like Turn back to an economy without production. It
he does, and therefore there may be no possibility is true that there will exist, under general
of arriving at an allocation of consumption and assumptions, allocations that are both equitable and
work effort among all that is both equitable and Pareto optimal in the pure exchange economy. But
Pareto optimal. Feldman and Kirman ( ) show two
Various possible solutions to this quandary have disturbing facts: First, even if traders start at the
been suggested (e.g. in Pazner , and Pazner and equal allocation, and they make a Pareto move to
Schmeidler ). For instance, consider an economy the core (the solution set for frictionless barter),
where ‘everybody shares an equal property right in they may end up at an inequitable allocation.
everybody’s time’. This may lead to the existence Second, if traders start at an equitable allocation,
of allocations that are both equitable and optimal, and make a Pareto move to a competitive equilib-
but it makes Pavarotti a slave to everyone who is rium they may end up at an allocation where
less gifted. Or, as another possible solution, someone envies someone else. The ‘green sickness’
consider an e g a l i t a r i a n springs up where once there was equity.
e q u i v a l e n t allocation. This is one such The Edgeworth box diagram below illustrates
that the utility distribution it produces could be the second possibility. In Fig. , Xu and X 1 2 rep-
generated by a theoretical economy in which all resent quantities of goods 1 and 2 belonging to
consumers are assigned identical consumption trader I; XJI and xj2 represent quantities belonging
bundles. Pazner and Schmeidler ( ) show that to J. Also, i \ and i 2 are two of trader I’s
egalitar indifference curves: /) and / 2 and two of trader J’s
ian equivalent allocations that are also Pareto indifference curves; w = ( w t , W j ) is
optimal exist, even in economies with production. the initial
allocation; vv 1 = (u;, vv,) is the allocation which Foley, D. 1967. Resource allocation and the public sector.
switches the bundles between I and J. Note that vv 1 Yale Economic Essays 7(1): 45-98.
Goldman, S., and C. Sussangkam. 1978. The concept of fairness.
is found by reflecting w through the centre of the Journal of Economic Theory 19(1): 210-216. Kolm, S.-C.
box. Now vv is equitable since the indifference 1972. Justice et equite. Paris: Editions du Centre de la
curves through it pass above vv 1, and the move Recherche Scientifique.
from w to x is a competitive equilibrium trade that Pazner, E. 1976. Recent thinking on economic justice. Journal of
Peace Science.
makes both better off. But x ( x b x , ) is not Pazner, E., and D. Schmeidler. 1974. A difficulty in the concept of
equitable, since C passes below x_1 = (x7, x,:), which fairness. Review of Economic Studies 41(3): 441^443.
means that trader I envies J when they are at x. Pazner, E., andD. Schmeidler. 1978. Egalitarian equivalent
In an interesting extension of the Feldman and allocations: A new concept of economic equity. Quarterly
Journal of Economics 92(4): 671-687. Schmeidler, D., and K.
Kirman result, Goldman and Sussangkam ( )
Vind. 1972. Fair net trades.
show with generality that in 2 person, 2 good Econometrica 40(4): 637-642.
exchange economies there exist allocations x such Varian, FI. 1974. Equity, envy and efficiency. Journal of
that (a) x is equitable in the non-envy sense but (b) Economic Theory 9(1): 63-91.
x is not Pareto optimal and (c) every y which is
Pareto superior to x is inequitable! This is formal
proof of Johnson’s assertion ( T h e
R a m b l e r , No. 183) that ‘envy is almost the
only vice which is practicable at all times, and in Equivalence Scales
every place; the only passion which can never lie
quiet from want of irritation’. Arthur Lewbel and Krishna Pendakur
The concept of equity as non-envy is still alive
among prominent economists; for instance, Baumol
( ) applies non-envy to an analysis
of rationing. This in spite of the fact that recent
Abstract
history suggests the average man fares better under
An equivalence scale is a measure of the cost of
regimes that are less committed to elimination of
living of a household of a given size and demo-
envy through redistribution of goods, and in spite of
graphic composition, relative to the cost of
the serious theoretical objections raised to the
living of a reference household (usually a single
concept as outlined above. Should we care about
adult), when both households attain the same
equity? The temptation to pronounce judgement on
level of utility or standard of living. Equivalence
what is equitable and what is not may be irresistible.
scales are difficult to construct because
But economic- theory suggests that the pursuit of
household utility cannot be directly measured,
equity in the sense of non-envy will lead to some
which results in economic identification
peculiar and unpalatable results.
problems. Applications of equivalence scales
include measurement of social welfare,
economic inequality, poverty, and costs of chil-
dren; indexing payments for social benefits, life
insurance, alimony, and legal compensation for
See Also
wrongful death.
► N::.:.vv:
Keywords

Bibliography Consumer expenditure; Engel scales; Equiva-

lence scales; Happiness, economics of; Inter-
Baumol, W. 1982. Applied fairness theory and rationing policy. personal utility comparisons; Marshallian
American Economic Review 72(4): 639-651. Feldman, A., and demand functions; Neuroeconomics; Poverty
A. Kirman. 1974. Fairness and envy. American Economic
lines; Revealed preference theory; Rothbard
Review 64(6): 995-1005.
scales; Shephard’s Lemma; Wellbeing
 JEL Classifications family size, and on the links between demand
D12 functions and utility for these different household
types.
One strand of the equivalence scale literature
History focuses on the former issue, and so deals primarily
with the empirical question of how best to model
Providing two different households with the same
the dependence of household Marshallian demand
standard of living, making them equally well off,
functions on demographic characteristics. Examples
requires some definition of well-being. In the early
are Sydenstricker and King ( ), Prais and
literature on equivalence scales, a household’s well-
Houthakker ( ), and Barten ( ) scales, in
being was defined in terms of needs, such as having
which a different Engel type scale is constructed for
a nutritionally adequate diet. every good people purchase, roughly corresponding
Engel ( ) observed that a household’s food to a different economies of scale measure for each
expenditures are an increasing function of income good. Other examples are Gorman’s () general
and of family size, but that richer households tend linear technologies,
to spend a smaller share of their total budget on Lewbel’s ( ) modifying functions, and
food than poorer households. He therefore proposed Pendakur’s ( ) shape invariance.
that this food budget share could be a measure of a The second, closely related literature, focuses
household’s welfare or standard of living. The on the joint restrictions on both preferences and
resulting Engel equivalence scale is defined as the interpersonal comparability of utility required for
ratio of incomes of two different sized households measuring the relative costs of providing one
that have the same food budget share. This is household with the same utility level as another.
essentially the method used by the US Census Examples include Jorgenson and Slesnick ( ),
Bureau to measure poverty. The bureau first defines Lewbel( ), Blackorby and Donaldson ( ),
the poverty line for a typical household as three and Donaldson and Pendakur ( ; ).
times the cost of a nutritionally adequate diet, then
uses food shares (Engel scales) to derive
comparable poverty lines for households of Definition
different sizes and compositions, and finally adjusts
Consider a consumer (an individual or a household)
the results annually by the consumer price index to
with a vector of demographic characteristics z and
account for inflation (see Fisher )•
nominal total expenditures x that faces the M
Given two households that differ only in their
vector p of prices of M different goods. The
number or age distribution of children, Rothbarth (
consumer chooses a bundle of goods to maximize
) equivalence scales are similar to Engel
utility given a linear budget constraint. Define the
scales. They can be defined as the ratio of incomes
cost (expenditure) function x = C(p, u , z) which
of the two households when each household pur-
equals the minimum expenditure required for a
chases the same quantity of some good that is only
consumer with characteristics z to attain utility level
consumed by adults, such as alcohol, tobacco, or
u when facing prices p. C(p, u , z) is a conditional
adult clothing.
cost function in the sense of Poliak ( ) because it
Modem equivalence scales measure wellbeing in
gives the expenditure necessary
terms of utility, using cost (expenditure) functions
to attain a utility level u , conditional on the con-
estimated from consumer demand data via revealed
sumer having characteristics z.
preference theory. Engel or Rothbarth scales are
Equivalence scales relate the expenditures of a
equivalent to valid cost function based equivalence
consumer with characteristics z to a consumer with
scales only under strong restrictions regarding the
a reference vector of characteristics z. The reference
dependence of demand functions on characteristics
vector of characteristics may describe, for example,
such as age and
a single, medically healthy, middle-
aged childless man. The equivalence scale is curve of type z yields the same level of utility as
defined by Z)(p, u , z) = C(p, u , z)/C(p, u , z). any given indifference curve of type z.
Equivalent-expenditure X ( p , x , z) is defined Given only goods demand data, Blundell and
as the expenditure level needed to bring the well- Lewbel ( ) show that changes in equivalence
being of a reference household to the level of well- scales that result from price changes can be iden-
being of a household with characteristics z, soX(p,x, tified, but the levels of equivalence scales are
z) = x//J(p, u , i ) = C(p, M,Z) where uis completely unidentified, because for any cost
replaced by the indirect utility function, that is, x = function C and any positive number d, there exists a
C(p, u , z) solved for u . p (u , z) function that makes Z)(p, u , z) = d.
Changes in D resulting from price changes can be
identified because the ratio Dfpj, u , z)/Z)(p0, «, z)
Identification equals a ratio of ordinary identifiable cost of living
(inflation) indices.
In economics, a parameter is said to be ‘identified’ Identification of equivalence scales therefore
if its numerical value can be determined given requires either additional information or untestable
enough observable data. Here we show why iden- assumptions regarding preferences over
tification of equivalence scales requires either characteristics z and hence regarding < p . There
strong untestable assumptions regarding preferences are also other identification issues associated with
or unusual types of data. Equivalence scales depend equivalence scales. For example, different members
on utility, which cannot be directly observed and so of a household may have different standards of
must be inferred from consumer demand data, that living, so a single level of utility that applies to the
is, from the quantities that consumers buy of entire household to be compared or equated to
different goods in varying price regimes and at anything may simply not exist. Lewbel ( )
various income levels. The observable lists additional equivalence scale identifi
(Marshallian) demand functions for goods derived cation issues.
from a conditional cost function C(p, u , z) are
the same as those obtained from C(p, < p ( u ,
z), z) for any function < p ( u , z) that is strictly Identification from Demand Data
monotonically increasing in u . By revealed pref-
erence theory, demand data identifies the shape and Let W be the fraction of total expenditures a house-
ranking of a consumer’s indifference curves over hold spends on the /th good (its budget share) and
bundles of goods, but not the actual utility level let w be the vector of budget shares of all purchased
associated with each indifference curve. Changing goods. Shephard’s Lemma states that w = co(p, u ,
z) just changes the utility level associated with each z) V^plnQp, H, z), the price elasticity of cost. Let
indifference curve. W f c o p (p, H, z) indicate the food equation.
Therefore, given any C(p, u , z) derived from Engel’s method notes that since is monotonically
demand data, the consumer’s true cost of attaining a declining in utility u, u7 may be taken as an
utility level u is C(p, p ( u , z), z) for some indicator of well-being. If, in addition, w f
unknown function 9, so true equivalence scales are indicates the same level of well-being for all
D(p, u , z) = C(p, p ( u , z), z)/C(p, p ( u , z), household types z, then the expenditure levels
z). This is the source of equivalence scale non- which equate the food share w y across household
identification. We cannot identify £>(p, u , z) types are the equivalent-expenditure function,
because the change from z to z has an unobservable whose ratios give the equivalence scale.
affect on D through p . The problem is that Monotonicity of ey in u is observable, but the
revealed preferences over goods identify one set of second restriction concerning utility levels for
indifference curves for households of type z and different types of households refers to p and so is
another set for households of type z, but we have no not testable.
way of observing which indifference The Rothbarth approach is similar. Let q a =
h a (P, U , z) indicate the quantity demanded
for a good consumed only by adults, such as not a problem if what we mean by making house-
holds equally well off refers to some observable
alcohol. If h a is increasing in utility (a testable
characteristic such as nutritional adequacy of diet.
restriction), q a may be taken as an indicator of the
well-being of adult household members. If, in As an alternative to revealed preference, identifi-
addition, q a indicates the same level of adult cation may be based on surveys that ask respon-
wellbeing for adults living in all types of house- dents to either report their happiness (and hence
holds (untestable), then the expenditure levels utility) on some ordinal scale, or ask, based on
which equate q a across household types are the introspection, how their utility or costs would
equivalent-expenditure function, whose ratios againchange in response to changes in household char-
give the (Rothbarth) equivalence scale. acteristics. An early example is Kapteyn and Van
Lewbel ( ) and Blackorby and Donaldson Praag ( ), who estimate equivalence scales
( ) consider the case where the equivalence based on surveys where households rank income
levels as ‘excellent’, ‘sufficient’, and so on.
scale function is independent of utility, which they
call ‘independence of base’ (IB) and ‘equivalence- Identification requires comparability of these
scale exactness’ (ESE), respectively. In this case ordinal utility measures across consumers. Happi-
ness studies by psychologists and experimental
there is a function A such that D(p, u , z) = A(p, z)
and C(p, u , z) = C(p, u , z) A(p, z). The special economists may prove useful for validating these
case where D ( p , u , z) is also independent of types of subjective responses regarding utility,
p yields Engel scales. especially with recent neuroeconomic results
Given IB/ESE, Shephard’s Lemma implies that measuring brain activity associated with pleasure,
regret, and economic decision-making (see, for
co(p, u , z) = co(p, u , z) + n(p, z), where n(p, z)
= V|nplnA(p, z). Since households with the same example, McFadden ).
equivalent expenditure have the same utility, and Another possible source of identification is
since in this case, equivalent expenditure is givenwhen consumers can choose z, and we can collect
by x/A(p, z), we may write the relation as w(p,x,z)information relevant to these choices. Assuming z is
w(p,x/A(p, z), z) + n(p, z), where w(*) is the chosen to maximize utility can provide information
Marshallian budget share vector. Here, A(p, z) about how utility varies with z, and hence may
‘shrinks’ the budget share functions in the restrict the set of possible < p transformations.
expenditure direction, and the amount of With enough information regarding how z is chosen
‘shrinkage’ identifies the equivalence scale. one could identify ‘unconditional’ cost or utility
Pendakur ( ) shows that this ‘shape functions over both goods and z and thereby
invariance’ expression equals the testable impli- identify the dependence of < p on z. Poliak ( )
cations required for IB/ESE. The untestable refers to the use of unconditional versus
restriction, which uniquely defines < p ( u , z) conditional data to calculate the cost of demo-
(up to transformations of u that do not depend on graphic changes as ‘situation comparisons’ versus
z) is that all households with the same value of ‘welfare comparisons’.
x/A(p, z) have the same level of utility. Blackorby Traditional equivalence scales assign a single
and Donaldson ( ) show when cost functional level of utility to a household, implicitly assuming
forms uniquely identify IB/ESE. Donaldson and that all household members have the same utility
Pendakur ( , level and hence ignoring the effects of the within-
) consider identification for
equivalence scales with more general functional household distribution of resources. Features of this
forms. intra-household allocation of resources can be
identified and estimated with demand data. Given
the indifference curves and resource shares of each
household member, instead of trying to calculate the
Other Sources of Identification cost of making an individual as well off as a
household, one may instead calculate the cost of
Equivalence scale identification depends on how we
putting the individual on the same indifference
define utility or well-being. Identification is
curve when living alone that he attained as a See Also
member of a household. Whereas the former
calculation requires a welfare comparison, the latter
calculation only involves comparing the same ► Cost Functic
individual in two different price and income ►

environments. Browning, Chiappori and Lewbel ► Engel Curve

(2006) call this type of comparison an ‘indifference ► 3::.ge?c 1; w
scale’, and provide one set of conditions under ► Hicksian anc
which such scales can be non- parametrically ► Identificatioi
identified. ► Inequality (A
► Interpersona
► c7
Applications of Equivalence Scales ► Welfare Eco:

Equivalent expenditures and equivalence scales

may be used for social evaluation, for example, Bibliography
inequality and poverty analysis. Given an equiva-
lence scale, d i , and household expenditure, x i , Barten, A.P. 1964. Family composition, prices, and
for each person i in a population, one constructs expenditure patterns. In Econometric analysis for
national planning: 16th symposium of the colston
equivalent expenditure for each person: xf = society, ed. P. Hart, L. Mills, and J.K. Whitaker.
x i / d i . Expenditure data are observed at the London: Butterworth.
level of the household, but xf is constructed for each Blackorby, C., and D. Donaldson. 1993. Adult-
individual. By construction, die population equivalence scales and the economic
implementation of interpersonal comparisons of
distribution of equivalent expenditures is equivalent well-being. Social Choice and Welfare 10: 335-361.
in welfare terms to the actual distribution of Blundell, R.W., and A. Lewbel. 1991. The information
expenditures across households. Therefore, one can content of equivalence scales. Journal of
use this ‘as if’ distribution for constricting Econometrics 50: 49-68.
Browning, M., P.-A, Chiappori., and A. Lewbel. 2006.
population measures of poverty or inequality, or for Estimating consumption economies of scale, adult
calculating the welfare implications of tax and equivalence scales, and household bargaining power,
transfer programmes. Working Paper No. 588. Boston: Boston College.
Equivalence scales can also be used to calibrate Donaldson, D., and K. Pendakur. 2004. Equivalent-
expenditure functions and expenditure-dependent
social benefits payments and poverty lines. For equivalence scales. Journal of Public Economics 88:
example, if the social benefit rate (or poverty line) 175-208.
xis agreed upon for a single household type, for Donaldson, D., and K. Pendakur. 2006. The
example, a single childless adult, then one could use identification of fixed costs from consumer
behaviour. Journal of Business and Economic Statistics
equivalence scales to set rates for other household
24: 255-265.
types z as /J(p, u , z)x where u is the utility level Engel, E. 1895. Die Lebenskosten Belgischer Arbeiter-
of the reference type with expenditures x. Some Familien Fruher and jetzt. International Statistical
statistical agencies flow information in the other Institute Bulletin 9: 1-74.
Fisher, G.M. 1997. The development and history of the US.
direction: poverty lines are constructed for each
poverty thresholds - A brief overview. Washington, DC:
household type, which can then be use to construct Newsletter of the Government Statistics Section
an implicit ‘poverty relative’ equivalence scale. If and the Social Statistics Section of the American
scales are IB/ESE, this provides enough information Statistical Association.
Gorman, W.M. 1976. Tricks with utility functions. In
to identify equivalence scales for all households.
Essays in economic analysis: Proceedings of the 1975
Other applications of equivalence scales are for AUTE conference, ed. M. Sheffield, J. Artis, and
life insurance, alimony, and wrongful death cal- A.R. Nobay. Cambridge: Cambridge University
culations (see Lewbel ), and for indirectly Press.
measuring the cost of children based on equivalence Jackson, C.A. 1968. Revised equivalence scale for estimat-
ing equivalent incomes or budget cost by family type,
scales for households of different sizes. Bulletin 1570-2. Washington, DC: U.S. Bureau of
Jorgenson, D.W., and D.T. Slesnick. 1987. Aggregate con- x j ( — oo < t < oo) represents the
sumer behavior and household equivalence scales. trajectory (orbit) passing through the point x = x 0 at
Journal of Business and Economic Statistics 5: 219-232.
Kapteyn, A., and B. Van Praag. 1976. A new approach to the time t = 0 of a c o n s e r v a t i v e
construction of family equivalence scales. European d y n a m i c a l s y s t e m , when can
Economic Review 7: 313-335. one make the identification
Lewbel, A. 1985. A unified approach to incorporating
demographic or other effects into demand systems.
Review of Economic Studies 52: 1-18. (*)_lim (1/T)[ f(x,)dt = [ fdm/m(Q)
Lewbel, A. 1989. Household equivalence scales and welfare Jo Jn
comparisons. Journal of Public Economics 39:377-391.
Lewbel, A. 1997. Consumer demand systems and household for suitable functions defined on the p h a s e
equivalence scales. In Handbook of Applied
s p a c e Q of the system?
Econometrics, vol. 2. Microeconomics, ed. M.H. Pesaran
and P. Schmidt. Oxford: Blackwell. There are many things to be explained here. For
Lewbel, A. 2003. Calculating compensation in cases of example one might imagine a ‘large’ number of
wrongful death. Journal of Econometrics 113: 115-128. particles contained in a box, which collide with one
McFadden, D. 2005. The new science of pleasure, consumer
another and with the sides of the box according to
behavior and the measurement of well-being. Frisch
Lecture. London: Econometric Society World Congress. the usual laws of elastic collision. Each of these
Pendakur, K. 1999. Estimates and tests of base- independent particles has three coordinates of position and three
equivalence scales. Journal of Econometrics 88: 1-40. coordinates of velocity so that the state of the
Poliak, R.A. 1989. The theory of the cost of living index. New
system is describable by 6 n coordinates if n is
York: Oxford University Press.
Prais, S.J., andH.S. Houthakker. 1955. The analysis of family the number of particles. Newtonian laws, of course,
budgets. Cambridge: Cambridge University Press. provide a history and future for each of these points
Rothbarth, E. 1943. Note on a method of determining in 6n dimensional space. The same laws imply the
equivalent income for families of different composition.
law of conservation of energy, so that in principle
In War-time pattern of saving and spending, ed. C.
Madge. Cambridge: Cambridge University Press. dynamical systems may be studied with the
Sydenstricker, E., and W.I. King. 1921. The measurement of assumption that energy is constant for each
the relative economic status of families. Quarterly trajectory of a conservative system. Thus in ( ) we
Publication of the American Statistical Association 17: take the phase space Q to be that hypersurface of
842-857.
6 n dimensional space where the total energy has a
given (constant) value, and m is the hypersurface
volume (measure) associated with the Liouville
invariant volume whose existence is guaranteed by
the conservativity of the system. In general
m ( £ l ) is a finite quantity.
The left-hand side of ( ) is the time average
along a trajectory for a function (observable)/and
the right-hand side is the phase or space average.
Von Neumann proved a mean convergence
Ergodic Theory
version of ( ) and shortly after G. D. Birkhoff
William Parry proved ( ) as stated, for a l m o s t a l l states,
in both cases under the assumption that the system
(restricted to Q) is e r g o d i c , a notion, we
shall explain presently. (Cf. von Neumann ;
Birkhoff .) It was soon realized that both versions of
To begin in the middle; for that is where ergodic ( ) (the ergodic theorems) could be formulated and
theory started, in the middle of the development of proved in a more abstract setting and indeed one can
statistical mechanics, with the solution, by von say that this abstraction and the subsequent
Neumann and Birkhoff, of the problem of identi- mathematics thereby generated is ergodic theory
fying space averages with time averages. This proper.
problem can be formulated as follows: If
 Let (Q, i n ) represent an abstract space with a preserving are they ergodic? If so, interpret
finite measure. (There is no loss in generality in the ergodic theorems for them.
assuming m H l ) = 1, as we shall do.) Let T t (iv) Is it possible to (at least partially) classify the
represent a family of transformations indexed by myriad examples coming from other branches
time (in various contexts, the real numbers, the inte- of mathematics?
gers) such that T t + S = T t ° T s .
Assume that this family is measurepreserving One should notice that in posing these problems
( m T t B m B , for all ‘measurable’ sets). The ergodic theory became a g l o b a l analysis in
study of T t as t varies through its index set, two senses: The phase space dynamical system
provides a model for an evolutionary system, such described at the beginning of this entry is global in
as the dynamics in phase space described earlier, in that a l l solutions of a differential equation are
which measure (volume) is preserved. The system involved. Ergodic theory then moves on to treat all
is said to be e r g o d i c if Q cannot be other problems having a dynamical character in
decomposed into two disjoint invariant measurable which an invariant measure appears.
sets Concerning (ii) one should note that a measure-
preserving transformation T gives rise to an
isometric operator L f = f ° T on various
A , B ( A U B = Q,A n B = 0, TtA = A, T , B = B all t )
Banach spaces, the most important being L \ m ) .
In a similar way a Markov process gives rise to a
of positive measure. semi-group of positive contractions. For such
In a strict sense, the time-average space- operators there is a variety of ergodic theorems
average problem was not s o l v e d by von generalizing the classical results of Birkhoff and
Neumann and Birkhoff, as far as the classical von Neumann. As an example there is the power-
dynamical system given at the outset is concerned, fill general ergodic theorem (Chacon and
for the question of whether this system i s ergodic Omstein ): IfZ is a positive contraction on L ]
was left open and it is only recently (Sinai ) that ( m ) and/ g € L l ( m ) then
progress has been made in this direction.
Most workers in ergodic theory concern them-
selves with measure-preserving transformations T t
indexed by the integers, so that with T \ = T , k = 0 / A=0
T t is the iteration of T repeated t times. Results
converges almost everywhere on the set where the
in this context invariably lead to results for real
denominator is persistently positive.
continuous time.
Here we have an instance of ergodic theory
Having freed itself from a particular (albeit
providing a powerful tool for statistics. This should
important) dynamical system, ergodic theory or
hardly be surprising, however, as even the classical
more particularly the theory of measurepreserving
Birkhoff ergodic theorem has an immediate impact
transformations began to encounter a rich diversity
on stochastic processes, for one can always
of problems:
associate a measure-preserving transformation with,
say, a sequence of independent and identically
(i) When does a measurable transformation, non-
distributed random variables in such a way that the
singular with respect to a given measure,
strong law of large numbers is an easy corollary of
preserve an equivalent finite (or even cr-
Birkhoff’s theorem.
finite) measure?
Markov and other stochastic processes have
(ii) Are there analogues of the ergodic theorems for
played and continue to play a central role in the
Markov processes?
development of ergodic theory. In recent years a
(iii) Where do we find examples of measure-
modelling procedure for understanding hyperbolic
preserving (or non-singular) transformations
dynamical systems based on Markov chains
in other branches? If they are non-singular
answer question (i). If they are measure
has led to profound results in the area of differen- For the Bernoulli case Q consists of points
tiable statistical mechanics. Thus statistical ideas w = {w„}?x where w n represents the out-
are exchanged, measure for measure, with those of come of an experiment (heads or tails, for
ergodic theory. example, in the tossing of a coin) at time
Concerning (iii) here are some examples: n . m is the probability which guarantees the
independence of these trials, and T is the shift
(a) A n ‘ i r r a t i o n a l f l o w ’ . in time T w = w ’ where w ’ n =
Here Q = {(z, w ) : z , w complex | z | w n + \ .
= | w | = 1}, T t (z, w ) = (e 2 n m z , (h) A stationary Gaussian (normalprocess).
e 2 m P ' w ) , a , / > are real with a , (i) T h e c o n t i n u e d f r a c t i o n
j > irrational, m is an ordinary Lebesgue t r a n s f o r m a t i o n . Here Q
measure. consists of the irrational numbers between 0
(b) A s k e w p r o d u c t . Here (Q, m ) and 1. m is ‘Gauss’s’ measure whose density
is the same as in is 1/log 2 ( 1 + x ) and T x = l/.r mod 1.
(a) .
An alternative account of ergodic theory, which
2lim
T ( z , w ) = (e z,zw), a irrational. admittedly ignores the history of the subject, could
be given which is based on the above examples (and
(e) A n a u t o m o r p h i s m o f a many others). It would motivate the subject by the
t o r u s . Again (Q, m ) is the same as in questions: What do these examples have in
(a). common? What concepts underlie them? However,
only a posteriori would these questions lose their
artificiality.
T ( z , w ) = (z2vr,zw).
The first four examples (a), (b), (c) and (d), all
arise from algebraic or homogeneous space struc-
(d) A t r a n s l a t i o n o f a tures and even (e) falls into this category under
h o m o g e n e o u s s p a c e . G certain conditions on the curvature of the manifold.
is a locally compact Lie group and H is a In general, (e) arises from differential geometry.
closed subgroup such that the homogeneous The Bernoulli example (g) (or more generally a
space G / H = { g H : g C G j is Markov chain) arises from probability theory as
compact. Q = G / H and m is a Haar does (h). The example (i) occurs in the study of
measure. The transformation T is defined as a continued fractions.
translation. These examples (under suitable conditions) are
flows and transformations which display varying
T (g , H) = ag H
degrees of ergodicity or m i x i n g and ergodic
theoretical techniques reveal important information
for a given element a c G . about them. For example, in Furstenberg, ( )
(e) A g e o d e s i c f l o w . Here we (b) was used to give a proof of the famous theorem
consider an n-dimensional Riemannian of Weyl that a n 2 + f i n + y mod 1 is
manifold M with unit length tangent vectors u uniformly distributed in the unit interval [0, 1] as n
located at points of M . Such a vector o varies (as long as a or p is irrational). The example
defines a unique geodesic curve on M . Q is (c) was closely analysed as a prototype of
the totality of such o and T , u is the unit h y p e r - b o l i c i t y prior to the
tangent vector obtained by allowing u to flow development of Anosov and Axiom A dynamical
along its geodesic at unit speed after time t . systems. The examples covered by (e) (and the
The measure m may be taken to be the natural related h o r o c y c l e f l o w s ) are
one associated with Liouville’s measure. central to the study of hyperbolic geometry and to
(f) A H a m i l t o n i a n the theory of unitary representations of semisimple
d y n a m i c a l s y s t e m . Instead Lie groups. The examples (g), (h) provide the most
of defining this we mention that (e) above and
motion. Example (i) is of vital importance in multitude of Bernoulli transformations which are
number theory. not isomorphic. The basic ideas originate with
Question (iv) was first approached (von Neu- Shannon and McMillan, but they required signif-
mann ; Halmos and von Neumann ) using spectral icant adaptation before they could be used in
techniques. Two measurepreserving transformations ergodic theory. The new entropy theory developed
S , T are said to be (spatially) apace in the hands of, principally, Russian
i s o m o r p h i c if there is an invertible mathematicians in the 1960s and received its big-
measure-preserving transformation < f > between gest impetus from the American mathematician
their respective spaces such that < p S = Omstein, who in 1968 proved that two Bernoulli
T ( f > a.e. (almost everywhere). Isomorphism transformations with the same entropy are isomor-
E
implies that the unitary spectral characteristics arc phic (cf. Omstein ). From that time the subject has
indistinguishable (i.e. s p e c t r a l grown exponentially, with ever more
equivalence), but not vice versa. The main result transformations shown to be (isomorphic to)
obtained characterized all ergodic measure- Bernoulli transformations. Such transformations
preserving transformations with a pure point have to have (to say the least) positive entropy and
spectrum. For such transformations S , T their i n t r i n s i c random character is in
identity of point spectrum implies spatial marked contrast to the rigid examples referred to
isomorphism and such transformations are earlier which are d e t e r m i n i s t i c (with
(isomorphically) precisely the ergodic translations zero entropy).
of compact metric abelian groups. Entropy plays very little role in the looser
A similar theory was developed in Abramov ( classification theory which allows velocities (along
) for so-called transformations with quasi trajectories) to vary. There are continuous (real)
discrete spectrum. Example (b) provides an exam- time and discrete versions of this theory and as
ple of this type of transformation. They had been early as 1943 Kakutani had conjectured that all
studied earlier by Anzai. The works of Auslander, ergodic systems are K a k u t a n i
Green and Hahn ( ) and Parry ( ) provide e q u i v a l e n t , using the current
further developments in this direction. A completely nomenclature for this loose equivalence
analogous theory is modelled on the ‘rigid’ (Kakutani ). Although this conjecture turned out to
examples of n i l f l o w s and be false (in fact entropy ensures the existence of at
u n i p o t e n t a f f i n e s on nil least three Kakutani inequivalent systems), Feldman
manifolds. The rigidity here refers to the ( ) and Katok ( )
phenomenon of measure isomorphisms showed that remarkably dissimilar systems are
n e c e s s a r i l y being algebraic in equivalent according to this notion. In Omstein and
character. The most recent work concerning rigidity Weiss ( ) it is shown that a modification
in ergodic theory (Ratner ) finds this, and related of Kakutani’s conjecture is true. In this connection a
phenomena, in horocycle flows. grand theory of equivalence relations in ergodic
So far we have given a condensed account of theory has been developed in Rudolph ( ).
only one strand in isomorphism theory. The most This is ergodic theory with its head in the clouds.
active work has occurred in connection with From a more earthly point of view ergodic
examples of an entirely different and r a n d o m theory in the 1960s, through the developments of
character. entropy theory and stimulated by Anosov ( ) and
This work began with the problem of deciding Smale ( ), began to connect with
whether two Bernoulli shifts (which are necessarily the newly flourishing field of differentiable
spectrally isomorphic) are spatially isomorphic. The dynamical systems.
first breakthrough occurred with Kolmogorov’s Examples (c) and (f) are, respectively, proto-
introduction of entropy theory into the subject types of Anosov diffeomorphisms and flows. Their
(Kolmogorov ). As modified in (Sinai ) entropy is a principal feature here is their global hyperbolic
numerical invariant of isomorphism (i.e. if S , structure. Dynamicists are particularly interested in
T are isomorphic then then- entropies h ( S ) , such systems as they are s t r u c t u r e d l y
h ( T ) coincide). This fact provides a s t a b l e , a concept which became something
dogma in the 1960s and 1970s, as some mathe- chain) initially in the absence of any probability but
maticians went so far as to assert that any real and supplemented with a natural topology which reflects
persistent system must be structurally stable. (A the connectivity of the transformation. Such a shift
structurally stable system is, roughly speaking, one is called a t o p o l o g i c a l M a r k o v
which retains its principal features after a small c h a i n (or s h i f t o f f i n i t e
perturbation.) This important concept was modified t y p e ) .
by Smale when he introduced Axiom A systems Then one considers an action potential
and proved that the latter are Q-stable (structural describable in terms of a continuous function.
stability relative to non-wandering sets). Smale Under a stronger (Lipschitz) condition it turns out
thereby axiomatized a vast category of new that there is always a unique shift invariant
dynamical systems and presented us with an probability (called an e q u i l i b r i u m
approach which unified Anosov systems, gradient s t a t e ) given by a variational principle
like dynamical systems and his so-called ‘horse involving the p r e s s u r e of the potential.
shoes’. For these systems Smale proved his spectral A key tool in this theory is the t r a n s f e r
decomposition theorem, which describes the non- matrix or operator associated with the potential and
wandering set of an Axiom A system in much the under suitable (aperiodic and irreducible) condi-
same way as one describes the irreducible block tions, iterations of this operator will force arbitrary
behaviour of a non-negative matrix, in the theory of probabilities to converge to the equilibrium state.
Markov chains (Smale 1970). The b a s i c sets The one-dimensional lattice gases provide
of an Axiom A system received further scrutiny in models for simple gases and also for statistical
terms of Markov partitions by Sinai (Anosov case) mechanics on manifolds. The results above have
and Bowen (Axiom A case). analogues (when appropriate conditions are
Bowen was a key figure in the fruitful conver- imposed) for differential or even topological
gence of ergodic theory and differentiable dynam- dynamical systems (Pesin ). Moreover, at least for
ical systems because of his profound expertise in hyperbolic systems, one can view topological
both subjects. In a series of papers he provided deep Markov chains with their potentials, equilibrium
analyses of Axiom A diffeomorphisms and flows states, closed orbits, transfer operators and pressures
(roughly speaking, hyperbolic dynamics) from the as (in a technical sense) building schemes for these
point of view of symbolic dynamics and periodic systems.
orbits (Bowen ). His work connected happily with A recent new area of ergodic theory which
the direction Ruelle and Sinai were taking in stands outside the developments just sketched is
statistical mechanics (Sinai ; Ruelle ). Together concerned with the application of ergodic theory
they laid the foundations for statistical mechanics and topological dynamics to combinatorial number
on manifolds. theory. The motivation for this recent work was
The subject then has gone full circle to its Szemeredi’s proof of a conjecture of Erdos and
origins, but on the way it encountered a dazzling Turan. The conjecture, which emanated from a
variety of iteration problems from other areas, viz. result of van dcr Wacrdcn’s, states that \ f a . \ <
maps of the unit interval (Collet and Eckmann ), a2 < • • • is an increasing sequence of positive inte-
boundary measures associated with Fuchsian gers and if ^denotes the number of these integers
groups (Patterson ; Sullivan ( ), analytic less than N , then for every k > 0 there is an
maps of the Riemann sphere or arithmetic progression in the sequence of length k ,
complex plane (Rees ), to name but three. as long as O f i N > c infinitely often (for some
As to recent developments in statistical e > 0).
mechanics the one-dimensional lattice gas has Furstenberg ( ) provided an ergodic theo
received the most attention. Here one considers a retical proof of this result and of many other results
shift transformation (as in the case of a Markov with the same ‘flavour’. His technique involved
building a sequence { x „ J of zeros and
ones (.r„ = 1 when and only when n is in the See Also
sequence), and embedding this sequence in a shift
space. The details, which are quite intricate, involve ► Continuous at
► Fc vinuous T
the proof of a multiple recurrence theorem:
If Tis a measure-preserving transformation on
( X , i n ) and if m ( A ) > 0 then for every ► Continuous Time Stochastic Processes
positive integer k
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 exp-j [ x a
h + >
j f ' E b € N { a ) J
exp- [ xa ° h + x b ] x a h x 0 ' l 2 b e N (
j x J 2 b e N ( a ) \ +expj — a ) =
Endogenous
J x b
} Preference Formation l J x b } capita excess demand is small in economies with
many agents, that is, for which
In his pioneering paper on endogenous preference
formation, Follmer ( ) developed an equilib
rium analysis of large exchange economies where z(x° ,p*)ji(dxa) = 0. (2)
the conditional excess demand z ( x a , p ) of
the agent a C A given a price systemp is subject The assumption of independence of states can
to a random shock .r" and where the probabilities be dropped as long as p is e r g o d i c , that is,
(jia)a e A governing this randomness have an as long as ( ) holds. However, when preferences are
interactive structure. interactive, the probabilities % a specifying the
In a benchmark model where the s t a t e s dependence of the individual states on the states of
x " are independent across agents, the distribution others do not necessarily determine the j o i n t
p of the vector of states x = ( x " ) a e A takes distribution p of all the states. This effect can best
the product form p 1I„ e A 7ta, and the law of large be illustrated by means of an ‘Ising economy’
numbers yields where the agents are indexed by the two
dimensional integer lattice (A Z2), the set of
possible states is {—1,1}, and where the conditional

n—* oo | A,
25, iii £ distribution of agent a’s state depends on all the
other states x ° only through the states x b of
=<■'» his four nearest neighbours b e N ( a ) := { a e
z ( x t l , p ) p { d x ) p — almost surely (1) A : \ a — a \ = 1}. The distribution also
depends on some constant h c R which assigns an
intrinsic value to private states and on a non-
for an increasing sequence of finite populations [ A„
negative quantity / that measures the strength of
| „ e N. Under standard conditions on z ( x " , ■ )
social interactions. Specifically,
there exists aunique price system/** forwhiehper

7ia(v“;x
a
) (3)

A probability measure p on S = {x = (x°)a e A* critical value, two ergodic global phases p+ and p
x a e { — 1, +1}} is called a g l o b a l exist. In this case aggregate behaviour cannot be
p h a s e if its one-dimensional marginal inferred from looking at microscopic characteristics
distributions are consistent with the microscopic alone. Moreover, there is typically no price system
data given by the individual characteristics (7i a)a e A» that equilibrates both phases
that is, if s i m u l t a n e o u s l y . Thus,
randomness in preferences becomes a source of
/i(*fl = ±l|*-fl) = jifl(±l;|*-fl)- (4) uncertainty about market clearing prices.
An ergodic phase p can be
e q u i l i b r a t e d if there exist prices p *
Stochastic Strategy Revision
for which ( ) holds. For independent preferences (/=
in Population Games
0) global phases and, hence, equilibrium prices are
always determined uniquely by the agents’ The pioneering work by Blume ( ) puts
characteristics. However, if the distribution of states Follmer’s model into a dynamic framework of
depends only on the states of others ( h = 0) interactive choice and exploits the link of discrete
and the interaction is sufficiently strong, that is, if J choice models with Gibbs distribution theory. It is
mainly concerned with the aggregate behaviour in The conditional probability n a ( x f l ,
population games of bounded rational play, looking x ~ a ) with which player a e A selects an action
for ‘Nash-like play in the aggregate rather than at x ‘ t ‘ at time t , given the current states x ~ a
the level of an individual player’. In Blume’s model of all the other agents takes the form ( ) with h =
choice opportunities arise randomly according to p h and J = p j . Here p > 0 specifies the
individual players’ Poisson ‘alarm clocks’. When a strength of interaction. For p = 0 the agents
choice opportunity arises for player a C_ A at time choose the actions with equal probability while a
/, his choicex" results in an instantaneous payoff best response dynamics corresponds to the limiting
G ( x a t , x , ‘ ) from each neighbor b G case when p tends to infinity. The constants h and
N ( a ) and in a total payoff J are determined e n d o g e n o u s l y by
the payoff matrix G through ( ). Specifically,
£ G(x%xb,). (5)
b e N(a )

exp { p[^h+^J2beN(a/4]}
na(x?;xta)
f
exp [ p x f h I^ T , b c N ( a y 4 } } + exp{ p \ x ^ ‘ h I 4'E* r }■

These f l i p r a t e s generate a process with a s y n c h r o n o u s updating.

continuous time Markov process A on S which In local interaction models with
describes the evolution of the agents’ choices s y n c h r o n o u s updating, the dynamics of
through time. A probability measure g is called an individual behaviour is typically described by a
e r g o d i c m e a s u r e for X if the Markov chain whose transition operator takes the
distribution of choices does not change over time product form
and empirical averages converge to a deterministic
limit if the initial state is chosen according to /(. The na
=n (' ; {*?}*£(«))• (6)
process X is called e r g o d i c if it has a aSA
unique ergodic measure. It is well known from the
theory of interacting particle systems that the set of Thus, the distribution of the state .vj'+1 in period
all ergodic probability measures for X is given by t + 1 depends on the neighbours’ states R}» e
the ergodic global phases corresponding to the local/v(a) • in period t . The long-mn dynamics of such
specification ( ). As a result, Blume’s stochastic Markov chains plays an important role in
strategy revision process is ergodic if h / 0 and / >
macroeconomic models of economic growth.
0. This is the case if G describes a two person The substantial differences in output levels and
coordination game. Eigo- dicity breaks down for growth rates across countries have long been a
games with symmetric payoff matrices ( h = 0) major focus of macroeconomic research. A
when the interaction gets too strong. In this case, the
hallmark of the stochastic growth model pioneered
long-run average choice depends on the starting by Brock and Mirman is the convergence of
point. The long-run macroscopic behaviour is as economies with identical preferences and
unpredictable as equilibrium prices in Follmer’s production functions to a common level of aggre-
model by looking at microscopic characteristics gate output. Yet many analyses of long-run output
only. movements have concluded that per capita pro-
duction is not equalizing across countries. To
Non-ergodic Economic Growth explain this divergence, Durlauf ( ) studies a
dynamic model of capital accumulation of an
The evolution of individual choices in Blume ( ) is economy with an infinite set A of interacting
described by a c o n t i n u o u s time Markov companies where local technological externalities
affect the process of production. Each company a Models of Social Interaction - Mean- Field
C A chooses a capital stock sequence { K ) ' } . Interaction
that maximizes the present value of future profits,
and the technique-specific production functions Much of the literature on social interactions
generate output assumes very special interaction structures such as
nearest neighbour interactions as in Blume ( ), or
Durlauf ( ) or mean-field interac
Y“=f(KU,x“,Ftf)) (7) tion. If agents care about the average behaviour
throughout the whole population, the analysis is
where x ' ' c {0.1}. Technique x f ) = 1 is more most naturally done in the context of an infinity of
productive, but comes at a higher fixed cost: />'( 1) agents, as in Brock and Durlauf ( ). These
> /TO). Local technological complementarities authors analyse aggregate behavioural outcomes
affect the production as the distribution ofx^ when individual utility exhibits social interaction
depends on the techniques implemented by the effects. In the simplest setting agents take actions
nearest neighbours b e N ( a ) in the previous x a from the binary action set {— 1, + 1} and their
period. The dynamics of production technologies is utilities consists of three components:
then described by an interactive Markov chain of
the form ( ). Assuming that past choices of U a
( x a
, m a
= u(xa) +Jx/,nf + (8)
technique 1 improve the current relative produc-
tivity of the technique and that the high-
productivity state x “ t = \ for all a e A is an Here m a denotes agent u’s expectation about
the average choice of all the other agents. The
equilibrium, Durlauf ( ) shows that the high-
second term in the utility function may thus be
productivity state is the only longrun outcome if the
viewed as a social utility expressing an agent’s
complementarities are weak enough: there exists 0 <
desire for conformity (./ > 0). The quantity
6 < 1 such that
u ( x a ) , on the other hand, represents the
private utility associated with a choice while
hm p[v? = l|xg = 0] = 1 if7i„(l; {*?_! } b e N { a ] ) s ( x a ) is a random utility term independent of
other agents’ utilities and extreme-value distributed
x>0.
with parameter /? > 0. The extreme-value
distribution assumption for the random utility term
Even when one starts with all low-production
yields conditional choice probabilities n a of the
industries, an economy eventually coordinates on
form ( ) if we replace the dependence of
the high-production technology when negative
a c t u a l actions by a dependence on
feedbacks from lowproduction technologies are
e x p e c t e d actions. When agents have
sufficiently weak. Powerful negative complemen-
homogeneous expectations about the behaviour of
tarities, on the other hand, can generate a non-
others ( m “ = m ) , then
ergodic growth path. In fact, there exists 0 < 0 <
6 < 1, such that
7i„(x"; i n )
exp{^(M(.L7) +Jxam)}
Inn !>[.< = l\4 = 0] < 1 ifKa(l; Ri}fteA,(ll))
exp{P(u(l) + Jm)} + exp{[S(u(—1) — Jm)}
x<8 . (9)

If the complementarities are too strong, indus- In the limit of an infinite economy all uncer-
tries fail to coordinate on highproductivity equi- tainty about the average action vanishes because the
libria, and economies may get trapped in low- agents’ choices are conditionally independent given
productivity equilibria. their expectations about aggregate behaviour. The
average action is t a n h ( f l h + f i j m )
where
h | ( u ( 1) - u ( — 1)). If the agents have space. The parameter p can be seen as the agents’
rational expectations the average satisfies the fixed common expectation about the average behaviour.
point condition Under standard curvature conditions on U an equi-
librium xp exists for any such expectation p. If some
m = tanh (flh + flJm). (10) form of spatial homogeneity prevails and under a
weak interaction condition that restricts the
This equation has a unique solution\ f h / ( ) influence of an agent’s choice on the optimal
and [ I is large enough. For large enough [ 1 the decisions of others, xp is unique. Furthermore, there
uniqueness property breaks down if h = 0, in exists a unique p that coincides with the average
which case ( ) has three roots. action p(xp) associated with xp. In this case the
agents correctly anticipate the average behaviour,
and xp turns out to be the unique equilibrium. The
Models of Social Interaction - Local
weak interaction condition also guarantees spatial
and Global Interaction
ergodicity: the equilibrium of the infinite system is
the limit of equilibria of finite systems when the
When agents care about both the average action and
number of agents grows to infinity; see Horst and
the choices of neighbours, the equilibrium analysis
Scheinkman ( ) for details.
becomes more involved. Horst and Scheinkman (
) provide a general framework
for analysing systems of social interactions with an Dynamic Models of Social Interaction
infinite set of locally and globally interacting agents
located on an integer lattice (for example, A = Z2), When dynamic models of social interaction are
continuous action spaces and random preferences. studied the analysis is often confined to the case of
Specifically, they consider utility functions of the backward-looking myopic dynamics, either as a
form simple explicit dynamic process with random
sequential choice or as an equilibrium selection
a b
u“(x,d ) = u(^,{X }beN{a),p(x),9 ) a procedure. Rational expectations equilibria of
economies with local interactions are studied in
Bisin et al. ( ). While agents interact locally in
where p(x) denotes the average choice associated
these models, they are forward-looking. Their
with the action profile x, and the random variables
choices are optimally based on the past actions in
6 a specify the distribution of taste shocks. While
their neighbourhood as well as on their anticipations
the distinction between local and global interactions
of the future actions of their neighbours. The
is unnecessary for models with finitely many
resulting population dynamics can be described by
agents, it is important for the analysis of infinite
an interactive Markov chain of the form ( ) but the
economies. The continuity of the utility functions
transition probabilities JIa are
u a ( : , 6 a ) in the product topology on the
e n d o g e n o u s l y specified in terms of
configuration space requires, implicitly, that the
the agents’ policy functions. Bisin et al. ( )
dependence of an agent’s utility function on another
also allow
agent’s action decays sufficiently fast as the
for local and global interactions and combine spatial
distance from that other agent grows. Thus, if
and temporal ergodicity results. The dynamics on
preferences depend on average actions, utility
the level of aggregate behaviour is deterministic
functions are typically discontinuous. To overcome
(spatial ergodicity) and the distribution of individual
this problem, Horst and Scheinkman ( )
choices settles down in the long run (temporal
separated the
ergodicity) when the interaction is weak enough.
local and global impact of an action profile .r = (x )a
a
The analysis, however, is confined to one-sided
g A on individual preferences by viewing the
interactions. It is an open problem to fully embed
average action as an additional parameter, p , of a
the theory of social interactions into a dynamics
c o n t i n u o u s utility function on an
analysis of equilibrium.
e x t e n d e d state
See Also time were regarded as either unrealistic or inde-
fensible by many, including the Occupation
► vg- j. Powers.
► Social Interactions (Empirics) In a sense, Erhard’s life before 1948 was a
► Social Interactions (Theory) preparation for this moment, and his career after-
► Social Multipliers wards a continuation of its theme. Bom in Furth in
Franconia into a small business family, Erhard
Bibliography studied economics after World War I and joined an
economic research institute. His teachers were, on
Bisin, A., U. Horst, and O. Ozgiir. 2006. Rational the one hand, Wilhelm Rieger, first director of the
expectations equilibria of economies with local
interactions. Journal of Economic Theory 127: 74-116. Nuremberg Commercial College, and, on the other,
Blunre, L. 1993. The statistical mechanics of strategic Franz Oppenheimer, economist and sociologist in
interactions. Games and Economic Behavior 5: 387-424. Frankfurt, whose influence on Erhard went much
Brock, W., and S. Durlauf. 2001. Discrete choice with deeper. In the Sixties Erhard described
social interactions. Review of Economic Studies 68: 235-
260. Oppenheimer’s importance for him in this way: his
Brock, W., and L. Mirrnan. 1972. Optimal growth own economic policy was in a sense the redirection
under uncertainty: The discounted case. Journal of of Oppenheimer’s ‘liberal socialism’ to ‘social
Economic Theory 4: 479-513. liberalism’. During World War II he wrote a
Durlauf, S. 1993. Nonergodic economic growth.
Review of Economic Studies 60: 349-366.
memorandum sketching his project for a market
Follmer, H. 1974. Random economies with many economy in ways which left no doubt that he
interacting agents. Journal of Mathematical Economics foresaw and wished for the defeat of the Nazis. This
1:51-62." was one reason why he was appointed Bavarian
Horst, U., and J. Scheinkman. 2005. A limit theorem
Minister of Economic Affairs in 1945, and in 1947,
for systems of social interactions. Working paper.
Horst, U., and J. Scheinkman. 2006. Equilibria in head of the small special unit which prepared the
systems of social interactions. Journal of Economic currency reform of 1948. When Konrad Adenauer
Theory. 127:74-116. formed the first Federal Government, Erhard
became Minister of Economic Affairs, a post which
he held until he succeeded Adenauer as Federal
Chancellor in 1963. It was as Economics Minister
that Erhard preached and implemented the concept
of‘social market economy’, a market economy
tempered by basic social policies, for which the
Erhard, Ludwig (1897-1977)
Federal Republic has become famous. Erhard’s
Ralf Dahrendorf Chancellorship was undistinguished; in 1966, his
own party, the Christian Democratic Union (CDU)
forced him to resign. However, his effect on
Germany’s economic institutions and the prevailing
mould of economic thought is profound and lasting.
Erhard was a man who had his moment in history
and grasped it. As head of the Economic Depart-
ment of the administration which preceded the
creation of the Federal Republic of Germany, he
was the author of the decision to combine the
currency reform of 1948 with the abolition of
rationing, and of restrictive regulations concerning References
production, distribution and capital movements.
Caro, M.K. 1965. Der Volkskanzler - Ludwig Erhard.
Many have argued that Germany’s ‘economic Cologne: Kiepenheurer & Witsch.
miracle’ (and not less the political miracle) owes Lukomski, J.M. 1965. Ludwig Erhard - Der Mensch und der
much to these decisions which at the Politiker. Dusseldorf: Econ.
 in pointing out that future growth was limited after
Erlich, Alexander (1913-1985) 1925 by the existing high-capacity utilization and
scarce investment funds, Pre- obrazhenskii and
Diane Flaherty others were wrong in underestimating the reaction
of the peasantry to an industrialization policy that
would squeeze peasant incomes. On the other hand,
the right opposition did not appreciate the
Keywords implications of high-capacity utilization for
Bukharin, N.I.; Erlich, A.; Industrialization; continued growth through small profit margins and
Preobrazhensky, E.A.; Socialism; Soviet Union, high turnover of consumer goods and light
economics in manufacturers. The right, and Bukharin in
particular, were seen by Erlich to be naive on the
intensity of the conflict between consumption and
JEL Classifications investment once existing capacity was fully utilized.
B31 This, his major work, exhibits a detailed knowledge
of the Soviet experience and a dispassionate and
Alexander Erlich was born in St Petersburg on 6 rigorous analysis of policy choices that set the
December 1913 and died on 7 January 1985. He standard for such work in the field.
moved to Poland with his family in 1918. In 1914,
his father Henryk Erlich, a leader in the Socialist
movement in Poland, was executed. In the same Selected Works
year, after university studies in Berlin and Warsaw,
Erlich emigrated to the United States, where he 1950. Preobrazhenskii and the economics of Soviet
earned aPh.D. at the New School for Social industrialization. Q u a r t e r l y
Research and joined the faculty of Columbia J o u r n a l o f E c o n o m i c s
University in 1955. From 1966 until his retirement 64: 57-88.
in 1981 Erlich was professor of economics at 1959. The Polish economy after October 1956:
Columbia, teaching in the economics department, Background and outlook. A m e r i c a n
the Russian Institute and the Institute for East E c o n o m i c R e v i e w ,
Central Europe. Professor Erlich was revered by his P a p e r s a n d
smdents for his unstinting help and encouragement P r o c e e d i n g s 49: 94-112.
and respected by his colleagues for his breadth of 1960. S o v i e t
knowledge and understanding of socialist i n d u s t r i a l i z a t i o n
economics. d e b a t e . 1 9 2 4 - 1 9 2 8 .
Alexander Erlich’s main contribution to the Cambridge, VIA: Harvard University Press.
economics of socialism is his work on the critical 1967a. Development strategy and planning: The
issue of industrialization policy in the USSR in the Soviet experience. In N a t i o n a l
1920s. To this issue, Erlich brought an unusual e c o n o m i c p l a n n i n g , ed.
blend of sophisticated economic reasoning and VI.F. Millikan. New York: Columbia University
penetrating political analysis. His major thesis Press.
concerning Soviet policy in this period is that the 1967b. Notes on a Marxian model of capital accu-
structural disproportions in the Soviet economy mulation. A m e r i c a n
were so deep that virtually any policy would have E c o n o m i c R e v i e w ,
had negative side effects on reconstruction. P a p e r s a n d
Specifically, Erlich argued throughout his career P r o c e e d i n g s 57: 599-616.
that the economic policies of both the left a n d 1973. A Hamlet without the Prince of Denmark.
the right opposition were equally problematic. P o l i t i c s a n d S o c i e t y
While the left analysis was correct 4( 1): 35-53.
1977. Stalinism and Marxian growth models. In
Stalinism: Essays in historical
Bibliography biased and inconsistent. The errors thus pose a
potentially serious estimation problem. In regard to
Marxism, central planning and the
Desai, P. (ed.). 1983.
Soviet economy: Economic essays in honour of systematic errors in variables, they will not be
Alexander Erlich. Cambridge, MA/London: MIT Press. discussed, since they raise complex issues of model
misspecification which he outside the scope of this
entry.
Errors in variables have a curious history in
economics, in that economists have shown an
Errors in Variables ambivalent attitude toward them despite the uni-
versal awareness that economic variables are often
Vincent J. Geraci measured with error and despite the commitment to
economics as a science. Griliches ( ) suggested
that much of the ambivalence
stems from the separation in economics between
The Historical Ambivalence data producers and data analysers. If so, why have
not economists made a greater effort to cross the
This entry surveys the history and recent develop- breach? Griliches (p. 975) further suggested that
ments on economic models with errors in variables. ‘another good reason for ignoring errors in variables
These errors may arise from the use of substantive was the absence of any good cure for this disease’.
unobservables, such as permanent income, or from If so, why have not economists made greater use of
ordinary measiuement problems in data collection the econometric techniques developed since
and processing. The point of departure is the Griliches wrote his survey?
classical regression equation with random errors in We propose an alternative explanation: the way
variables: of economic thinking, epitomized by utility theory
y = X*P + u and consumer maximization, has promoted a
neglect of measurement errors. Bentham ( ,
where y is a n x 1 vector of observations on the ch. IV) was a pioneer of measurement theory in the
dependent variable, k t is a n x k matrix of social sciences in his attempt to provide a theory for
unobserved (latent) values on the k independent the measurement of utility. He went so far as to
variables, (3 is a k x 1 vector of unknown coeffi- recommend that the social welfare of a given policy
cients, and u is a n x 1 vector of random distur- be computed by summing up n u m b e r s
bances. The matrix of observed values on X * is expressive of the ‘degrees of good tendency’ across
individuals. Bentham’s notion of cardinal utility
X = X* +V
met rightfully with great resistance. Pareto ( , ch.
where Fisthe n x it matrix of measurement errors. Ill) pressed the dominant view: the
If some variables are measured without error, the economic equilibrium approach, by producing
appropriate columns of Fare zero vectors. In the empirical propositions about consumer demand in
conventional case the errors are uncorrelated in the terms of observables (quantities, prices, incomes), is
limit with the latent values X * and the distur- to be favoured over theories connecting prices to
bances u ; and the errors have zero means, utility, a metaphysical entity. Thus, theory - here
constant variances, and zero autocorrelation. In optimization by rational consumers in a competitive
observed variables the model becomes market - overcame a fundamental measurement
problem.
y=Xp+(u-Vp). We do not wish to quarrel with the neoclassical
equilibrium approach to the study of demand,
Since the disturbance ( u F|3) is correlated
although some economists wonder whether the
with X , ordinary least squares estimates of (3 are
assumptions of the theory have sufficient validity to
warrant their acceptance (as part of the
maintained hypothesis) in so many empirical part. His complicated correlation approach, some-
demand studies. Rather, our point is that the great times resembling common factor analysis, did not
successes of this theory, and analogous successes of satisfactorily resolve the errors-in-variables prob-
similar theories about other economic behaviour, lem, but he raised fruitful questions. While
have implanted a subconscious bias toward the Koopmans ( ), Geary ( ), Hurwicz and
substitution of economic theory (assumptions) for Anderson ( ), Reiersol ( ), and a few
difficult measurement. In consequence, many others followed up on Frisch’s endeavour, interest
economic models do not have an adequate empirical in the problem waned by the start of the 1950s. The
basis, cf. Leontief ( ) and famous Cowles Commission may have
Koopmans ( ). unintentionally buried the errors-in-variables
Whatever the reasons for their neglect, errors in problem when the chief investigators put it aside in
variables have been hard to keep down. Substantive order to make progress on the simultaneity problem.
unobservables such as permanent income, expected Applied economists, in their zeal to employ the new
price and human capital continue to work their way simultaneous equations model, ignored the
into economic models and raise measurement limitations in their data despite the warning cry of
issues. Friedman’s ( ) perma Morgenstem ( ). Sargan
nent income model has served as a prototype for the ( ), Liviatan ( ), Madansky ( ), and a
errors-in-variables setup: few others made contributions in the 1950s and
1960s, but for the most part errors in variables lay
cp = k y v dormant. Widely used econometrics textbooks
aggravated matters by highlighting the lack of
y = yv+yx
C = Cp + c,
identification of the classical regression equation in
the absence of strong prior information such as
where c consumption, y = income, subscript known ratios of error variances. Neglect by the
‘p’ = permanent, subscript ‘f transitory, and A; is a theorists led to the widespread use of a d h o c
behavioural parameter. Friedman (p. 36) clearly proxies in practice.
recognized the connection of the model expressed
in observed c and y to the errors-in- variables
setup; in his words, ‘The estimation problem is the Recent Econometric Developments
classical one of “mutual regression” or regression
Zellner ( ) sparked a revival of interest in
“when both variables are subject to error”.
errors in variables. He attained identification of the
In the next two sections, early and recent devel-
permanent income prototype by appending a
opments on economic models with random errors in
measurement relation that predicted unobservable
variables will be surveyed. Then, we will speculate
permanent income in terms of m u l t i p l e
on the future use of errors-in-variables methods.
c a u s e s (e.g. education, age, housing value),
to accompany the natural i n d i c a t o r
relation in which observed current income is a
formal proxy for permanent income. Goldberger ( ,
)
Early Econometric Developments stimulated the revival by showing how models with
substantive unobservables could be identified and
Frisch ( ) was the first econometrician to face estimated by combining all of the measurement
squarely the problem of errors in variables. In a information in a set of multiple equations that arise
brave book addressing model search, multi- from multiple indicators or multiple causes. He also
collinearity, simultaneity, and errors in variables, he drew out the connections among the errors-in-
decomposed the observed variables into a sys- variables model of econometrics, the confirmatory
tematic (latent) part and a random disturbance factor analysis model of
psychometrics, and the path analysis model of unobservable home value. The framework could be
sociometrics. On the applications side, Griliches extended to endogenous causes, as Robinson and
and Mason ( ) and Chamberlain and Griliches Ferrara ( ) demonstrated.
( ) studied the important socioeconomic prob
lem of estimating the economic returns to school- Simultaneity
ing, with allowance for unobservable ‘ability’. With The MIMIC model assumes unidirectional causa-
Goldberger and Griliches leading the way, the tion. Suppose instead that unobservables appear in a
econometric literature on errors in variables simultaneous equations model. This case calls for
flourished in the 1970s. less ‘outside information’ than the singleequation
case, since coefficient overidentification, as it
Multiple Equations would exist in the hypothetical absence of
For the permanent income prototype, Zellner’s measurement errors, may compensate for the
multiple cause relation and indicator relation underidentification associated with errors. This idea
formed a two-equation measurement system that had appeared in early unpublished works by
could be appended to the structural consumption Hurwicz and Anderson ( ); Goldberger
equation. For this three-equation model, Zellner ( resurrected it in 1971. Geraci ( ), Hausman
) provided an efficient generalized least ( ), and Hsiao ( ) subsequently developed
squares estimator, and Goldberger ( ) added identification analyses and estimators for the
a maximum likelihood estimator. This errors-in- simultaneous equations model with errors, taking
variables framework, which can be applied to many account of the ‘disturbance’ covariance restrictions
situations in which an unobservable appears as an induced by the error structure as well as the usual
independent variable in an otherwise classical coefficient restrictions. Many of their results have
regression equation, has been very useful. Example an instrumental variables interpretation. For
applications have included Aigner’s ( ) study of illustration, an indicator for an unobservable in a
labour supply in which the wage simultaneous equations system is a valid instru-
is an unobservable, Lahiri’s ( ) study of the mental variable for a given structural equation if the
Phillips curve in which price expectations is an unobservable either (a) does not appear in that
unobservable, and Geraci and Prewo’s ( ) equation or (b) appears but has an associated error
study of international trade in which transport costs variance that is identified using information from
is an unobservable. some other part of the system. Once the latter
Joreskog and Goldberger ( ) generalized linkage is recognized, the model well may be
the framework to situations in which there are more identifiable and hence estimable. A notable appli-
than two observed dependent variables. Their model cation has been Griliches and Chamberlain’s series
combined prior constraints on the reduced-form of studies on the economic returns to schooling.
coefficients (of the type that arise in econometric They employed a triangular model with structural
simultaneous equations models) with prior disturbances specified as a function of
constraints on the reduced-form disturbance unobservables (common factors). In various ways
covariance matrix (of the type that arise in their models incorporated simultaneity, multiple
psychometric factor analysis models). For this indicators, and multiple causes.
model which contains multiple indicators and
Dynamics
multiple causes (MIMIC) for a single unobservable,
Maravall and Aigner ( ), Hsiao ( ), and
they developed a maximum likelihood estimator.
Hsiao and Robinson ( ) extended the errors-
Applications of the MIMIC framework have
in-variables analysis to dynamic economic models.
included Kadane et al’s ( )
Among their findings, dynamics are a ‘blessing’ for
study of the effects of environmental factors on
identification in that autocorrelation of exogenous
changes in unobservable intelligence over time, and
variables may provide additional
Robins and West’s ( ) study of
information; and, upon taking a discrete Fourier windfall income. His model is a special simulta-
transform of the data, many of the results for the neous equations model with errors, in which iden-
contemporaneous model can be carried over to the tification of the individual structural equations can
dynamic model. In the same vein, Geweke ( ) be established on a recursive basis. Geweke and
developed a maximum likelihood estimator for the Singleton ( ) also have taken up the perma
dynamic factor analysis model by reprogramming, nent income model, adapting the classical latent
in complex arithmetic, Joreskog’s ( ) maximum variables model to this time series context and
likelihood algorithm thereby generating some new tests of the permanent
which had developed into the widely used LISREL income hypothesis. As another example, Garber
software package. Geweke applied this estimator to and Klepper ( ) have defended the
investigate manufacturing sector adjustments to competitive model of short-run pricing in concen-
unobservable product demand. Singleton ( ) trated industries through an explicit accounting for
extended this factor analysis errors in measuring cost and output changes. They
approach to study the cyclical behaviour of the term concluded that short-run price behaviour may
structure of interest rates. His framework allowed appear to be related to market structure primarily
estimation of the model without specifying the because of estimation biases due to the
causes of the unobservable real rate of interest and measurement errors. As a final example, Stapleton (
price expectations, thus isolating the classic Fisher ) has shown that the symmetry restrictions
hypothesis for testing. on structural parameters imposed by demand theory
As the preceding survey indicates, the recent can be used to identify a linear model’s parameters
econometric literature contains many theoretical when measurement errors in price perceptions exist.
results on the identification and estimation of This study is noteworthy in two respects. First, it
structural models that contain substantive unob- shows how price, that bedrock of economic theory,
servables and measurement errors. (For a further may be measured erroneously. Second, economic
survey, see Aigner et al. .) The literature also theory is used to permit the explicit treatment of
contains some interesting applications, but not errors in variables.
many. Are more forthcoming? These recent empirical works indicate the
potential of errors-in-variables methods to lend
fresh insights into important economic issues, and
Prospects should stimulate more use of these methods. There
are other encouraging signs as well. Recent studies
We have an uneasy feeling about the state of empir- using micro data have shown increasing attention to
ical economics. The development of formal eco- measiuement error problems. In the macro area the
nomic theory and associated econometric technique rational expectations hypothesis has raised
has proceeded at an extraordinary pace. At the same economists’ consciousness of the difference
time, what do economists know empirically? Many between key conceptual variables of economic
reported inferences hinge upon model assumptions theory (i.e. permanent income, expected price, ex
whose validity remains to be assessed, and the gap ante real rate of interest) and the available
between econometric technique and available data measiuements. With respect to applications of
seems to be growing. None the less, there are errors-in-variables methods in economics, the stock
grounds for some optimism. is not great but the flow is encouraging.
Although few in number, the applications of
errors-in-variables methods in the 1980s have been
striking in their relevance to central economic See Also
issues. For example, Attfield ( ) has
made the permanent income model a more complete
explanation of consumption by incorporating ► "A:::.;
unobservable liquid assets, rateable value, and ► Regression and Correlation Analysis
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Sargan, J.D. 1958. The estimation of economic relationships proportional, or if the inheritance tax interacts with
using instrumental variables. Econometrica 26: 393-415. other forms of taxation (such as income tax).
Singleton, K. J. 1977. The cyclical behavior of the term
structure of interest rates. Unpublished PhD dissertation.
Further sources of variation in how these types of
Madison: University of Wisconsin. tax appear around the world include differences in
Stapleton, D. 1984. Errors-in-variables in demand systems. how family members are treated, deductions
Journal of Econometrics 26(3): 255-270. allowed, treatment of certain categories of assets,
Zellner, A. 1970. Estimation of regression relationships
containing unobservable independent variables. Inter-
treatment of capital gains and interaction with other
national Economic Review 11: 441 -454. types of tax. Two additional types of tax are closely
associated with estate and inheritance taxation.
First, some countries impose additional tax on
transfers that skip generations. Such transfers
would otherwise avoid taxation at death of an
Estate and Inheritance Taxes intermediate generation and hence would provide
tax savings. Second, taxes on i n t e r v i v o
Wojciech Kopczuk gifts are imposed to protect the base of estate
taxation (this is not their sole purpose, however:
they also reduce the incentive for income shifting
across individuals subject to different individual
income tax brackets).
Abstract
Most developed countries impose some form of
This article briefly describes features of real-
taxation of intergenerational transfers; the
life estate and inheritance taxes, economic
exceptions are Canada, Australia and New Zealand.
arguments for and against these types of taxa-
European countries usually impose inheritance
tion and empirical evidence on economic dis-
taxes. See Gale and Slemrod ( )
tortions associated with such instruments.
for more details.
Keywords
Bequests; Capital gains and losses; Charitable
contributions; Estate taxation; Gift taxation; Estate Taxation in the United States
Inheritance taxation; Progressive and regressive
taxation; Redistribution of income and wealth; In the United States, estate and gift taxes are
Tax avoidance; Taxation of income; Wealth ‘integrated’, that is, gifts over the lifetime influence
accumulation computation of the estate tax burden at death. On
top of federal taxation, many states impose their
own taxes (in some cases inheritance rather than
JEL Classifications estate), although since the 1970s most states have
H2 changed their taxes to only ‘soak up’ federal credit
for state taxation without imposing any incremental
Taxes imposed on intergenerational transfers are tax liability for those who are subject to the federal
among the oldest types of taxation, apparently tax. The modem federal estate tax was introduced in
dating back at least to the Roman Empire 1916, although many states imposed their own
(Pechman, ). There is substantial variation in their taxes before that and the federal government made
design in actual tax systems. The tax may be two earlier attempts to tax estates (during the Civil
imposed on the donor or the donee side: it can War and the Spanish-American War). The structure
apply either to the total estate (the total value of of estate taxation changed often before the Second
assets left by the decedent) or it can apply World War, when the top marginal tax rates hit 77
separately to transfers received by each beneficiary. per cent. Marginal tax rates were not reduced until
This distinction matters when there are multiple the early 1980s, when the top rate was cut to 55 per
beneficiaries and the tax is not simply
cent. Further reductions are taking place as a part of These are countered by the following:
the phase-out of estate tax initiated in 2001 that is
supposed to culminate in a repeal in 2010. The • Distortions introduced by estate taxation.
repeal is a part of the set of provision that sunset in • Theoretical arguments for zero capital taxation
2011, and hence the future of this tax is uncertain at in the long run (recently challenged in the
the time of this writing. The US estate tax has context of the estate tax by Farhi and Weming,
)•
always been characterized by a large tax exemption.
• Florizontal inequity due to unequal treatment of
At the peak in 1976, slightly over seven per cent of
‘savers’ and ‘spenders’ (see for example
adult deaths corresponded to taxable estates, but,
McCaffery, ).
other than during the period of the growth in the
• Easy tax avoidance.
reach of the tax in the 1960s and 1970s induced by
• Gift externality (providing an argument for
‘bracket creep’ (brackets not indexed for inflation),
subsidizing transfers).
only two per cent or less of all estates were subject
to the tax. Revenue collected by this tax has always A broader overview of the normative issues can
been relatively small, constituting one to two per be found in Gale and Slemrod ( ) and
cent of total federal revenue after the Second World Kaplow ( ).
War.

Economic Distortions

Arguments for and Against Estate Among the types of economic distortions often
and Inheritance Taxation discussed in this context are effects on saving,
investment and labour supply, tax avoidance and
A number of arguments are often given in favour damage that is potentially done to small (family)
of this type of taxation: • firms when the owner dies (see Brunetti, , for
weakly supporting evidence that survival of small
businesses is affected by the presence of this tax;
• Administrative convenience - taxation occurs at
note, though, that small firms already enjoy sig-
the time when assets have to be valued anyway,
nificant preferences in the US tax code). A related
thereby reducing the burden of compliance
argument involves forcing taxpayers to pursue
relative to other forms of wealth taxation.
‘deathbed’ planning and implications of the tax for
• Presumed lack of distortions if bequests are
‘widows and orphans’ (see Kopczuk, ). Because of
mostly ‘accidental’, that is, when taxpayers save
the presence of a deduction for charitable
for their own lifetime consumption rather than
contributions in the United States, an important
for bequests (see Kopczuk, , for a critique of this
topic is the effect of the estate tax on charitable
argument).
contributions. Some of the more important
• Redistribution (although, Kaplow, suggests that
empirical findings regarding US estate tax are
income taxation may be sufficient for
discussed in what follows.
redistribution).
Estate tax avoidance is thought to be very easy.
• Backstop to avoidance of income taxes.
Cooper ( ) suggested that a motivated tax
• Providing equality of opportunities and breaking
planner could easily reduce tax liability very sig-
down concentration of wealth.
nificantly, if not altogether. Others have challenged
• ‘Carnegie effect’ - inherited wealth is a ‘bad’
this view: for example, Schmalbeck ( ) argues that
because it makes children unproductive mem-
most avoidance strategies
bers of society (see Holtz-Eakin, Joulfaian and
involve losing control over assets. There is some
Rosen, , for supporting empirical
evidence in support of both views. Anecdotal
evidence).
evidence of widespread estate tax avoidance is
• Providing incentives for charity.
easy to obtain, and the existence of a large estate tax are unrealized capital gains that would escape
planning industry is a prima facie evidence that a lot taxation at death due to step-up provisions (capital
of effort goes into such planning. At the same time, gains unrealized at the time of death are not subject
it has been established that some simple tax to the capital gains tax, and the base for the
avoidance strategies are not pursued enough from recipient is stepped up to the current value of the
the tax minimization point of view. McGarry ( ) and asset). Auten and Joulfaian ( ) find that
Poterba ( ) show that lower estate tax rates reduce capital gains realiza-
taxpayers do not take frill advantage of annual gift tions, and thus exacerbate the lock-in effect. The
tax exemption (annual gifts of less than $11,000 per estate tax constitutes a backstop to this type of
donee are exempt from taxation). Kopczuk ( ) avoidance and a repeal of the tax would require a
shows that significant adjust modification of the step-up rale. Bemheim ( )
ments take place following the onset of a terminal questioned whether the estate tax raises any net
illness, thereby revealing that not enough planning revenue once its interaction with other taxes is taken
took place earlier in life. Kopczuk and Slemrod ( into account.
) argue that the widespread reliance The effect of estate taxes on charitable contri-
by married decedents on the unlimited marital butions is theoretically ambiguous due to offsetting
deduction implies that taxpayers do not take full income and substitution effects. Most studies find
advantage of tax savings from splitting an estate. that higher marginal estate tax rates stimulate
This is so despite the existence of trust instruments charitable giving, but the magnitude of the overall
that allow for separating tax planning from other effect, accounting for both price and wealth effects,
considerations such as taking care of the surviving remains controversial: Joulfaian ( )
spouse. On the other hand, while gifts do not seem provides a recent overview of the empirical
to be fully utilized as a tax-planning device, they are literature.
nevertheless responsive to tax considerations, as Other than dealing with tax avoidance (the issue
demonstrated by Bemheim, Lemke and Scholz ( that may be better handled by fixing the income
) and tax), the strongest arguments in favour of the tax are
Joulfaian ( ). based on its role in redistribution, breaking up
A number of papers have focused on estimating concentration of wealth and providing equality of
the responsiveness of estates to tax rates. Kopczuk opportunities. Kopczuk and Saez ( ) use
and Slemrod ( ), Holtz-Eakin and historical estate tax return data to pro
Marples ( ) and Joulfaian ( ) all found vide estimates of wealth concentration over the
small but positive elasticities implying that higher course of the 20th century, and discuss the role that
marginal tax rates lead to lower estate values. the estate tax might have played in shaping trends in
Kopczuk and Slemrod ( ) and Joulfaian concentration. Piketty and Saez ( )
( ) rely on estate tax data and therefore cannot document the contribution of the estate tax to
distinguish between tax avoidance and the effect on overall progressivity. Understanding how estate
wealth accumulation. Holtz-Eakin and Marples ( taxation influences the distribution of wealth should
) use actual wealth, but their results be the top priority for anyone interested in an honest
are based on a relatively low-wealth sample and assessment of its value as a policy instrument.
hence are hard to generalize from. Due to the nature
of estate taxation, these studies are based on cross-
section, repeated cross-section or time series, and See Also
hence the econometric assumptions that underlie
them are strong. ► Bequests and the Life Cycle Model
The estate tax is a part of the tax code, and ► Capital Gains Taxation
considering it in isolation is not appropriate. Poterba ► Excess Burden of Taxation
and Weisbenner ( ) find that over ► Inheritance and Bequests
50 per cent of the value of estates over $ 10 million
 Kopczuk, W., and E. Saez. 2004. Top wealth shares in the
United States: Evidence from estate tax returns. National
Tax Journal 57: 445-488.
Kopczuk, W. and Slemrod, J. 2001. The impact of the estate
tax on the wealth accumulation and avoidance behavior
of donors. In Gale, Hines and Slemrod (2001).
Kopczuk, W., and J. Slemrod. 2003. Tax consequences on
wealth accumulation and transfers of the rich. In Death
Bibliography and dollars: The role of gifts and bequests in America,
ed. A.H. Munnell and A. Sunden. Washingon, DC:
Brookings Institution Press.
Auten, G., and D. Joulfaian. 2001. Bequest taxes and capital
McCaffery, E. 1994. The uneasy case for wealth transfer
gains realizations. Journal of Public Economics 81:213-
taxation. Yale Law Journal 104: 283-365.
229.
McGarry, K. 1999. Inter vivos transfers and intended
Bemheim, B.D. 1987. Does the estate tax raise revenue? In
bequests. Journal of Public Economics 73: 321-351.
Tax policy and the economy, vol. 1, ed. L.H. Summers.
Pechman, J. 1987. Inheritance taxes. In The newpalgrave: A
Chicago: NBER, Cambridge, MA: MTT Press.
dictionary of economics, ed. J. Eatwell, M. Milgate, and
Bemheim, B.D., R. Lemke, and J.K. Scholz. 2004. Do estate
P. Newman, Vol. 2. London: Macmillan.
and gift taxes affect the timing of private transfers?
Piketty, T., and E. Saez. 2007. How progressive is the U.S.
Journal of Public Economics 88: 2617-2634.
federal tax system? An international and historical
Brunetti, M. 2006. The estate tax and the demise of the family
perspective. Journal of Economic Perspectives 21(1): 3-
business. Journal of Public Economics 90: 1975-1993.
24.
Cooper, G. 1979. A voluntary tax? New perspectives on
Poterba, J.M. 2001. Estate and gift taxes and incentives for
sophisticated tax avoidance. Washington, DC: Brookings
inter vivos giving in the US. Journal of Public Eco-
Institution Press.
nomics 79: 237-264.
Farhi, E., and I. Weming. 2007. Progressive estate taxation.
Poterba, J.M. and S. Weisbenner 2001. The distributional
Mimeo: MIT Department of Economics.
burden of taxing estates and unrealized capital gains at
Gale, W.G. and J. Slemrod 2001. Rethinking the estate and death. In eds. Gale, Hines and Slemrod.
gift taxes: Overview. In eds. Gale, Hines and Slemrod. Schmalbeck, R. 2001. Avoiding federal wealth transfer taxes.
Gale, W.G., J.R. Hines Jr., and J. Slemrod, eds. 2001. In eds. Gale, Hines and Slemrod.
Rethinking estate and gift taxation. Washington, DC:
Brookings Institution Press.
Holtz-Eakin, D., and D. Marples. 2001. Distortion costs of
taxing wealth accumulation: Income versus estate taxes.
Working Paper No. 8261. Cambridge, MA: NBER.
Holtz-Eakin, D., D. Joulfaian, and H.S. Rosen. 1993. The Estimation
Carnegie conjecture: Some empirical evidence. Quarterly
Journal of Economics 108: 413-435. Marc Nerlove and Francis X. Diebold
Joulfaian, D. 2004. Gift taxes and lifetime transfers: Time
series evidence. Journal of Public Economics 88: 1917-
1929.
Joulfaian, D. 2005. Estate taxes and charitable bequests:
Evidence from two tax regimes. Working Paper No. 92. Point estimation concerns making inferences about
Office of Tax Policy Analysis, US Department of the
Treasury.
a quantity that is unknown but about which some
Joulfaian, D. 2006. The behavioral response of wealth information is available, e.g., a fixed quantity 6 for
accumulation to estate taxation: Time series evidence. which we have n imperfect measurements .Vi,..
National Tax Journal 59: 253-268. „ x n ) The theory of estimation deals with how
Kaplow, L. 2001. A framework for assessing estate and gift
taxation. In eds. Gale, Hines and Slemrod. best to use the information (combine the values
Kopczuk, W. 2003. The trick is to live: is the estate tax social x lt.. , , x n ) to obtain a single number, estimate,
security for the rich? Journal of Political Economy 111: for 6 , say 6 . Interval estimation does not reduce
1318-1341.
the available information to a single number and is
Kopczuk, W. 2007. Bequest and tax planning: Evidence from
estate tax returns. Quarterly Journal of Economics a special case of hypothesis testing. This entry deals
122(4). only with point estimation.
Justification for any particular way of combining
the available information can be given only in
 012
<L>1 022

Note that 9 i is a linear function of x which

depends upon the parameters of the originally
assumed joint distribution; this function is called the
r e g r e s s i o n o f y onx.
r e g r e s s i o n a n a l y s i s deals with
the general problem of estimating such functions
which characterize conditional distributions, usually
those derived from normal distributions.
A standard method, and the one most common in
econometrics, for obtaining estimators is the method
of m a x i m u m l i k e l i h o o d .
Consideration of this method provides a good
introduction to alternative principles of estimation.
Let the data x = (xlv.., x„)' be fixed and regard p ( x
\value6 ) ofas 9a function
= 9of 9(xi,..
it is. then
p „ )called the
which
maximizesp ( x \ 9 ) ,
if it is exists and is unique, is called the maximum-
likelihood estimator, or estimate (MLE). (For a gen-
eral survey, see Norden -1973, or Lehmann
.) The MLE of a continuous function g(0) isg(0
) w h e r e 0 is the MLE of 9 . Other desirable
properties
of the MLE are asymptotic as n —><oo. EUnder ) = 1reg-
for
ularity
all E conditions:
> 0. (1) The
(2) MLE
The is
MLE'weakly is
a s y m p t o t i c a l l y n o r m a l ,
ni.e.y die
9 ndistribution
9 j , of 9 appropriately
tends to the normalnormalized,
distribution,\
with
1
mean O and variance-covariance matrix [7(0)1
where
1 ( 9 ) = -£[a2logp(jr|0)/a090'].

1(0) is called the information matrix and shows

the information a single observation contains about
the parameter 0. (3) The MLE is a s y m p t o t -
i c a l l y e f f i c i e n t in the sense that if
0* is any other estimator such that Vn 0„ o ' j
tends in distribution to the normal with mean zero
and variance- covariance matrix Y l ( 9 ) . the
matrix E(0) - 7_1(0)1 is positive semi-definite. For
example, in the case of one parameter this means
that no other asymptotically normal estimator has, dominates it in the sense that the latter leads to
as n —> oo, a smaller variance than the MLE. The estimates having uniformly lower expected loss
conditions for asymptotic normality do ensure, with irrespective of 6 . Estimators satisfying this crite-
probability tending to one, a solution to the rion are called a d m i s s i b l e .
l i k e l i h o o d e q u a t i o n d log In the sampling theoretic approach, emphasis is
p(x|0)/ d 6 = 0, which is consistent and placed on finding estimators which have desirable
asymptotically normal and efficient. The problem is properties in terms of relative frequencies in
that there may be more than one solution, but only hypothetically repeated samples. For example, we
one can be the MLE. When the number of might require that the distribution of an estimator be
parameters to be estimated (elements of the vector centred on the true parameter value, i.e., E ( 6 —
9 ) tends to infinity with n , the MLE’s for 6 ) = 0 . S u c h e s t i m a t o r s
some may exist but may not be consistent (Neyman a r e c a l l e d u n b i a s e d . Among
and Scott ). all unbiased estimators we presumably would prefer
Solutions to the likelihood equation are not the one yielding estimates with a distribution
only estimators which may be consistent, asymp- concentrated about the mean. Such minimum
totically normal and efficient, but comparison with variance unbiased estimators (MVU) play a key role
the MLE, assuming correct specification of in the theory of estimation. Specifically, the famous
p ( x \ 9 ) , is facilitated by the fact that all have Rao-Blackwell Theorem states that if an unbiased
a normal distribution as n —> oo. For fixed n , estimator 6 is a function of a complete sufficient
the distributions of different estimators are difficult statistic for 6 then it is MVU. A statistic, say T ,
to determine and may, indeed, be quite different. is said to be sufficient for 6 if the conditional
Moreover, when the distributions underlying the distribution of the observations given T is
data are misspeeified, the MLE’s generally no independent of 6 . Completeness is also a property
longer have these optimal properties (White ; of the distribution functions for the observations; (a
Gourieroux et al. ), although other, weaker, family P of distributions (of 7) indexed by a
optimality properties remain. Apart from parameter 9 is said to be complete if there is no
specification problems, however, the likelihood ‘unbiased estimator of zero’ other than <f> (x) = 0.)
function provides an important and useful summary Note that choosing an estimator so as to minimize
of the data, and point estimates and hypothesis the expected squared error of the estimate it yields
testing procedures based on it are often justified in is equivalent to minimizing the unweighted sum of
this way (Fisher ; Barnard et al. ; Edwards ). the variance and the squared bias. From a decision
The ‘accuracy’ of an estimator 6 of a scalar theoretic point of view, it may be better to accept an
parameter 9 may be measured (defined) in a vari- estimator with a small bias if such an estimator has
ety of ways: by its expected squared or absolute a smaller risk.
error, relative error, or by Pr{| 0 0 \ < cl) In the sampling theoretic approach, emphasis is
for given to the distribution of estimates yielded by a
some a. Any choice is arbitrary; for convenience specified estimator. The likelihood approach, on the
expected squared error is the usual choice. Some other hand, emphasizes the distribution of the
justification for a particular choice may be provided observations, given a parametrically specified dis-
in terms of a l o s s f u n c t i o n L ( 6 , tribution, under alternative values of these param-
6 ) o r t h e e x p e c t e d l o s s eters. Concern is primarily with the maximum value
E L ( 6 , 6 ) o r r i s k of the likelihood function with respect to the
f u n c t i o n of s t a t i s t i c a l parameters and its curvature near the point at which
d e c i s i o n t h e o r y . Choice of the global maximum occurs, but some approaches
estimators may be justified in terms of the extent to stress the relevance of the likelihood function in
which the choice minimizes risk or some aspect other neighbourhoods (Barnard et al. ; Edwards ).
thereof. Both the s a m p l i n g t h e o i y The Bayesian approach carries concern with the
and B a y e s i a n approaches to estimation can entire
be interpreted in these terms.
likelihood function further: estimation and inference data and the uncertainty with respect to 9 are taken
are based on the posterior density of the unknown into account: 9 p o s t e r i o r distribution of
parameters of the distribution generating the 9 .
observations. This posterior density is proportional As is the expected value of 9 based on the n
to the likelihood function multiplied by a prior - x oo, it may be shown that the influence of the
density of the parameters, i.e., a weighted average of prior distribution diminishes until in the limit it
likelihoods for different parameter values where the disappears; then, under general circumstances, the
weights are determined by prior (subjective) behefs. minimization of mean square error in the Bayesian
(See BAYESIAN INFERENCE.) framework yields the MLE. The principal difficulty
In the Bayesian approach, both observations and in the Bayesian approach is the choice of a
parameters are taken to be stochastic. Let p ( x j , reasonable prior for 9 , p ( 9 ) . (For a
9 ) be the joint probability density function for an comprehensive discussion, see Zellner .)
observation vector, x , and a parameter vector 9 ; Instead of minimizing the expected loss, one
then p ( x h 9 ) = p ( x \ 9 ) p ( 0 ) = may minimize the maximum loss. Estimators which
p ( 0 \ x ) p ( x ) , where p ( t \ x \ ) do are called m i n i m a x ; the theory is devel-
denotes the conditional density of c given i ] oped in Wald ( ).
andp ( ' Q denotes the marginal density of C . There are three general approaches to choice of
Thus p ( 0 \ x ) i s p r o p o r t i o n a l a prior in Bayesian analysis. First, the prior may be
t o p ( 9 ) p ( x \ 0 ) by the factor obtained empirically (Maritz ). For example,
suppose that the problem is to estimate the percent-
P(x) = Jp(0)p(x\0)d(). age of defective items in a particular batch. Assum-
ing such batches were produced in the past suggests
p ( 6 \ x ) is the p o s t e r i o r distribution a prior based on the proportion of defective items
observed in previous batches. This kind of
of0 after having observed the data; p ( 9 ) is the
‘updating’ forms the basis for the celebrated
p r i o r distribution of 9 and p ( x \ 9 ) is
Kalman filter. Second, the prior may be viewed as
the l i k e l i h o o d . Alternatively, consider
representing a ‘rational degree of belieF (Jeffreys ).
the weighted average risk (as defined
What represents a ‘rational degree’ is not specified,
above):
but the idea leads directly to the use of priors that
represent knowing little or nothing, so-called
J E L ( 9 , n o n - i n f o r m a t i v e p r i o r s .
However, total ignorance has proved difficult to
capture in many cases. A third approach is that the
9 ^ w ( 9 ) d 9 , with weights
prior represents a subj ective degree of belief
(Savage ; Raiffa and
w ( 9 ) such that Schlaifer ). But, of whom? and how arrived at?
Minimax-estimation theory offers one possible
approach for it leads to the minimum mean-square-
vt’(0)d0 = 1.
error Bayes estimator, i.e., die mean of the posterior
WhenZ,(0, 0) = (0 - 0)’, the estimator which distribution of the parameters, when the prior is
minimizes such a weighted average risk is least favourable in die sense of making expected
loss the largest for whatever class of priors is
9(x) = J9w(9)p(9w(9)p(x\9) d9jw(9)p(x\9) xd 9. chosen.
Related to this problem is the more general
If the w e i g h t s w { 9 ) are taken to be question of r o b u s t e s t i m a t i o n .
the values of the marginal density p ( 0 ) , the In order to make sense of any data, it is necessary to
mean of the posterior Bayes distribution minimizes assume something. For example, the justification
the expected squared error of the estimates when for using the sample mean to estimate the mean of
case, the sample mean is not only asymptotically regression model is y = f { X , f t , 6 ) or
efficient but uniformly MVU, minimax, admissible, more frequently y = f { X , p ) + e.
etc. But suppose that the distribution is Cauchy Leastsquares or maximum-likelihood estimates may
(having roughly the same shape as the normal but still be obtained, but the first-order conditions for a
with very thick tails); then, the sample mean has the minimum or a maximum will generally be non-
same distribution as any individual observation, its linear, frequently ruling out analytic expressions for
accuracy does not improve with n and it is not even the estimates. Consider the problem of minimizing
a consistent estimator. At least, within the class of the sum of squared residuals, ( y f ( X ,
distributions which include the Cauchy, the p ) ) ’ (y - f [ x , p ) ) ' with respect to p
properties of the sample mean, and similarly (non-linear least squares); numerical methods for
ordinary least squares, are quite sensitive to the true solving this problem are of the general form: /( ,,
nature of the underlying distribution of the data. We = /J, — s , P , V,-, where /i, = the value of the
say that such estimators are not r o b u s t . estimator parameter vector at iteration i , s , =
Complete discussions are contained in Huber ( ) and the step size at iteration i , I f = the direction
Hampel et al. ( ). matrix at iteration i , and V, = the gradient of the
To conclude, three estimation problems of spe- objective function at iteration i . The matrix
cial concern in economics are discussed: (1) clas- P „ determines the direction in which the
sical linear regression; (2) non-linear regression, and parameter vector is changed at each iteration; it is
(3) estimation of simultaneous structural equations. generally taken to be the Hessian matrix evaluated
The classical theory of linear regression deals at the current value of the parameter vector or some
with the following problem: Let Abe an n k approximation to it. Let g((3) be the objective
matrix of nonstochastic observations ( n for each function; then
variable (xj,..., x*), P be a k 1 vector of
parameters (one of which becomes an intercept if pi=[d2g(p)/dpdpt\p = pi}-1
x t = 1, say), and y be an n 1 vector of
is the Hessian. A justification for this choice is
stochastic variables such that y - x p C ~ /V (0,
obtained from the second-order (quadratic)
IT). The o r d i n a r y l e a s t -
approximation to the objective function in the
s q u a r e s e s t i m a t e s (OLS), [ 1
neighborhood of the current estimate. For a detailed
( X ' X ) 'Ay
treatment of this problem as well as constrained
are
non-linear estimation see Quandt ( ). The
MLE and MVU when X = a2 When this is not statistical properties of non-linear
true, although the OLS estimates are unbiased and estimators are discussed by Amemiya ( ).
consistent, they are not asymptotically efficient or Economic theory teaches us that the values of
minimum variance. The g e n e r a l i z e d many economic variables are often determined
l e a s t s q u a r e s e s t i m a t e s simultaneously by the joint operation of several
(GLS), (3 (A V1 X ) X V are efficient, but of economic relationships, for example, supply and
course X , and therefore X ’ is generally demand determine price and quantity. This leads to
unknown. Often, however, a consistent estimate of a representation in terms of a system of simul-
X is available, leading X o f e a s i b l e , taneous structural equations (simultaneous equa-
o x e s t i m a t e d , GLS estimates. tions model, or SEM). The problem of how to
Many problems in economics lead to non-linear estimate the parameters of an SEM has occupied a
relationships. Linear regression may be a good central place in econometrics since Haavelmo (). A
(local) approximation to such relationships if the linear SEM is given by, B y , Tx, = ut
data do not vary too widely. Moreover, many non- t = 1,..., T where B is G x G , r is G x
linear relationships may be transformed into linear K , y t is G x l,x,isA x l,and«,isG x
ones (e.g., the Cobb-Douglas production function). 1.u^isassumed to be zero mean with variance-
Often, however, the data are sufficiently variable to covariance matrix X often normally distributed,
make a linear relationship a poor approximation and
identically for each t . Thus the u t are serially applying OLS to each equation of the RF; such
independent. It is also assumed that plim estimates are ML. If the restrictions are just suffi-
Z \ x i t U j t / T = 0 all i = 1,..K and j cient to identify the parameters of each equation,
=1,.. . , G and plim X X \ T is a positive the resulting estimates d i e f u l l -
definite matrix, where X = (xb..x T ) ' . If B is i n f o r m a t i o n m a x i m u m -
non-singular this system of s t r u c t u r a l l i k e l i h o o d (FIML) estimates. When an
e q u a t i o n s , as they are called, may be equation is over-identified, in the sense that there
solved for the so called ‘endogenous’ variables,^, in are more than enough restrictions to identify it,
terms of the ‘exogenous’ variables x t \ y = t w o - s t a g e l e a s t s q u a r e s
n x „ + v, w h e r e T l = v t (2SLS) or l i m i t e d - i n f o r m a t i o n
1
= B wt, so m a x i m u m l i k e l i h o o d (LEVEL)
that E v , = 0 ;and E v f i , = B ~ l Z may be applied equation by equation to each
( B ')' = O. I t i s , i n g e n e r a l , equation which is identified. Provided the model is
n o t p o s s i b l e t o correctly specified, such estimates are consistent
d e t e r m i n e B , E and Z from and asymptotically unbiased but not asymptotically
knowledge of the r e d u c e d f o r m efficient, because some restrictions are neglected in
(R F ) parameters T l and Q there are, in the estimation of some parameters. An analog of
principle, many structural systems compatible with 2SLS, t h r e e - s t a g e l e a s t
the same RF. Given sufficient restrictions on the s q u a r e s (3SLS), yields estimates which are
asymptotically equivalent to FIML and therefore
structural system, however, knowledge of the RF
efficient Amemiya ( ) extends all of these
parameters can be used, together with the assumed
methods
restrictions, to determine the structural parameters.
to non-linear systems. Sargan ( ) discusses
The SEM is then said to be i d e n t i f i e d .
identification in non-linear systems.
For l i n e a r structural equations with
n o r m a l l y d i s t r i b u t e d
disturbances, the conditions for* identification may See Also
be derived from the condition that for any system
► iayesian 1 erence
B * y , + r*xt = u * f o r w h i c h
► ^east Squares
u t and u t , are identically distributed, where B
► ood
= F B , Y * = F I and i f = F u t ,
► ; e sion and Correlation Analysis
then F = f l is implied by the restrictions,
where / is any positive scalar (Hsiao ).
Methods of estimating the parameters of SEMs Bibliography
may be put into two categories: (1) l i m i t e d -
i n f o r m a t i o n methods which estimate Amemiya, T. 1983. Nonlinear regression models. In Hand-
book of econometrics, vol. 1, ed. Z. Griliches and M.- D.
parameters of a subset of the equations, usually a Intriligator. Amsterdam: North-Holland.
subset consisting of a single equation, taking into Barnard, G.A., G.M. Jenkins, and C.B. Winsten. 1962.
account only the identifying restrictions on the Likelihood inference and time series (with discussion).
Journal of the Roval Statistical Society, Series A 125:
parameters of equations in that subset, and (2)
321-372.’
f u l l - i n f o r m a t i o n methods which Cox, D.R., and D.V. Hinkley. 1974. Theoretical statistics.
estimate all of the identifiable parameters in the London: Chapman & Hall.
system simultaneously and therefore take into Cramer, H. 1946. Mathematical methods of statistics.
Princeton: Princeton University Press.
account all identifying restrictions. Full- or limited-
Edwards, A.W.F. 1972. Likelihood. Cambridge: Cambridge
information methods may be based on either least- University Press.
squares or maximum-likelihood principles. ML- Fisher, R.J. 1925. Theory of statistical estimation. Pro-
based methods yield estimates which are invariant ceedings of the Cambridge Philosophical Society 22:
700-725.
according to the normalization rule (choice of j ) .
For systems or single equations in SEMs for
Gourieroux, C., A. Monfort, and A. Trognon. 1984. Pseudo particular) has developed in which formal ana-
maximum likelihood methods: Theory. lytical tools of economic theory are mobilized in
Econometrica 52: 681-700.
Haavelmo, T. 1944. The probability approach in econo-
order to relate basic principles of social ethics to
metrics. Econometrica 12(Supplement): 1-115. precise criteria for the evaluation of social states
Hampel, F.R., E.M. Ronchetti, P.J. Rousseeuw, and W.A. of affairs. The efficacy of arguments based on
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Lehmann, E.L. 1983. The theory of point estimation. New
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Maritz, J.S. 1970. Empirical bayes analysis. London: Keywords
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Neyman, J., and E.L. Scott. 1948. Consistent estimates based
Arrow, K.; Axiomatic bargaining; Axiomatic
on partially consistent observations. Econometrica 16: 1- theory of indices; Bargaining; Bergson-
32. Samuelson social welfare function; Borda rule;
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estimation. Review of the International Institute of
formation; Competitive equilibrium;
Statistics 40: 329-354; 41: 39-58.
Quandt, R.E. 1983. Computational problems and methods. In Consequentialism; Consumer sovereignty;
Handbook of econometrics, vol. 1, ed. Z. Griliches and Cooperative games; Corporate social responsi-
M. Intriligator, 699-764. Amsterdam: North-Holland bility; Cost-benefit analysis; Cost-surplus
Raiffa, H., and R. Schlaifer. 1961 .Applied statistical deci-
sharing; Dominance criteria; Dworkin, R.;
sion theory. Boston: Harvard Business School.
Rao, C.R. 1973. Linear statistical inference and its appli- Egalitarian equivalence; Egalitarianism; Equality
cations, 2nd ed. New York: Wiley. of capabilities; Equality of opportunity; Equality
Sargan, J.D. 1980. Identification and lack of identification. of resources; Ethics and economics; Fair
Paper presented to 4th World Congress of the allocation; Gini coefficient; Harsanyi, J.;
Econometric Society, 28 August-2 September
1980, Aix-en- Provence. Hypothetical insurance (Dworkin); Identity;
Savage, L.J. 1954. The foundations of statistics. New Impartial observer (J. Harsanyi); Impartiality;
York: Wiley. Impossibility theorem; Income distribution;
Wald, A. 1950. Statistical decision functions. New York: Indexing problem; Inequality (measurement);
Wiley.
White, H. 1982. Maximum-likelihood estimation of Inequality aversion; Interest aggregation;
mis- specified models. Econometrica 50: 1 25. Interpersonal comparisons of utility;
Zellner, A. 1971. An introduction to Bayesian inference in Intertemporal preferences; Judgements vs
econometrics. New York: Wiley. interests; Liberal paradoxes; Libertarianism;
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Maximin principle; Multidimensional inequality;
Nash, J.; New Welfare Economics; Normative
Ethics and Economics
economics; Objective advantage; Ordinal non-
Marc Fleurbaey comparable (ONC) preferences; Original
position (Rawls); Other- regarding preferences;
Pareto principle; Positive economics; Potential
Pareto improvements; Poverty measurement;
Preferences; Rawls, J.; Responsibility; Rights;
Abstract
Risk aversion; Samuelson, P.; Sen, A.; Shapley,
In recent decades, an important corpus of the-
L.; Social choice; Social contract; Social justice;
ories in normative economics (social chit ice
Social welfare functions; Subjective utility;
theory, the theory of fair allocation, and
inequality and poverty measurement in
 Tastes; Utility functions; Utility possibility sets; given concepts or the relations between concepts. In
Value judgements; Veil of ignorance (Rawls); such work the economist can largely put his own
Well-being value judgements aside. As Samuelson ( , p.
220) aptly wrote, ‘it is a legitimate
exercise of economic analysis to examine the con-
JEL Classifications sequences of various value judgments, whether or
D6; J63 not they are shared by the theorist’. The role of
ethical judgements in economics has received
Economics, as a discipline connected to policy valuable scrutiny in Sen ( ), Hausman and
decisions, has always been involved in the analysis McPherson ( ) and Mongin ( ).
of social objectives and of their underlying ethical Wariness about value judgements has often led
values. economists to shun issues of distribution and to
More recently, an important corpus of theories focus on efficiency as encapsulated in the Pareto
has been developed in which the formal analytical principle. In particular it is tempting to think that a
tools of economic theory are mobilized in order to Pareto improvement (that is, a new situation that
relate basic principles of social ethics to precise everyone in the population prefers to the status quo)
criteria for the evaluation of social states of affairs. cannot be questioned since, by definition, everyone
This corpus is not yet fully unified, and is still would approve it. But focusing on Pareto
replete with debates and open questions, but the improvements does not protect from controversy.
outlook of the field is rapidly evolving. The most pressing reason is that there are important
Economics is also connected to individual ethical values, especially regarding the distribution,
ethics, as economic decisions by households and which are not captured by the Pareto principle. As a
firms sometimes involve issues of morality and consequence, there may exist a non-Pareto
responsibility toward partners and co-traders. improving reform that is much better for social
Experimental economics has revealed that altruism, welfare than any Pareto improvement. In particular,
fairness and reciprocity considerations are a key in the presence of large inequalities, focusing on
component of strategic interactions between Pareto improvements implicitly amounts to
individuals. Ethical issues for firms relate to ‘busi- condoning the status quo, as noted in Arrow ( ). A
ness ethics’ and ‘corporate social responsibility’. second reason is that people’s
immediate preferences, which are relied upon in
applications of the Pareto principle, may not cor-
Normative Versus Positive Economics rectly represent people’s interests. The difficult
issue of defining individual interests is examined
‘Positive economics’ seeks to understand and
below.
explain economic mechanisms, whereas ‘normative
The Pareto criterion, on the other hand, is very
economics’ deals with the assessment of policies or
restrictive because it applies only when unanimity
states of affairs. While this distinction is useful, one
of preference is obtained. New Welfare Economics
must not be misled into believing that a clear-cut
(surveyed in Chipman and Moore ) and cost-benefit
separation is obtained in practice. Positive
analysis have developed less restrictive criteria
economics is naturally inclined to focus on ethically
dealing with potential Pareto improvements (that is,
important social and economic issues. Moreover,
reforms that would be Pareto improving if certain
forecasting the consequences of various policies
transfers from the gainers to the losers were
belongs to its realm and, even though this is in
performed in addition, even though they are not
principle a purely positive task, it is practically
actually implemented). Such criteria have been
relevant when it is associated with normative
condemned by many authors, from Arrow ( ) to
conclusions. Meanwhile, normative economics
Blackorby and
contains many results which merely consist in a
Donaldson ( ), for being inconsistent (they
logical analysis of the content of
can produce cyclic social preferences), and also
unethical because they may approve reforms that criteria (that is, criteria ascertaining that a distri-
seriously hurt the worst-off sub-populations bution dominates another for a family of indices),
(because the transfers that could compensate the and, more recently, statistical tests to be performed
losers may not be actually made). More sophisti- on samples. Surveys of this field can be found in
cated versions of cost-benefit analysis (Dreze and Atkinson and Bourguignon ( )
Stem ) rely on consistent and distribution- sensitive and Silber ( ). The fourth - the theory of
social welfare functions. axiomatic bargaining and cooperative games, ini-
tiated by Nash ( ) and Shapley
( ) - analyses how to find a fair compromise
The Branches of Normative Economics in utility possibility sets, under different assump-
tions about coalition formation. A synthesis on
Four main branches of normative economics can be axiomatic bargaining is available in Thomson ().
distinguished. The first - the theory of social choice, Three other branches must be mentioned, which
sparked off by Arrow ( ) with a pro can be viewed perhaps as sub-branches of the main
vocative impossibility theorem - examines the ones. Connected to social choice theory, Harsanyi’s
properties of functions that define an ordering of a impartial observer argument (1953) and aggregation
set of alternatives (policies, social states, candi- theorem (1955), offered in defence of utilitarianism,
dates) on the basis of the ordinal non-comparable have generated an important literature and some
(ONC) preferences of the population over these debates (see Broome ; Weymark ; Roemer ). Sen’s (
alternatives. In economics individual ONC pref- ) and Gibbard’s ( ) liberal para
erences, which can be retrieved from observable doxes have also triggered debates about how to
choices, are usually considered the natural infor- formalize rights and incorporate them in the theory
mational basis. However, the theory of social choice of social choice (see in particular Gaertner et al. ;
has been extended (following Sen ) to cover the Arrow et al. , ii, part IV). The theory of axiomatic
possibility of incorporating more information about cost and surplus sharing, which lies somewhere
individual utilities. This theory has achieved a between cooperative games and fair allocation,
thorough understanding of the properties of voting studies the allocation of cost or surplus shares
rules (surveyed in Brams and Fishbum ; Pattanaik ) across individuals not as a function of their
and of the informational requirements about preferences but as a function of their actions
individual utilities of various social welfare (demands or contributions). It is surveyed in (
functions (surveyed in d’Aspremont and Gevers ; ).
Bossert and Weymark ). The second - the theory of The various branches have developed more or
fair allocation, initiated by Kolm ( ) - studies the less independently but, if one puts aside the theory
allocation of resources among individuals with of cooperative games and the theory of cost- surplus
heterogeneous tastes and abilities, in terms of sharing, they can all be formally described as
fairness criteria such as no-envy (no agent should seeking to rank alternatives of various sets Aon the
prefer another’s bundle), lower bounds (for exam- basis of the population’s utility functions U \ , . .
ple, no agent should prefer the equal-split alloca- ., U n , and possibly other personal characteristics
tion), solidarity (for example, no agent should be such as abilities and needs. The theory of social
hurt by an increase in available resources), among choice usually considers only one given set A and in
others (see survey in Moulin and Thomson ). The Arrow’s initial version, retains information only
third - the theory of inequality and poverty about individual ONC preferences; the theory of fair
measurement, originally anchored to the Gini allocation takes the As to be sets of feasible
coefficient and the Lorenz curve - focuses on allocations and usually seeks only to identify a
income distributions and has developed after Kolm subset of optimal allocations in each A on the basis
( ), Atkinson ( ) and Sen ( ) of ONC preferences; the theory of
into an axiomatic theory of indices, dominance
inequality and poverty indices usually takes X to be achievement, and to seek equality of capability sets,
the set of income distributions and focuses on a that is, the sets of functionings that are accessible to
special aspect of distributions instead of a general individuals. Ameson ( ) and Cohen
notion of social welfare, although it sometimes ( ) have also proposed to focus on opportuni
establishes a link between special indices and social ties rather than achievements on the ground that
welfare functions; the theory of axiomatic individuals should be viewed as responsible for
bargaining usually ignores the structure of the sets seizing the opportunities that are offered to them.
X and directly examines the utility possibility sets These recent theories of justice have generated an
{(t/i (x ) , . . , U „ (.r))|„r C X\ . This increased interest in normative economics for the
formal similarity between the various branches is notions of freedom and responsibility (see, for
favourable to cross-fertilizing. One observes that the example, Roemer , and, for surveys, Fleurbaey and
frontiers between these fields, which are largely due Maniquet ; Peragine ; Barbera et al. , ). Among
to the contingent circumstances of their creation, are many other philosophical contributions that have
progressively vanishing, to be replaced by more been influential in normative economics, one must
substantial differences in principles, such as whether also mention Parfit’s ( ) thought-provoking
ONC preferences provide morally sufficient essay on utili
information about individual well-being. tarianism, identity and population issues.
Cross-fertilizing with political philosophy is also
an essential part of the history of the field. Rawls’s (
) theory of justice, borrowing many The Measurement of Individual Well-
features from economics, has had a profound Being
influence in return in at least three ways. It has
With reference to the traditional social welfare
rekindled interest for equality and the maximin
function W ( U b . . . , U „ ) , it is convenient to
principle among economists; it has popularized the
decompose the problem of defining a criterion for
idea that putting individuals behind a ‘veil of
the evaluation of social states into two sub-
ignorance’ concerning their own circumstances, as
problems, namely, the problem of assessing each
in Harsanyi’s impartial observer argument (with
individual situation and the problem of constructing
differences in assumptions and conclusions which
a synthetic measure for the whole population. This
have aroused controversies between these two
decomposition, however, does not imply that the
authors and commentators), is a way to define
former is any less normative than the latter. The
justice; it has also provided an implicit justification
measurement of individual well-being is not just an
of the theory of fair allocation by defining justice in
empirical exercise and raises many ethical issues.
terms of equality of resources (even if by resources
First, in such measurement one must consider
he meant ‘primary goods’, that is, all-purpose goods
whether one should take account of individuals’
rather than ordinary commodities), firmly rejecting
political and social preferences or only of their
interpersonal comparisons of utility across
tastes about their personal situation. It appears that
individuals with incommensurable preferences.
these two kinds of preferences belong to different
Dworkin’s ( ) theory of
levels of social evaluation. Political and social
equality of resources makes a clear reference to the
preferences are relevant in the democratic debate
no-envy criterion and combines it with the veil of
about general principles, while personal tastes
ignorance in a hypothetical insurance market in
belong to the concrete evaluation of social
which individuals can insure against bad personal
situations. Mixing the two levels may yield absurd
characteristics. Social policy should then, according
consequences. In particular, making the allocation
to this theory, mimic the hypothetical insurance
of resources directly depend on the satisfaction of
premiums and indemnities by suitable taxes and
individual political preferences may produce
transfers. Sen’s ( ) theory of capa
grossly unfair distributions, for instance when a
bilities proposes to shift the focus from resources to
functionings, a general notion of individual
simple summation of utilities representing hetero- at most cater to a synthetic measure of his
geneous political preferences induces the altniist to satisfaction.
transfer their resources to the malevolent. As Sen ( More importantly, if individuals are considered
) nicely put it, one must not confuse the responsible for how they transform ordinal satis-
aggregation of ‘judgments’ with the aggregation of faction into numerical utility, then social evaluation
‘interests’. It is worth emphasizing that, concerning can disregard their utility functions and take care of
judgement aggregation, the contribution of their ONC preferences only. The focus of Arrovian
normative economics is not limited to studying social choice and of the theory of fair allocation on
voting procedures with the goal of neutrally ONC preferences instead of utilities can hereby find
aggregating judgements, because it may play an a justification in terms of individual responsibility,
active role in shaping those judgements. Indeed, by in addition to more traditional arguments about the
scrutinizing issues in i n t e r e s t aggregation difficulty to compare subjective utility across
it clarifies the substance of the debates and may help individuals. Similarly, in Sen’s theory of
in the formation of personal j u d g e m e n t s capabilities, the social criterion deals with
on these matters. It may thereby make a useful capability sets and disregards what combinations of
contribution in the deliberation process and the functionings individuals choose in those sets. The
construction of a consensus. normative appreciation of what individuals should
When dealing with the aggregation of ‘inter- be held responsible for (or be left free to handle by
ests’, personal tastes themselves are not necessarily themselves) and what they should not is a difficult
appropriate as a basis for ranking social states, since domain of philosophical debating to which
they may be influenced by unjust social pressures economists are not necessarily well equipped to
and conditioning, or based on mistaken beliefs. It contribute. But economic models are very
may then appear preferable to try to guess what convenient to examine the consequences of various
individual tastes would be if formed in correct choices in this matter and it is instructive to relate
conditions. Practical procedures eliciting such various policy choices to underlying attributions of
authentic preferences have yet to be invented, but responsibility to the target population (see, for
one may observe that ‘safety belt’ policies are example, Roemer ).
commonplace and are usually justified by reference The important divide between welfarist and
to people’s well-considered interests. non-welfarist approaches is largely connected to
A more radical questioning of the reference to this issue. A welfarist approach retains subjective
personal tastes comes with the observation that, utility (interpreted in terms of happiness or in terms
even in absence of conditioning or bad information, of satisfaction) as the ultimate metric of well-being.
those with demanding tastes do not necessarily A non-welfarist approach will typically discount
deserve more resources than those with more subjective utility and take account of objective
modest wishes. Should individuals not assume achievements, resources, opportunities or rights,
responsibility, in some cases, for then- expensive although Sen’s theory, for instance, does retain
tastes’ (Dworkin )? The emergence of principles of utility as one relevant functioning among others.
freedom and responsibility in recent theories of Critiques of welfarism invoke not only the (at least
justice has in fact revealed how important such partial) responsibility of individuals for their
considerations have always been in the selection of subjective utility, but also the idea that there are
relevant dimensions of individual well-being. Even some objective dimensions of achievement which
the standard principle of consumer sovereignty matter independently of their effect on satisfaction.
according to which every individual is the best For instance, a physical disability may justify help
judge of his own interests implies that the social even if the concerned individual has perfectly
criterion will let the allocation of personal resources adapted to his situation in terms of subjective
be managed under the individual’s sole utility. Or granting basic rights and freedoms may
responsibility and will be viewed as so essential to the constitution of a
community of morally
autonomous agents that they should be granted espouse each individual’s preferences, it is then a
uniformly, independently of their potentially utility representation of preferences and one is back
unequal effect on individuals’ various utility func- into the welfarist framework. The alternative is to
tions. More generally, fairness in the allocation of impose a uniform index to all individuals, but this is
resources typically involves non-welfarist concerns. tantamount to adopting a special view of how to
For instance, the axiomatic theory of bargaining, as weight the various goods (or capabilities), that is, a
recalled above, disregards the economic allocations dogmatic or perfectionist definition of the good life.
and focuses exclusively on utility possibility sets. At this point economic analysis is helpful because it
This has counter-intuitive consequences. Consider shows that a non-welfarist approach can nonetheless
problem 1 which consists in deciding with which respect individual preferences. Consider the simple
probability Ann or Bob will win a ten-dollar prize, case of an exchange market with identical prices at
and problem 2 which also consists in deciding the various allocations under consideration. Then,
winning probabilities, except that if Arm wins she on the assumption that individuals are free to
gets ten dollars whereas if Bob wins he only gets choose their consumption in their budget set,
one dollar. Nash’s bargaining solution (which indexing their well-being by the market value of
maximizes the product of utility gains) selects the their consumption is congruent with their
fifty-fifty solution for both problems, whereas it preferences over consumption bundles, although it
would seem more reasonable to give Bob a greater is certainly non-welfarist since across individuals
probability of winning in the second case. See there is no relation between utility and wealth. More
Roemer () for a detailed criticism of welfarism in generally, with each preference ordering one can
axiomatic bargaining. always associate an index function which is
The welfarist-non-welfarist distinction, how- ordinally equivalent to the welfarist measure of
ever, is mainly philosophical and the economist can utility without coinciding with it, as noted in
always reinterpret the utility index U , as an index Roemer ( ). In conclusion,
of capability, opportunity or objective advantage between the pure welfarist approach and the ‘per-
instead of subjective utility, without changing much fectionist’ non-welfarist approach, there is room for
to the formal analysis of normative criteria. What is ‘Paretian’ non-welfarist approaches which respect
more important for economic analysis is whether individual preferences. This distinction can be
the relevant data about individual situations consist formally described as follows. In the problem of
in a numerical index permitting comparisons across ranking alternatives on the basis of the profile
individuals or in ONC preferences only (a third ( U \ , , U „ ) , the welfarist approach relies
possibility, considered in the theory of on the utility values ( U \ ( x ) , . . . ,
multidimensional inequality, is when individual U „ ( x ) ) at each alternative x; the perfectionist
situations are described by vectors of numerical approach ignores individual preferences, imposes an
indices, with no synthetic index or ordering). In the index U and evaluates x in terms of (U (x), . . . ,
first case, one has a kind of ‘formal welfarism’ and U (x)); the ‘Paretian’ non-welfarist approach
the standard framework of social welfare functions retains the ONC preferences represented by
is readily available. In the second case (as well as U \ , . . . , U n and constructs an ordering
the third), one may eventually be able to construct a of alternatives obeying the Pareto principle
comparable index, but such an index is not given a (additional examples are provided below).
priori and its construction must be justified. Another issue for economic analysis is whether
The indexing problem is considered a vexing the social state must be described in terms of
issue for non-welfarist theories of justice such as consequences or in terms of procedures. Most of
Rawls’s (involving an index of primary goods) or normative economics is still largely consequen-
Sen’s (involving an index of capabilities). Indeed, it tialist, but the growing focus on opportunities,
appears that if this index is personalized so as to rights and freedom of choice definitely enlarges the
scope of analysis beyond narrow consequen-
tialism. So far, the studies of rights and freedom
have remained rather abstract, dealing with the veil of ignorance provides a helpful guide. In the
general definition of rights, the foundations of a simple version of this device (Harsanyi, Rawls), the
measure of individual freedom and the analysis of observer simply imagines that she could become
distributions of opportunity sets, but there is some any individual of the considered society. One may
interest for more concrete economic settings (on introduce variations about whether this implies
these various approaches, see, for example, Laslier taking on all the personal characteristics of each
et al. ; Pattanaik et al. ). Contractarian theories of possible individual or simply some of them (his
justice, which analyse justice norms as being shaped ability, his preferences). In more complex versions
by individuals’ interests in mutual cooperation, also of the scheme (Dworkin’s hypothetical insurance,
appeal to game theorists. For instance, Binmore ( or Rawls’s original position under some
-8) interpretations), individuals may all be put behind
relates various degrees of egalitarianism and lib- the veil and be left free to bargain or make
ertarianism to different time horizons of social transactions. The attraction of the veil of ignorance
interaction, arguing that the latter prevails in the comes from the obvious fact that it guarantees the
long run. impartiality of decisions. But impartiality is a very
weak requirement and any symmetric social welfare
function such as those listed above is impartial. The
The Definition of Social Criteria important issue in the choice of a social welfare
function is not that it must be impartial, but how
When a suitable index of well-being U j ,..., J J n averse to inequality it should be. In this respect, the
is given, as in the welfarist or the perfectionist veil-of-ignorance device appears actually ill-suited.
approaches, the only problem that remains is to It links inequality aversion to the degree of risk
choose a social welfare function W from the menu aversion of the observer. A very risk-averse
offered by the theory of social choice. For instance, observer will come close to some maximin
the sum-utilitarian function criterion, whereas a risk-neutral observer will adopt
a utilitarian kind of rule. If she maximizes her
W { U \ { x ) , . .. , U n { x )) = U i ( x) + .. . + expected utility, her decision will at any rate be
Un(x) structurally utilitarian in some metric. How this
translates into a choice of social welfare function W
displays no aversion to inequality in utilities, the
depends on the specific form of the ignorance veil
maximin function
(that is, what personal characteristics are inherited
W { U \ ( x ) , U n { x ) ) = min{£/i(x),..., U n ( x) } by the observer when she becomes a particular
individual). In Dworkin’s hypothetical insurance,
has an infinite aversion, while the product (or Nash) expected-utility maximizers will adopt insurance
function contracts that will produce utilitarian kinds of
allocations. It is hard to find a reason why risk
W { U x { x ), . . ., U „ { x )) = U l { x ). . .U n { x ) aversion about the possibility to becoming different
persons should determine distributive judgements
is an example of an intermediate function. With a about actually existing individuals. One could as
small or zero inequality aversion over utilities, as well imagine other devices, such as living all the
with the utilitarian function, priority is given to lives of the population, one after the other, in a
individuals with a high marginal utility, indepen- reincarnation process. Again, one does not see why
dently of their utility level, whereas with a high- intertemporal preferences over sequences of rein-
inequality aversion, as with the maximin, priority is carnations should be especially relevant for dis-
given to the worst-off (in terms of uti I ity level), tributive judgements over coexisting individuals.
even if they have a low marginal utility. The attraction of the veil of ignorance may perhaps
In the choice of an appropriate degree of inequality come from the mistaken belief that
aversion, it is often thought that the
impartiality is all there is to social justice. But the
theory of social choice clearly shows that impar-
tiality is just a minimal requirement. The multi-
plicity of impartial observer devices (lottery,
reincarnation.. .) proves that each of them is just one
way among many others to achieve impartiality, and
presumably none of them reaches a comprehensive
view of justice (on these issues, see, for example,
Roemer ).
If one forgets the veil and genuinely thinks
about inequality aversion in terms of fairness
between existing individuals, one still faces a moral
dilemma, since typically the social welfare
functions that do not give Ml priority to the worst-
off have the repugnant feature that a very small gain
to many well-off individuals can always, if these Ethics and Economics, Fig. 1
individuals are sufficiently numerous, outweigh a
large loss to a badly-off person. On the other hand,
Consider the following example. A certain
the maximin function always prefers giving a very
quantity of divisible goods has to be distributed. At
small gain to the worst-off, no matter how costly
any allocation in which all individuals receive a
this may be to all the other individuals. The way out
personal bundle, evaluate every individual’s bundle
of this dilemma has yet to be invented.
by the fraction of the social endowment that is
equivalent according to this individual’s preferences
(see Fig. ).
Aggregating Preferences
This is a standard way of representing individual
Let us now turn to the case in which ONC prefer- preferences by an index function, and such indexes
ences are the only relevant data about individual can then serve as arguments of a social welfare
utilities. Arrow’s impossibility theorem of social function W . This exemplifies a Paretian and
choice suggests that there is a conflict between the impartial way to aggregate individual ONC
Pareto principle and impartiality in this context, in preferences. This example has an interesting life of
contrast to the context of the previous paragraph in its own in the literature. It is briefly examined in
which many social welfare functions were Arrow ( , p. 31), and rejected on the ground
simultaneously increasing and symmetric in util- that it violates the above independence requirement.
ities. But this alleged conflict occurs only when one This observation, however, could as well suggest
requires the social ranking of two alternatives to abandoning the requirement. A variant of the
depend only on how individuals rank them, to the example is mentioned in Kolm ( ). It is
exclusion of any other alternative. This ‘inde- invoked by Samuelson ( ) in order to show
pendence’ requirement is very restrictive and pre- that it is possible to construct a
cludes using information about individual Bergson-Samuelson social welfare function on the
preferences such as their marginal rate of substi- sole basis of ONC preferences. As explained in
tution, how they compare their current bundle to Samuelson ( ), such a function is a mapping
natural benchmarks, and so on. The theory of fair E { x ) = W { l h { x ) , .. . ,U n { x ))
allocation actually features many fairness criteria
(such as no-envy or lower bounds) which violate where are suitable indices representing
this requirement by examining extended portions of individual preferences. (That the construction
indifference curves in order to evaluate an depends only on ONC preferences is verified by the
allocation. fact that the same function E can be written
with other, ordinally equivalent, indices V u ..., cost-benefit criteria without sharing their draw-
V „ provided W is correspondingly adapted - backs, is slightly more complex than the previous
some commentators have identified W instead of examples as it makes the evaluation of individual
E as the fixed Bergson-Samuelson function, situations depend on a price vector that itself
thereby concluding that Samuelson must have been depends on the whole allocation. Observe how even
wrong.) Eventually, it is used by Pazner and the maximin criterion, which is just a particular case
Schmeidler ( ) in the definition of the concept of inequality-averse social welfare function, can
of egalitarian equivalence, which has become quite rationalize a competitive equilibrium, no matter
important in the theory of fair allocation (an how unequal the endowments are. This is due to the
allocation is egalitarian-equivalent if it is Pareto- deduction of the value of endowments in the index
equivalent to a resource egalitarian allocation). U p , which is justified if individuals are held
This example shows a simple way to aggregate responsible for their endowments, so that one is not
preferences: first constmct an index and then apply interested in individual total consumptions but only
a standard social welfare function. The Borda rule, in the value difference between their consumption
in the voting context, is another example of the and their endowment.
same vein. The selection of the index need not be Even though such constmctions are based on
arbitrary and the above example, for instance, refers ONC preferences, they always involve some kind of
to fractions of the social endowment and thereby interpersonal comparison (of the relevant indexes)
makes sure that individuals who prefer their bundle in order to determine who should be given priority
to the equal-split are always considered better-off in the allocation of resources (for a synthesis on
than those in the opposite situation. There are less interpersonal comparisons in general, see Fleurbaey
simple aggregation methods. Consider for instance and Hammond ).
the index

U'-ixj) = ei(Ui(xi),p) — Hard Issues

where x t and o>, denote f s personal bundle and A few hard ethical issues have already been
endowment, e t his expenditure function, p a described. There are many others. Consider, for
price vector. At every feasible allocation .r (that is, instance, Fig. . ft describes two individuals’ utility
such thatxi <»! -... + (»„) and for every price under three different policies, depending on a
vector p , one has random state. Policy B is better than A, since for the
same e x p o s t distribution of utilities it
t/'i(xi) + ... + U p
( x ) < ( p x provides a less unequal distribution of prospects e x
n t
- p a t ) < 0, a n t e . And Policy C is better than B, since for
i the same distribution of e x a n t e prospects it
guarantees an equal distribution of utilities e x
while a feasible allocation v is a competitive
p o s t .
equilibrium associated to price vector p if and only
However, a social criterion that computes the
if one has U p * ( x * ) 0 for all i . Therefore,
expected value of social welfare will be indifferent
for between A and B, while a criterion satisfying the
any inequality-averse social welfare function IK the Pareto criterion with respect to expected utilities
function will be indifferent between B and C. Harsanyi’s
utilitarian criterion, which satisfies both properties,
E ( x ) = maxpe;5fK(Cf(xi), . . . , is indifferent between the three policies. The search
p
U „ ( x „ ) ) ,
for a better criterion in this context is still going on
(where S is the simplex of appropriate dimension) (see, for example, Ben Porath et al. ).
exactly selects the competitive equilibria as the best
allocations in the set of feasible allocations. This
function, which bears some similarity to
 State (or effort) 1 State (or effort) 2
Individual 1 1 1
Individual 2 0 0

State (or effort) 1 State (or effort) 2

Individual 1 1 0
Individual 2 0 1

State (or effort) 1 State (or effort) 2

Policy B
Individual 1 0 1
Individual 2 0 1

Policy C

A similar difficulty plagues the theory of equal framework of social choice should then be extended
opportunities, since, in spite of essential differences, in order to rank not just allocations but pairs
there is an obvious similarity between random (allocation, population) involving populations with
prospects and opportunities. In the same figure, different preferences and different sizes.
replace the random states by effort levels exerted by Interestingly, there are contexts in which size
the individuals. Then one can read the rows as should be a neutral matter (for example, com-
depicting opportunity sets for the individuals. Under parison of living standards between big and small
this new interpretation, Policy B is still better than countries) and other contexts (demographic policy)
Policy A because opportunity sets are less unequal, for which a theory of the optimal size is needed.
and Policy C is even better because it perfectly Optimal demography is a famously hard domain.
equalizes the opportunity sets. None of the social Classical utilitarianism, which is based on the total
criteria in the literature displays this pattern of sum of utilities, has the unappealing feature that a
preference, because each of them focuses either on population with arbitrarily low average welfare is
the distribution of e x a n t e opportunities or always better, if it is sufficiently large, than any
on the e x p o s t neutralization of the effect of given population (Parfit ). The criteria proposed by
variables for which the agents are not responsible Blackorby et al. ( )
(this issue is discussed in Fleurbaey and Maniquet ). (see also Broome ) avoid this ‘repugnant
Another issue is the comparison of social wel- conclusion’ by computing individual welfare as the
fare across different populations. The theory of surplus U , — U over some positive threshold
social choice is curiously restricted, in its standard of utility U and then apply a social welfare func-
formulation, to the ranking of options for a given tion to these surpluses. The i f threshold corre-
population (with a specific ranking for each pos- sponds to the minimal welfare level that an
sible profile of preference of this population). But individual must reach in order for his addition to
economic analysis is recurrently asked to compare society to be an improvement. Such criteria may
standards of living across time (measurement of thus induce judgements that a given population
growth) or space (international comparisons). The would be better off without its members whose
utility is below the threshold, even when these
members have positive utility. There is again a Barbera, S., P. Hammond, and C. Seidl, ed. 2004b.
dilemma here. Handbook of utility theoty. Vol. 2. Dordrecht:
Kluwer.
This is just a sample of those hard ethical issues Ben Porath, E., I. Gilboa, and D. Schmeidler. 1997. On
about social evaluation that economic analysis may the measurement of inequality under uncertainty.
never be able to render easy, but is able to clarify Journal of Economic Theory 75: 194-204.
Binmore, K. 1994-8. Game theoty and the social contract.
and to which it does, sometimes, give inventive
Vol. 1: Playing fair. Vol. 2: Just playing. Cambridge:
solutions. MIT Press.
Blackorby, C., and D. Donaldson. 1990. Review
article: The case against the use of the sum of
compensating variations in cost-benefit analysis.
See Also Canadian Journal of Economics 23: 471^494.
Blackorby, C., W. Bossert, and D. Donaldson. 2005.
► Arrow, Kenneth Joseph (Bom 1921) Population issues in social-choice theoty, welfare
economics and ethics. Cambridge: Cambridge
► Bargaining University Press.
► 3ei gson, Abram (1914-200.; ; Bossert, W., and J. Weymark. 2004. Utility in social
► Jost-Benefit Analysis choice. In Handbook of utility theory, ed. S.
► igalita; . Barbera, P. Hammond, and C. Seidl, Vol. 2.
Dordrecht: Kluwer.
► Equality of Opportunity Brams, S., and P. Fishbum. 2002. Voting procedures.
► air Allocation In Handbook of social choice and welfare, ed. K.
► I Arrow, A. Sen, and K. Suzumura. Amsterdam:
► Inequality (Measurement North-Holland.
Broome, J. 1991. Weighing goods: Equality, uncertainty,
► .ibertarianism
and time. Oxford: Basil Blackwell.
► Pareto Principle and Competing Principles Broome, J. 2004. Weighing lives. Oxford: Oxford
► Philosophy and Economics University Press.
► Samuelson, Paul Anthony (1915-2009) Chipman, J., and J. Moore. 1978. The new welfare eco-
nomics, 1939-1974. International Economic Review
► A V .. IS;;) 19: 547-584.
► 2; V :. 2 : I h w 2 cpments) Cohen, G. 1989. On the currency of egalitarian justice.
► 2 c . . 2c:::':::; Ethics 99: 906-944.

► Social Welfare Function d’Aspremont, C, and L. Gevers. 2002. Social welfare

functionals and interpersonal comparability. In Handbook
► > ces
of social choice and welfare, ed. K. Arrow, A. Sen, and
K. Suzumura. Amsterdam: North-Holland.
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Economic analysis and moral philosophy). Sen, A. 1987. On ethics and economies. Oxford: Basil Blackwell.
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Pazner, E., andD. Schmeidler. 1978. Egalitarian equivalent Abstract
allocations: A new concept of economic equity. Quarterly The European Semester is an EU effort to better
Journal of Economics 92: 671-687.
Peragine, V. 1999. The distribution and redistribution of coordinate member states' economic policies.
opportunity. Journal of Economic Surveys 13: 37-69. Coordination of national fiscal and economic
Rawls, J. 1971. A theory of justice. Cambridge. MA: Harvard policy has long been considered essential for the
University Press. tenability of a monetary union lacking the
Roemer, J. 1996. Theories of distributive justice. Cambridge,
MA: Harvard University Press. federal features of taxing and spending. The
Roemer, J. 1998. Equality of opportunity. C ambridge. MA: European Semester coordinates national
Harvard University Press. economies by setting collective deadlines for
Roemer, J. 2002. Egalitarianism against the veil of ignorance. the submission, analysis and discussion of
Journal of Philosophy 99: 167-184.
Samuelson, P. 1947. Foundations of economic analysis. Cambridge, national budgetary plans as well as the various
MA: Harvard University Press. forms of economic coordination that the EU has
Samuelson, P. 1977. Reaffirming the existence of ‘reason- accumulated through time, from the
able’ Bergson-Samuelson social welfare functions. Macroeconomic Imbalance Procedure (an
Economica 44: 81-88.
Sen, A. 1970a. Collective choice and social welfare. San Francisco:
agreement amongst EU members to prevent
Holden Day. risky macroeconomic policy) to Europe 2020
Sen, A. 1970b. The impossibility of a Paretian liberal. Journal of (the EU’s growth strategy).
Political Economy 78: 152-157.
In policy terms, the European Semester
Sen, A. 1973. On economic inequality. Oxford: Clarendon Press
(expanded edn, Sen, A. and Foster, J., 1997).
provides more evidence for those who saw the
Economic and Monetary Union (EMU)
developing through soft coordination, as some
of the most notable outputs are Council
 recommendations addressed to member states. = %2 leconon / : m c r » f A 2 (
However, more intrusive tools such as the Sta-
bility and Growth Pact (the agreement by which Warin: Stability and Growth Pact.
all EU member states commit to maintaining the
value of the euro through fiscal responsibility)
are now framed within the Semester schedule.
Importantly, the design of this framework Larch and Jonung: Stability and Growth Pact of
exemplifies a broader shift in EU economic the European Union, The
governance from an ex post monitoring of
member states’ preferences to an effort to ex
ante shape their adoption. This occurs by %20growtb &topicid=&result_number= .
scheduling EU discussions before national ones, Wyplosz: European Monetary Union
thus aiming to inform and shape the latter, and
by imposing synchronised submission of
different policy documents, thus forcing
member states to be consistent in their
commitments across policy areas. This might The European Semester represents the most
raise questions as to the limits of EU action, recent EU effort to better coordinate member states’
particularly in the light of subsidiarity concerns.
economic policies. Coordination of national fiscal
While the Semester is now part of the official
and economic policy has long been considered
jargon of EU and member states’ economic essential for the tenability of a Union lacking the
policy, commitment to such processes in the federal features of taxing and spending. This is
absence of external pressures (e.g. crisis) hascrystallised in the Treaties, where reference is made
been questioned, as recorded by falling imple- to the need for member states to ‘regard their
mentation rates. Further, while the first years of
economic policies as a matter of common concern’
the Semester were associated with weak eco- and to ‘coordinate them within the Council’
nomic growth, the picture has recently turned (European Union : Art. 121), and for euro area
more positive. That said, there seems to be countries to ‘strengthen the coordination and
limited effect on macroeconomic imbalances, surveillance of their budgetary discipline’ and ‘to
one of the main stated objectives of the set out economic policy guidelines for them, while
framework. ensuring that they are compatible with those
adopted for the whole of the Union and are kept
under surveillance’ (European Union : Art. 136).
Keywords Academic commentators have described policy
EMU governance; Monitoring and coordination; coordination as ‘supranational rules or norms which
EU integration are agreed by all member states, leave primary
responsibility for the policy area with national
authorities, but set limits on their discretion’ (Begg
JEL Codes et al. : 66). The rationale and extent of such
E61; F02; 052 coordination, beyond the narrow fiscal policy
targets included in the Maastricht Convergence
Criteria (that is, the criteria which EU member
states need to meet in order to be accepted to the
Related Articles euro), has been subject to much debate. Alesina et
al. argued ‘explicit coordination of monetary and
Begg: Genuine Economic and Monetary Union. fiscal policy is not necessary, if the monetary and
: tt);//ww v dictiona: TOfeconomics.com/article? fiscal authorities (independently) follow appropriate
and prudent policies’ (Alesina et al. : 7). Issing it looks at the early assessments of its results. The
reinforced this point by adding that close fifth section concludes the entry.
coordination between monetary and fiscal author-
ities risks blurring respective competences and
therefore weakening accountability mechanisms The Rationale Behind the European
(Issing ). Eichengreen and Wyplosz argued that Semester
efforts at consolidating budget implied by the
Stability and Growth Pact (SGP) (the agreement by Scholars and policy-makers alike have intensely
which all EU member states commit to maintaining debated the nature of the relationships between
the value of the euro through fiscal responsibility) monetary policy on the one hand and fiscal and
would consume politicians’ political capital to economic policies on the other, in the context of
tackle structural reforms, significantly limiting their Economic and Monetary Union (EMU). Early
growth prospects as well as their capacities to policy proposals on monetary union in the 1970s
jointly stimulate the economy - in other words, regarded these two poles as inseparable and foresaw
more budgetary surveillance might entail less nothing short of ‘budget aggregates’ decided at the
economic coordination (Eichengreen and EU level (Pisani-Ferry : 824-825). Since the
Wyplosz ). Collignon highlighted that, considering creation of EMU, monetary policy has been fully
that economic policies are kept at the state level, delegated to the European Central Bank (ECB),
‘one cannot expect that purely independent member states have cooperated on budgetary policy
decisions will necessarily result in the efficient with binding rules envisaging an institutional
provision of collective goods’, and hence might hierarchy as well as monitoring and sanctioning
become detrimental to a common undertaking such powers at the EU level (the SGP), while other
as the single market (Collignon ). Pisani-Ferry economic policies (e.g. structural reforms,
further pointed out employment policies) have been subject to a
that in a decentralised system such as the EMU, mixture of policy coordination forms where no
‘where decision makers are numerous and diverse sanctions were in order and policy outputs that
[...] discretionary co-ordination inevitably implies mainly materialised in recommendations (e.g. the
high transaction costs’ (Pisani-Ferry : 9), thus Broad Economic Policy Guidelines, BEPGs: non-
revealing the added benefit of coordination. legally binding recommendations guiding annual
In practice, the European Semester aims at economic policy in member states).
coordinating national economies by putting col- Once a decision to create a monetary union is
lective deadlines on the submission, analysis and taken, there remains a choice for either a centralised
discussion of national budgetary plans as well as the or decentralised budget that can automatically
various forms of coordinated monitoring that the stabilise the euro-area (De Grauwe ). Due to
EU has accumulated through time. It is a ‘semester’ political reasons (Hodson ), a centralised budget has
as after a period of EU-level coordination not been feasible in the EU. That leaves only the
(approximately from November to May each year), national budgets to stabilise business cycle shocks
a period of national coordination follows. (De Grauwe : 214-217). Here, policy-makers hit a
This entry first puts the European Semester in conundrum. On the one hand, fiscal policies remain
the context of the efforts to build and strengthen their only tool to deal with negative shocks. On the
economic coordination at the EU level. Second, it other, unconstrained budgetary policies represent a
looks at continuities and changes in the Semester as risk for the monetary union in terms of negative
compared to previous economic coordination spillovers in interest rates from highly indebted
exercises. Third, it provides a description of the countries to others and regarding ECB
European Semester and places it in the context of independence. Begg et al. ( : 67-68) summarise the
the EMU reforms undertaken since 2010. Fourth, political
economy rationale for economic coordination as
aiming to solve two problems. First, negative appropriate level where political power should be
externalities are likely to stem from excessive exercised (De Grauwe : 3). While monetary policy
government deficits in the context of currency has been fully supranationalised, De Grauwe states
union, which are then spread onto other member powers over tax and spending should remain at the
states in the form of a ‘higher unified interest rate’ national level because that is where accountability
(for a critique, see Eichengreen and Wyplosz : 76- mechanisms are grounded. Such arrangements do
77). The second relates to the provision of not and cannot work, De Grauwe argues, simply
independence and ultimately the credibility of the because states have no incentives to comply and
central bank in the context of a multiplicity of draw their legitimacy from their electorates, not EU
different fiscal policies. If markets presume that the institutions. The emphasis on ownership that
central bank will ultimately come to rescue states emerged in EU official documents in the mid-2000s
with high deficit and unsustainable public debt, its (see next section), can be regarded as a surrogate to
credibility is at risk. To solve both these issues, overcome such fundamental political economy
cooperation and coordination provide some form of problems. The basic idea is that the more
collective insurance (Schelkle )• governments buy into the reform process, the less
The EMU solution to the dilemmas posed by its likely they will be to back down from that path in
institutional configuration was to establish some the face of organised interests or electorate
form of pre-accession convergence (the Maastricht opposition. Confirming this importance,
Convergence Criteria), to tie continued membership Directorate-General for Economic and Financial
of the EMU to some form of adherence to Affairs (DG ECFIN) Director Marco Buti has
budgetary rules (the excessive deficit procedure recently declared ‘the take-away, from my
within the Treaty and its further specification within perspective, is not that fiscal rules per se proved
the SGP), and to coordinate economic policies (see their inadequacy within the crisis. Rather, the main
Treaty obligations in Art. 2(3), Art. 5(1) TFEU). lesson is that fiscal rales operate in a certain
Since Maastricht, the EU has consistently decided institutional and political environment, which has to
to reduce economic divergence and the creation of be conducive to sensible implementation’ (Buti :
excessive budgetary deficits in some countries for 186).
the purpose of common interest. It has done so by
setting EU-wide rales, and at the same time issuing
A Brief History
guidelines to nudge member states towards com-
monly agreed objectives for macroeconomic pol- The first manifestations of economic coordination
icies and structural reforms. were the Broad Economic Policy Guidelines
Economists diverge as to how effective such a (BEPGs), included in the Treaty of Maastricht, and
solution was. Indeed, besides the Tack of planning now based on Article 121 TFEU. The BEPGs’ main
to deal with financial stability’ and Tack of trans- objective was to maintain and foster economic
parency of the ECB’, Giavazzi and Wyplosz iden- convergence, thus limiting the potential impact of
tify ‘the poor articulation between monetary policy asymmetric economic cycles and shocks in the
and national fiscal policy’ as one of the three main context of a currency union. In terms of scope, the
flaws in the construction of the EMU ( : 723-724). BEPGs provided recommendations to member
De Grauwe ( : 3) holds states on structural reforms and macroeconomic
that such asymmetric institutional architecture policies, ‘ranging from budgetary policy and wage
(centralised for monetary policy, decentralised for developments to labour market reform and
economic ones) has been problematic since its financial-market integration’ (Deroose et al. : 828).
inception. Further, such an asymmetrical The alignment of the Lisbon Agenda (the agreement
arrangement ‘disregards elementary principles of amongst EU member states to make the EU the
political economy’ inasmuch as it confounds the leading knowledge-driven economy by 2010) into
the
BEPGs in 2000 provoked a significant expansion of How Does It Work?
the scope of issues considered, as well as the
perception that their all-encompassing nature was to The crisis that exploded in Europe in 2010 alerted
the detriment of priority and focus, over- policy-makers to the need to equip the Union with a
complicating the process, and ultimately diluting its single framework to coordinate all the activities
success (Deroose et al. ). The absence of peer related to the reformed EU economic governance.
pressure amongst member states and a general lack The coordination through the Semester of the
of commitment further contributed to the correction of macroeconomic imbalances,
widespread perception that the BEPGs had limited unsustainable budgetary positions, as well as
effect (Deroose et al. ). This was paralleled by a competitiveness and growth strategies is an answer
negative assessment of the Lisbon Strategy (Kok ). to the lessons of the crisis as well as the longer-term
The European Semester itself was first proposed EU project of coordinating e n b l o c
member states’ growth strategies. The crisis has
in a 2004 Commission’s Communication wherein
revealed how an exclusive focus on a reduced
the opportunity represented by the failure of SGP
basket of indicators (i.e. mainly budget deficits) was
implementation was seized upon to suggest ‘a
not conducive to macroeconomic stability. Having a
revision of the economic policy calendar’
framework where a larger pool of indicators is
(Commission : 7). Notably, to strengthen the
discussed and possibly coordinated was regarded as
coordination between member states’ economies
a step forward from past policies.
and to facilitate the monitoring role of EU bodies,
Officially started in January 2011, the European
the Commission proposed an ‘EU semester’ to be
Semester cycle kicks off between November and
followed by a national one where budgets would be
December each year when the Commission releases
prepared. Such sequencing would have allowed ‘the
the Annual Growth Survey (AGS), which spells out
BEPGs and the Opinions on the [Stability and
the priorities to meet the jobs and growth agenda of
Convergence] programmes to be taken into account Europe 2020, and targets the EU as a whole for the
in the preparation of national budgets by following year (Fig. ). The AGS builds on three
governments’ (Commission : 7). In the eyes of the elements: an evaluation of Europe 2020 Strategy,
Commission, coordination under the Semester the Macro- economic Report and the Joint
would have had several merits: reorienting the SGP- Employment Report. At the same time, the Alert
related programmes from ‘description’ to ‘strategic Mechanism Report (AMR) is released, which is part
planning’; increasing the national ‘ownership’ of of the constant monitoring of the Macroeconomic
EU economic coordination as interactions between Imbalance Procedure (MIP: an agreement
the two levels intensified; strengthening legitimacy amongst EU members to prevent risky macroeco-
because of the deeper involvement of national nomic policy) (Commission : 7). In addition, the
parliaments in the policy-making process. Since Commission issues opinions on draft budgetary
these early proposals it has been possible to notice a plans. These opinions are then discussed in the
gradual shift towards consensus-building before Council, while the European Parliament (EP) is
measures are enacted, and away from what is involved in the Economic Dialogue on discussions
increasingly perceived as ultimately toothless over the AGS. In December/January the
monitoring. Ownership issues were contemplated at Commission and member states have bilateral
the time, and are still paramount in the Semester meetings, while euro-area member states approve
(Zuleeg ). The focus on ownership derives from their budgets. In January, the Commission can carry
IMF past experiences in structural reform, which out inspections in the member states to verify
indicated that the degree to which local policy and anomalies that emerged during monitoring. At the
political elites buy into reform programmes is same time, the Council adopts recommendations on
determinant to their success (Bird and Willett )• the euro-area and conclusions on the AGS and
AMRs. In March, the European Council
EU European Semester,
Fig. 1 The European
semester. p://w\
Who does what in the European Semester?
consilium.europa.eu/en/
policies/european-semester/
(© European Union, 1995-
2017) Nov oalytn *
> Preparatory phase
ANALYSIS OF THE SITUATION 'I
and follow up to the previous year

Phase 01
POLICY GUIDANCE
at the EU level

of HJ» «
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Phase 02
COUNTRY-SPECIFIC
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Phase 03
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A new cycle starts again towards the end of the year, when the Commission gives an overview of the economic situation
in its Annual Growth Survey for the coming year.

O European Union 2017

Council 0* the European Union Reproduction n suthonsed, provided the source 11 *c<
European semester Exclusively SGP Exclusively MIP Jointly SGP and MIP Integrated guidelines Total
2012 18 (13%) 31 (22%) 5 (4%) 84 (61%) 138
2013 18 (13%) 50 (35%) 6 (4%) 67 (48%) 141
2014 19 (12%) 58 (37%) 8 (5%) 72 (46%) 157
2015 11 (11%) 48 (47%) 10 (10%) 33 (32%) 102
13 (15%) 36 (40%) 9 (10%) 31 (35%) 89
2016

Source: EP , © European Union, 2016.

IPCL ATA(2014)52°757 37Tpdf

adopts the economic priorities on the basis of the Cyprus (between 2013 and 2015), Ireland (2012-
AGS. Following suit, the Commission again has 2013), and Portugal (2012-2013).
bilateral meetings with member states which focus As already mentioned, the Semester has an
on their submission of National Reform encompassing nature, which derives from hosting
Programmes (NRPs: the local implementation plan basically every mechanism that the EU has devel-
of EU objectives) and Stability and Convergence oped so far regarding fiscal, budgetary and eco-
Programmes (SCPs: the individual nomic coordination (see Table below for a recent
country’s budgetary plans for the coming years, overview). For instance, the 2015 European
connected with the member states’ obligations Semester started with an AGS focused on three
under the SGP). The National Reform Programmes pillars: ‘boost for investment’ (connected with the
are compiled by the member states under their other flagship project of an Investment Plan for
Europe 2020 commitments and should be in line Europe, which focuses on investment in
with the BEPGs and EGs as well as the Annual infrastructure), ‘structural reforms’, and ‘fiscal
Growth Survey (AGS). In May, the Commission responsibility’. Examples of specific CSRs are:
releases the Country Specific Recommendations stepping up efforts to fight tax fraud and evasion in
(CSRs) which encompass both economic and Spain and Italy, increasing tax revenues by
budgetary policies and draw on member states’ harmonising VAT in Germany and introducing tax
performance for the previous year. At this point, the incentives to strengthen home ownership in the
Commission starts discussions with the EP. Netherlands (EP ). What is the added value of
Between June and July the Council first debates the synchronising such a wide array of policy issues?
CSRs and then the European Council endorses Ideally, to lead member states to a consistent
them. The cycle comes to an end in September, approach under the several coordination schemes
when euro area member states submit to the present in the EU which cut across policy areas. At
Commission the draft budgets for the following a minimum, this means coherence between
year, while in October the EP discusses the new structural reforms and their budgetary implications.
AGS. The submission of draft budgets should allow In parallel, synchronisation would facilitate
the Commission to check their consistency with effective monitoring by magnifying inconsistencies
commitments made in the Stability Programmes between policies (Fig. ).
previously submitted. It should be noted that there As shown in Table below, the numbers of SGP-
is a differentiation at the heart of the process related recommendations have slightly decreased in
between euro- and non- euro members, reflecting absolute terms but remain fairly stable as a share of
the various arrangements present in the instruments the total; the MIP-relatedtoo have remained fairly
that the Semester encapsulates (e.g. SGP, MIP). stable in absolute numbers but, due to the
Finally, countries that are under specific decreasing overall numbers, have increased in
surveillance programmes are excluded from the overall share; the most dramatic decrease, however,
regular CSRs activities, as is currently the case for is in the Integrated Guidelines (which set out the
Greece, and was for framework for the Europe 2020
EU
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strategy and reforms at Member State level), which efforts’ had been spent only on 40% of recom-
have more than halved in absolute terms and nearly mendations in 2011 (Darvas and Leandro 10),
so in relative terms. decreasing to 29% by 2014. Euro-area member
As pointed out by the EP, failure to implement states, subject to tighter coordination and
recommendations might result in different kinds of monitoring, performed only limitedly better, and for
sanction, depending on the legal basis of the instance in 2014 implemented 31% of recom-
individual recommendations. For this reason, it may mendations, as compared to 23% of countries
be misleading to encapsulate the European Semester outside the Eiuozone. Further, implementation is
as either soft or hard law, as the framework displays analogous to what was achieved under a parallel
features of both (EP ). OECD framework, which casts doubt on the merits
Although finding an explicit legal recognition in EU of an operation which has become the flagship
secondary legislation (the Six Pack), this initiative for economic coordination in the EU
‘overarching framework’ (to use the Commission’s (Darvas and Leandro : 11—13 ).
words; : 10) is only as legally binding and only Commentators have adduced several reasons for
envisages the possibility of sanctions (two elements such a deficient implementation, including weak
frequently used to distinguish soft/hard law institutional architecture, softening of external
policies) as its components are. pressures as the crisis abated, lack of national
Finally, the Semester can be conceived as hav- ownership of the reform agenda, unfeasible and
ing two sources of legitimacy. The first is the poorly specified economic objectives. Such
involvement of the EP through the Economic implementation gaps have pushed some economists
Dialogue (albeit in a loose fashion), which might be to argue that ‘procedures culminating in sanctions
regarded as enhancing legitimacy by the sheer fact in the case of persistent non- compliance’ should be
of being directly elected. The second is the fact that, introduced to safeguard the ‘functioning of the
after a European Semester, a national semester is EMU as a whole’ (Gem et al. : 24). However, it
envisaged, where member states are supposed to should be noted that experience with the emphasis
internally debate the measures to be adopted by on sanctioning as a deterrent for non-compliance
their parliaments. The Commission has also has been mixed in the case of SGP (De Grauwe ;
recently tightened deadlines during the EU-level of Hodson ), and it is not clear why this case should be
the Semester with the stated aim of conferring more different. Others have regarded such implementa-
time to national-level discussion on economic tion gaps as the ultimate evidence of the need for a
reforms and budgets. ‘systemic governance reform’ and called for,
i n t e r a l i a , a ‘fiscal capacity’ that
member states could tap into provided that they met
The Track Record So Far ‘contractual’ obligations to be devised by the
Commission in the context of the European
Looking at implementation, commentators agree Semester (Zuleeg :
that the picture is disappointing (Darvas and 12,14). However, the empirical evidence for such a
Leandro ; Gros and Alcidi ; Zuleeg ). Member states move towards more binding coordination is mixed.
have made ‘full’ or ‘substantial’ progress in Comparing recommendations belonging to the SGP
decreasing shares of the total recommendations and those of the MIP and other policies (the former
addressed to them between 2012 and 2014 (from two are legally binding, not the latter), studies have
12.3% to 6.4%), while the percentage of measures found that while the older and more tightly
that were either only lim- itedly or not implemented coordinated SGP marginally outperform the others,
increased from 28.8% to 48.1% (Gem et al. : 8). In the 44% implementation rate on average for the
other words, there is an increasing risk of period 2012-2014 is not cause for celebration
irrelevance for the entire exercise. Other studies (Darvas and Leandro : 13-14).
have quantified the level of implementation, finding In 2015, the Semester was reshuffled into a
that ‘reform ‘Revamped European Semester’ after taking
 A MORE INTEGRATED EUROPEAN SEMESTER

HHia liTlaiii-j■' i

Country Level:
March to July year n

National Reform
Programmes Country-Specific
Country Reports + Recommendations
in-depth reviews for and opinions on
certain countries national budgets

EU European Semester, Fig. 3 A more integrated European Semester.

((C) European Union, 1995-2017)

stock of mixed implementation records officials as ‘the sum of country policies’ (Buti ).
(Commission ). EU officials seem to have The Commission argues that there is a ‘clear sub-
converged on the idea that less is better, meaning optimal repartition of the fiscal adjustment across
that addressing fewer recommendations to member countries’, but ‘those who do not have fiscal space
states might be easier for EU bodies to monitor and want to use it; those who have fiscal space do not
for national administrations to implement (Gem et want to use it’ (EP : 2). However, there seems to be
al. : 5). The reforms aim at creating even tighter little official indication as to how this adjustment
integration for euro-area member states, as well as should take place (EP ), and policy
gaining more political traction at the domestic level instruments are still
(with an eye to the unresolved issue of ownership). lacking for ‘stabilising economic cycles1 or forcing
Institutionally, two new advisory bodies are created ‘countries to run larger budget deficits’ (Darvas and
- a new European Fiscal Board (EFB) and a system Leandro ). The recommendation to Germany to use
of Competitiveness Authorities (Fig. ). the available fiscal space to boost investment was
Commentators have highlighted that while fre- the only divisive one between member states sitting
quent reference is made to ‘euro-area aggregate in the Council and the Commission in 2016
fiscal stance’, it is not clear how an ‘optimal (Council ), but a decisive one in terms of helping
aggregate fiscal stance should be determined’ alleviate the internal imbalances of the Union. This
(Darvas and Leandro : 6). The emphasis on the reflected (and re-confirmed) the difficulty of EU
aggregate fiscal stance comes from ECB invitations coordination to push for a measure that was widely
and is conceived by the Commission’s regarded as collectively beneficial in the face of
domestic opposition. Further, Deroose and Griesse themes featuring in successive waves of recom-
observe a higher rate of implementation in ‘areas mendations. For instance, social and labour market
where market pressure requires an imminent policy policies have been maintained in some counfries but
response’ (Deroose and Griesse : 1, 6), which casts not others from one cycle to another despite
doubt on whether the positive effects of the ostensible lack of progress in all of them (Gem et al.
Semester are due to coordination or external ). Others have observed an overall reduction in
pressure. recommendations for social inclusion, education
Looking at 2017-2018, the Commission has and skills, without an apparent justification
recently forecast a neutral stance until 2018. In its (Zuleeg : 11). Others have criticised the lack of
opinion, member states should run an expansionary focus on specific areas with significant potential for
fiscal policy, while also taking into account the negative spillovers, such as financial sector
ECB monetary policy (EP ). Giavazzi vulnerabilities and environmental issues (Gem et al.
regards the very concept of eiuo area aggregate : 12), or standards on tax compositions (Darvas and
fiscal stance as a response to the ECB hitting one of Leandro : 21).
the limits of monetary policy, meaning the decision Whether the Semester contributes to a more
to impose a zero percent interest rate (Giavazzi ). sustainable EMU is complex to assess, but looking
Tabellini argues that the crisis has shown that the at some fundamental macroeconomic variables
current setting of the EU, where full financial since the start of the framework might provide an
integration as well as stability is sought for but there initial indication. Euro area GDP growth increased
is no common fiscal policy or tools to manage to 2% in 2015 after weak if not negative perfor-
aggregate demand, is untenable (Tabellini ). In this mance since 2011, particularly when compared to
vein, the emphasis on the aggregate fiscal stance international competitors such as the USA. Euro
would probably be regarded as ineffective, as one of area unemployment rates decreased in 2015 to 10.9
the main lessons from the crisis was that the EU after an upward trend in the preceding 3 years. Euro
needs nothing short of a fiscal imion to provide area member states continued to consolidate their
‘fiscal stabilisation for the euro-area as a whole’ public balances (reaching 2.1% in 2015) and
and ‘resources to withstand systemic financial brought down their public debt after years of an
crisis’ (Tabellini ). While a euro-area aggregate fis- upward trajectory. These aggregate indicators,
cal stance that targets, for instance, ‘country- however, mask significant disparities and varying
specific demand deficiencies’ might be adequate to trends within the Eurozone, which jeopardise EMU
deal with fiscal stabilisation, its suitability to deal sustainability (Hodson : 154—157). It is in this
with systemic financial crisis is more contested highly uneven context that commentators have
(Monacelli ; Wyplosz ). In any case, this neglects wondered why, in contrast with all previous years,
the crucial question of how such coordination could ‘a recommendation on the need for symmetric intra-
come about, taking into consideration that euro adjustment [...] was not included in the 2015
coordination initiatives so far have yielded mixed recommendations’ (Darvas and Leandro ). DG
results. ECFIN forecasts limited progress until 2018, with
Wlide the Commission seems positive regarding four countries still with unemployment rates above
the implementation of the European Semester 10% (down from six), GDP growth constant and
(Darvas and Leandro : 25), others have outlined a deficits still above the SGP criteria in two countries
series of criticisms. A line of criticism that often (down from three) (Commission : 1; for a similar
emerges in commentaries relates to the unclear analysis, see OECD ). Recent studies have shown
selection criteria upon which recommendations are that core-periphery dynamics of unsynchronised
made, or prioritised (EP : 9). The basic point of a business cycles which marked the run-up to the
cycle was that recommendations could be followed adoption of the euro have softened but remain
up year on year. However, commentators have present for a subset of member states (Spain,
noticed an unevenness of the Portugal, Ireland and Greece)
(Campos and Macchiarelli ). Considering that imposing synchronised submission of different
remedying these asymmetries was one of the main policy documents, it forces member states to be
goals of economic coordination, as it is regarded as consistent in their commitments across policy areas,
one of the main factors contributing to making the which in turn facilitates monitoring by EU
EMU unsustainable, this suggests that coordination institutions. This exemplifies a broader shift in EU
has had limited effects so far. economic governance from an ex post monitoring of
The first years of operation have confirmed that member states’ preferences to an effort to ex ante
national governments are reluctant to fully buy into shape their adoption. In this regard, it should be
the process of coordination (Gem et al. : 5). This remembered that the Semester, by including a wide
shows that lack of ownership, to which the range of mechanisms such as Europe 2020 and the
Semester should have been an answer, is still at the MIP, now covers a broad spectrum of issues,
forefront. More transparency and timely informa- ranging from energy policy to civil justice. Besides
tion on implementation have been suggested as the Semester, the Commission ‘considers that ex
possible solutions with a view to increasing the take ante coordination should concern only major
up at national level. According to commentators national economic reform plans and that it should
(Gem et al. : 6), increased transparency could be take place at an early stage before the measures are
achieved by making more explicit the theoretical adopted’ (Commission : 3). Because of such
premises upon which recommendations to member methods, timing and scope, the Semester raises
state are made. More involvement of national questions as to the limits of EU action, introducing a
parliaments is regarded as instrumental in delivering degree of tension between economic policy
ownership, but implementation so far suggests that coordination and subsidiarity concerns.
efforts at better including them have largely failed To conclude, the Semester should be judged by
(Gem et al. : 9). Other commentators have pointed its outcomes. Two simple questions might help in
out that the only way out from the current situation this assessment. Has the Semester facilitated the
of lack of ownership and the consequent achievement of the SGP, MIP and Europe 2020
implementation gap, as well as sovereign and objectives? Has it made monitoring more effective?
legitimacy issues, is nothing less than an ‘economic The answer seems to be negative to the former, as
government’, even though there is ample implementation of recommendations related to all
recognition that this ‘is not on the cards politically’ three regimes has been falling since the start of the
(Zuleeg : 7). The EP has tried to increase ownership process - this in the context of decreasing numbers
by raising awareness of the process, for instance by of recommendations, which in turn helps answer the
inviting national finance ministers to hearings in the second question. This fact suggests that pohcy-
EP’s Economic and Monetary Affairs Committee as makers are converging on the idea that having less
part of Economic Dialogues set up by the Semester demanding monitoring duties is better for both
(EP ). national and European administrations. It also
reduces the complexity of the process and avoids
duplications. Eventually, it is hoped that focusing on
Conclusions a smaller number of priorities will improve
ownership of the reforms, even if experiences in this
As the overarching framework including both hard
regard have been disappointing so far. Regarding
and soft EMU policies, the European Semester is
coordination, the take-home message is that, while
noteworthy for its design. First, by scheduling EU
the principle of timely and close cooperation has
policy discussions before national ones it aims to
now entered the official jargon of EU and member
inform and shape the latter, and within the states’ economic policy, commitment to such
Eurozone this takes an intrusive form because of, processes in the absence of external pressures (e.g.
i n t e r a l i a , the budgetary implications of the euro area crisis) has been questioned (Gros and
the Two Pack (which involves closer monitoring of Alcidi ). This
the deficits of euro area member states). Second, by
resonates with evidence from outside the EU of low instruments, the extended remit of policies under
responsiveness to coordination recommendations in consideration, and the complexity reached by some
the absence of external pressures, as revealed by the of the components of the Semester (SGP, MIP), it is
limited success of the OECD advice to some possible to argue that it is becoming increasingly
member states (e.g. Austria, Finland, France, difficult for member states to identify the individual
Germany, the Netherlands) to undertake further gains from such exercises, understand others’
expansionary fiscal policies to support growth than contributions and have a clear sense of the overall
were currently planned (OECD , ). benefit of the exercise.
According to the Commission, the innovations
in EMU governance since 2010 - including the
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 Government should abstain from directly inter-
Eucken, Walter (1891-1950) vening into market processes, but it has to shape the
economic order by guaranteeing, through
Josef Molsberger O r d n i m g s p o l i t i k , the ‘constituent
principles’ of the market economy (monetary
stabilization, free entry, private property, freedom
of contract, liability, consistency in economic
Keywords policy and, primarily, maintaining competition).
Economic order vs. economic process; Eucken, Subsidiary arc the ‘regulatory principles’:
W.; Freiburg school; German historical school; monopoly regulation, social policy, process
Laissez-faire; Social market economy stabilization policy. Eucken’s theory laid the ground
for West Germany’s ‘social market economy’.

JEL Classifications Selected Works

B31
1923. Kritische Betrachtungen zum deutschen
Head of the Freiburg School of German neo-
Geldproblem. Jena: Gustav Fischer.
liberalism and founder of the yearbook O r d o ,
1932. Staatliche Strukturwandlungen und die Krise
Eucken was bom at Jena on 17 January 1891.
dcs Kapitalismus.
Eucken earned his doctoral degree at Bonn (1913).
W e l t w i r t s c h a f t l i c h e s
After the H a b i l i t a t i o n in Berlin
A r c h i v 36: 297-323.
(1921), he was professor of economics at Tubingen
1934. K a p i t a l t h e o r e t i s c h e
(1925) and Freiburg (1927-50). He died on 20
U n t e r s u c h u n g e n . Jena: Gustav
March 1950 in London, during a lecture series at the
Fischer. 2nd enlarged ed. Tubingen: Mohr;
London School of Economics.
Zurich, Polygraphischer Verlag. 1954.
Eucken’s works mark the return to (neo (classi-
1940. D i e G r u n d l a g e n d e r
cal theory in German economics after the domi-
N a t i o n a l o k o n o m i e . Jena:
nance of the Historical School. He stressed,
Gustav Fischer. 8th ed. Berlin, Heidelberg and
however, the theorist’s task to explain reality and
New York: Springer. 1965. Trans, as T h e
rejected model-building if it was purely an intel-
F o u n d a t i o n s o f
lectual game. Eucken’s outstanding analytical
E c o n o m i c s . London. 1950.
contributions include a masterly explanation of the
1948a. On the theory of the centrally administered
German inflation and currency depreciation on
economy: An analysis of the Geiman experi-
quantity-theoretical grounds (1923), a capital theory
ment. E c o n o m i c a 15; Pt I, May, 79-
(1934) building on Bohm-Bawerk and Wicksell
100; Pt II, August, 173-93.
and, in particular, his theory of economic systems
1948b. Das ordnungspolitische Problem. O r d o
(1940) and of economic policy (1952).
1: 56-90.
Eucken’s theory of economic policy starts from
1949. Die Wettbewerbsordnung und ihre
the distinction between the e c o n o m i c
Verwirklichung. O r d o 2: 1-99.
o r d e r , the legal and institutional framework
1951. Unser Zeitalter der Misserfolge: 5 Vortrage
of economic activity, and the e c o n o m i c
zur Wirtschaftspolitik. Tubingen: Mohr
p r o c e s s , the daily transactions of
1952. G r u n d s a t z e d e r
economic agents. Under laissez-faire the state
W i r t s c h a f t s p o l i t i k , ed.
neither shapes the economic order nor intervenes in
Eucken, E., Hensel, K.P. Bern: Francke.
the economic process; in a centrally planned
Tubingen: Mohr. 5th ed. Tubingen: Mohr. 1975.
economy the state dominates both. Eucken
conceived a
W e t t b e w e r b s o r d n u n g Bibliography
(competitive system) different from both systems:
Lenel, H.O. 1975. Walter Euckens ordnimgspolitische
Konzeption, die wirtschaftspolitische Lehre in der
JEL Classifications
Bundesrepublik und die Wettbewerbstheorie von Heute.
C61; El
Ordo 26: 22-78.
Lutz, F.A. 1961. Eucken, Walter. In Handworterbuch der
Soziahvissenschaften, vol. 3. Stuttgart/Tiibingen/ Gottingen: An Euler equation is an intertemporal version of a
Fischer/Mohr/Vandenhoeck & Ruprecht. first-order condition characterizing an optimal
Schmidtchen, D. 1984. German ‘Ordnimgspolitik’ as insti- choice as equating (expected) marginal costs and
tutional choice. Zeitschrift fur die Gesamte Staatswis- senschaft 140
marginal benefits.
(1): 54-70.
von Stackelberg, FI. 1940. Die Grundlagen der Many economic problems are dynamic optimi-
Nationalokonomie. Weltwirtschaftliches Archiv 51 (2): 245-286. zation problems in which choices are linked over
Lebensbilder grosser
Welter, E. 1965. Walter Eucken. In time, as for example a firm choosing investment
Nationalokonomen: Einjiihrung in die Geschichte
over time subject to a convex cost of adjusting its
der Politischen Oknonomie, ed. H.C. Recktenwald.
Cologne/Berlin: Kiepenheuer & Witsch. capital stock, or a government deciding tax rates
over time subject to an intertemporal budget con-
straint. Whatever solution approach one employs -
the calculus of variations, optimal control theory or
dynamic programming - part of the solution is
typically an Euler equation stating that the optimal
Euler Equations plan has the property that any marginal, temporary
and feasible change in behaviour has marginal
Jonathan A. Parker benefits equal to marginal costs in the present and
future. On the assumption that the original problem
satisfies certain regularity conditions, the Euler
equation is a necessary but not sufficient condition
Abstract for an optimum. This differential or difference
An Euler equation is a difference or differential equation is a law of motion for the economic
equation that is an intertemporal first-order variables of the model, and as such is useful for
condition for a dynamic choice problem. It (partially) characterizing the theoretical
describes the evolution of economic variables implications of the model for optimal dynamic
along an optimal path. It is a necessary but not behaviour. Further, in a model with uncertainty, the
sufficient condition for a candidate optimal path, expectational Euler equation directly provides
and so is useful for partially characterizing the moment conditions that can be used both to test
theoretical implications of a range of models for these theoretical implications using observed
dynamic behaviour. In models with uncertainty, dynamic behaviour and to estimate the parameters
expectational Euler equations are conditions on of the model by choosing them so that these
moments, and thus directly provide a basis for implications quantitatively match observed
testing models and estimating model parameters behaviour as closely as possible.
using observed dynamic behaviour. The term ‘Euler equation’ first appears in text-
searchable JSTOR in Tintner ( ), butthe equa
tion to which the term refers is used earlier in
Keywords economics, as for example (not by name) in the
Calculus of variations; Continuous-time models; famous Ramsey ( ). The mathematics was
Differential equations; Discrete-time models; developed by Bernoulli, Euler, Lagrange and others
Dynamic programming; Euler equations; centuries ago jointly with the study of classical
Expectations; Generalized method of moments; dynamics of physical objects; Euler wrote in the
Lagrange multipliers; Liquidity constraints; 1700s ‘nothing at all takes place in the universe in
Optimal control; Precautionary saving; Ramsey which some mle of the maximum ... does not
model; Shadow pricing; Uncertainty appear’ (Weitzman , p. 18). The
application of this mathematics in dynamic eco- u'(c,) = fiRu'(ct+\)fort = 1,2,3 ... (2)
nomics, with its central focus on optimization and
equilibrium, is almost as universal. As in physics, This set of Euler equations consists of nonlinear
Euler equations in economics are derived from difference equations that characterize the evolution
optimization and describe dynamics, but in eco- of the control along any optimal path. We
nomics variables of interest are controlled by considered a one-period deviation; several period
forward-looking agents, so that future contingencies deviations can be considered, but they follow from
typically have a central role in the equations and sequences of one-period deviations and so doing so
thus in the dynamics of these variables. does not provide additional information
For general, formal derivations of Euler equa- ( u ' ( c t ) = j > 2 R 2 u { c t - 2 ) ) -
tions, see calculus of variations or dynamic pro- These equations imply that the optimizing agent
gramming. This article illustrates by means of equalizes the present-value marginal flow benefit
example the derivation of a discrete-time Euler from the control across periods.
equation and its interpretation. The article proceeds The canonical application of this problem is to a
to discuss issues of existence, necessity, sufficiency, household or representative agent: call c
dynamics systems, binding constraints and consumption, u utility, and let W \ = the
continuous-time. Finally, the article discusses present value of
uncertainty and the natural estimation framework (exogenous) income, y . In this case, Eq. ( ) imply
provided by the expectational Euler equation. the theoretical result that variations in income do
not cause consumption to rise or fall over time.
Instead, marginal utility grows or declines over time
The Euler Equation
as f l R I; for [ 1 R 1, consumption is constant.
Consider an infinitely-lived agent choosing a con-
trol variable (c) in each period ( l ) to maximize
an intertemporal objective: [ 1 ‘ '«(<:',) Existence, Necessity and Sufficiency
where In general, to ensure that the Euler equation char-
u ( c t ) represents the flow payoff in t , u ' > acterizes the optimal path, one typically requires
0, u " > 0, and [ 1 is the discount factor, 0 < [ 1 that the objective is finite (in this example, i / >
< 1. The agent faces a present-value budget 0) and that some feasible path exists.
constraint: Further, since Euler equations are first-order
conditions, they are necessary but not sufficient
OO
^<W i (1) conditions for an optimal dynamic path. Thus,
i=i theoretical results based only on Euler equations are
applicable to a range of models. On the other hand,
where R is the gross interest rate ( R 1 + r where the equations provide an incomplete char-
r is the interest rate) and W \ is given. acterization of equilibria. In the example, only by
By the theory of the optimum, if a time-path of using the budget constraint also can one solve for
the control is optimal, a marginal increase in the the time path of consumption; its level is deter-
control at any t , d c t , must have benefits mined by the present value of income.
equal to the cost of the decrease in t + 1 of the
same present value amount, R d c t \
Dynamic Analysis

P‘~1u'(c,)dc, — [i‘u'(c, | | )Rdc, 1 1 = 0. More generally, complete characterization of opti-

mal behaviour uses the Euler equation as one
Reorganization gives the Euler equations equation in a system of equations. For example,
replacing the budget constraint (Eq. ( )) with the The multiplier L, , has the interpretation of a
capital-accumulation equation shadow price. When the constraint does not bind,
l , , = 0, the interior version of the Euler equation
K,+i =f(kl)-c, + (l-8)kl (3) holds, and the marginal-benefit-marginal-cost
interpretation is straightforward. When the con-
where k is capital, f ( k ) is output, /' > 0, /" <
0,M = 0, lim,_ o./i > r - (1 - S ), straint binds, the interpretation still holds, but
1

andlim/t^ ^ /, < f j A — (1 — 5), and adding almost tautologically: the change in utility of an
the constraints k } given, k t > 0, and c t > 0, extra marginal unit of consumption in t is equal to
gives the basic Ramsey growth model. The constant the change in utility from the marginal decreases in
real interest rate of Eq. ( ) is replaced by the mar- consumption in / - I plus the shadow price (in terms
ginal product of capital in the resulting Euler of marginal utility) of marginally relaxing the
equation constraint on c, For example, if f i R = 1 and
y , = y V t 2 and y 2 = y < y ,
u'(ct) = /1(1 — 8 +f(kl+1))u'(ct+1). (4) then =0 Vt ^ 2 , X 3 = - u ' { y )
> 0,
Equations ( ) and ( ) form a system of two
v+R y
differential equations with two steady states that has and ci = ci =---------------, c t = y Vt > 3. This
been widely studied as a model of economic growth. 1+R J
Linearization shows that the interesting ( k > 0) example illustrates that, relative to the
steady state is locally saddlepoint stable, and there is unconstrained equilibrium (V, y /■ (T yj), the
a unique feasible convergence path that pins down constraint can postpone consumption (/ = 1, 2
the dynamic path of consumption and capital. relative to t > 3 ), create a causal link from an
increase in income to consumption (/ 2 to 3),
and can lower consumption in unconstrained
periods ( t = 1).

Binding Constraints Continuous Time

The above Euler equations are interior first-order In general, continuous-time models have differential
conditions. When the economic problem includes Euler equations that are equivalent to the difference-
additional constraints on choice, the resulting Euler equation versions of their discretetime counterparts.
equations have Lagrange multipliers. Consider In the example, replacing t + 1 with t +
adding a ‘liquidity constraint’ to our example: that A t , c,+At = c , + At, expanding u ( c t +
the household maintain positive assets in every Ac,) around c„ and letting A t > 0 gives:
period s :
Y^l=1 R1 ‘yt r1 c
‘ ‘ - 0 for a11 v-ln
- = <r,(r + 1 - P)
this case, the program is more easily solved in a C
t
recursive formulation. Equation ( ) holds with a
single Lagrange multiplier, A.,+1 > 0, on the con- where a t = ■ While the marginal-costs-
straint that assets are positive in t + 1 since prior marginal-benefit interpretation of the equation is
to t + 1 assets levels are unaffected by the choice less obvious in continuous time, it is still clear that
of e, and in period t + 1 the present value of future consumption rises or falls with the difference
consumption is unchanged by the one-period between the interest rate (r) and the discount rate
deviation considered: ( [ 1 1), and more obvious that the strength of
this response is governed by a t , which for this
u ' ( c ,) = f 5 R u ' { c , + 1 ) + A,/+1. reason is called the elasticity of intertemporal
substitution.
Generalized Euler Equations not time consistent due to hyperbolic discounting.
At any s , an agent has objective: _j
Dynamic games can also lead to ‘generalized’ Euler 8 ' u ( c
s + r ) , where 0 <
equations. For example, Harris and Laibson ( )
<5 < 1. Defining recursively W t + i
considers a modification of the
= R ( W , — c t ) , the generalized Euler
example as a game among agents at different times
equation is
who disagree because their preferences are

fdcl+i(Wl+i)\ f du+1(tF,+1)\ l dW,+x )+ \ dW,+x

it (ct) = R"Effectivediscount factor" u'(ct+1 ).
)

where c t + i ( W t + i ) is the optimal e x p e c t e d consumption growth that rises

consumption choice made in t + 1 as a function with the real interest rate and falls with impatience.
of W t + The effective discount rate is a function Additionally, for ( p t > 0, risk leads to
of the (endogenous) marginal propensity to precautionary saving: higher expected consumption
consume wealth in t + 1. growth (much like liquidity constraints). Finally,
actual consumption growth is also driven by the
realization of uncertainty about current and future
Uncertainty income.
Models that contain uncertainty lead to expecta-
tional Euler equations. Add to the discrete-time Testing and Estimation
example that the agent believes income y v for s >
Mo be stochastic from the perspective of period /. An expectational Euler equation is a powerful tool
The Euler equation becomes for testing and estimating economic models in large
samples, because, along with a model of
expectations, it provides orthogonality conditions
u’{Cl) = fRE[u\ct+x)\It} (5)
on which estimation can be based. Only
where E \ . \ / , } represents the agent’s randomization, as under experimental settings,
expectation given information set I t . The delivers such a clean basis for estimation without
stochastic version of the consumption Euler near-complete specification of an economic model,
equation has an analogous interpretation to that including the sources of uncertainty.
under certainty: the household equates Considering our main example, define 8 t + 1
e x p e c t e d (discounted) marginal utility over = u \ c t + 1 ) - ( / S R ) Vfe). Hall ( )
time. pointed out that Eq. ( ) implies that
Taking a second-order approximation to mar- E [ 8 , + \ z , \ I , \ = E \ s : ,
ginal utility in t - I around c t and re-organizing 1 1 11 , ] =0 for a n y z t in the agent’s
gives information set, I t . Under the assumption of
rational expectations, mathematical expectations
E c«+i — a , ( l - G BRy )1 can be used in place of the agent’s expectations.
h
c , Thus, this equation predicts that observed changes
Ct in discounted marginal utility are unpredictable
+ ^,E ( t+1
c

using I t , or that marginal utility is a martingale,

a strong theoretical prediction that Hall ( ) tests.
m
Hansen and Singleton ( ) use a version of the
where < p t = — is the coefficient of relative stochastic Euler equation with a portfolio choice as
prudence (see for example Dynan ). It is now the basis for estimation (and testing) of the
parameters of the representative agent’s parame- ►
terized utility function. ►
Following these papers (and others), large-
sample testing and estimation of Euler equations
under the assumption of rational expectations has
played a central role in the evaluation of dynamic
economic models. Most research applies the gen-
eralized method of moments (GMM) of Hansen (
) using the restrictions on the moments of
time series implied by the expectational Euler
equation. Considering a/x 1 vector of z/s, z t ,
Bibliography
and, based on our example, define the column
vector g(c,+1, c „ z t ) = ( j i R u ' ( c , Dynan, K. 1993. How prudent are consumers? Journal of
+ l ) - u ( c t ) ) z t , so that we have the J Political Economy 101: 1104—1113.
moment restrictions E [ g ( c , + i , c t , z,)] Gourinchas, P.O., and J.A. Parker. 2002. Consumption over
the hfe cycle. Econometrica 70: 47-89.
= O . / y i . For example, letting u ' (c , ) Hall, R.E. 1978. Stochastic implications of the life cycle-
= c ; [ l / a ) and assuming that second permanent income hypothesis: Theory and evidence.
moments exist and the model is covariance Journal of Political Economy 86: 971-987.
Hansen, L.P. 1982. Large sample properties of generalized
stationary, the time-series average of g(c,+j, c t ,
method of moments estimators. Econometrica 50: 1029-
z t ) should converge to £Tg(c,+1, c t , z,)] for the 1054.
true <r, [ j and R . The GMM estimates of <r, Hansen, L.P., and J.K. Singleton. 1983. Stochastic con-
[ j and R are those that minimize the difference sumption, risk aversion, and the temporal behavior of
asset returns. Journal of Political Economy 91: 249-265.
(according to a given metric) between the observed Harris, C., and D. Laibson. 2001. Synamic choices of
empirical moments and their theoretical hyperbolic consumers. Econometrica 69(4): 935-958.
counterparts, Q j , \ . Ramsey, F.P. 1928. A mathematical theory of saving. Eco-
This general approach has the advantage that nomic Journal 38: 543-559.
Tintner, G. 1937. Monopoly over time. Econometrica 5: 160-
complete specification of the model is not 170.
necessary'. In our example, the stochastic process Weitzman, M.L. 2003. Income, wealth and the maximum
for income need not be specified nor the stochastic principle. Cambridge, MA: Harvard University Press.
process for consumption determined (which can be
quite demanding in terms of computer programming
and run-time). That said, more complete specifica-
tion can give more theoretical restrictions and thus
more power in asymptotic estimation. Gourinchas
and Parker ( ), for example, uses numerical Euler's Theorem
methods to bring more theoretical structure to bear
Peter Newman
in estimation. Further, more complete specification
can allow one to use small-sample distribution the-
ory and thus avoid the approximations inherent in
using asymptotic distribution theory for inference in
finite samples. A recent cautionary example is pro- Keywords
vided by the literature showing that standard Adding-up problem; Calculus of variations;
asymptotic inference can be highly misleading in Euler equations; Euler’s Theorem; Homoge-
large samples with ‘weak instruments’. neous functions; Lagrange multipliers

See Also JEL Classifications

C6
► Bayesian Methods in Macroeconometrics
Euler’s Theorem on homogeneous functions is one economics, Euler’s Theorem is a standard tool with
of those useful pieces of multivariable calculus that innumerable applications. So it is slightly odd that
has tended not to receive the attention in what was apparently its first use occurred so late,
mathematical textbooks that its importance in eco- and that it was not by an established mathematical
nomic theory warrants. An analogous case is economist. In his review of Wicksteed ( ),
Lagrange multipliers, though there the analysis in A.W. Flux ( ) pointed out
most textbooks falls far short of the rigour and that Wicksteed could have saved himself a great
depth that are needed for fruitful economic appli- deal of trouble if he had simply cited Euler’s
cations, as it often does of Euler’s other discovery Theorem instead of, in essence, proving it all over
of direct importance in economics, the so-called again. It was indeed in the controversy over the so-
Euler equations in the calculus of variations (for a called adding-up problem in the theory of
critical discussion, see Young ). With Euler’s distribution that Euler’s Theorem first gained
Theorem there are no such worries, however, and notoriety. For details of the adding- up problem, see
the discussion in a work like that of Courant ( , vol. Steedman ( ); here only a few of the main
2, pp. 108—10) is quite adequate. points will be lightly sketched in.
Once the necessary notation and terminology is Assume that the firm wishes to minimize the
established, the statement of the theorem follows cost of producing a scalar output s by the use of
easily. Given any real number k , let F be a real- factors xi, x2, . . . , x„ = x bought at competitive
valued function defined on some non-empty subset prices / > ] . p 2 , . . . . p „ p .
1
S of vectors .r c A ".Then F is said to be homogeneous of Under standard assumptions the first order
degree k (h.d.k.) if the equation conditions for this minimization yield

F(tx) = f F { x ) (1) Pi = (3)

holds for every x C S and every real number /. where i = 1, 2, ... , n and X is the associated
Let/be a differentiable function defined on a
Lagrange multiplier. This multiplier is of course the
non-empty open subset G c R n , and denote the marginal cost of output, a fact which can be guessed
gradient off at x, that is, the ^-dimensional vector of its
at from ( ) on purely dimensional grounds alone.
Assume now that the production function f where
partial derivatives f evaluated at x, by V/(x). The
inner product of any two vectors a and b is q = f i x ) , is homogeneous of some
written ( a f i ) . unknown degree k .
Then, substituting from ( ) into ( ) and
Euler’s Theorem The differentiable function / is remembering the meaning of V/(x),
homogeneous of degree k if and only if the fol-
lowing Euler relation holds for every x e G , X~1(x,p) = kf(x). (4)

If there is competition in the product market as

<x,V/(x)) = kf(x) (2)
well, that is, free entry, then in long-run equilibrium
For a proof, see Courant ( ). Notice that this marginal cost will equal the price q of the product,
theorem c h a r a c t e r i z e s homogeneous so that ( ) becomes
functions, that is, any function satisfying ( ) for all x
must satisfy ( ), hence be h . d . k . A simple but (x,p) = kqf(x). (5)
often useful corollary of the theorem is that, if f is The left-hand side of ( ) is total factor payments.
r - times differentiable and m < r , then If constant returns prevail/is h . d . 1 and so k -
each of its partial derivatives of order m is 1. All is well, since the right-hand side is then total
homogeneous of degree k m , so that each/ is revenue, equal to the sum of factor payments. If on
h . d . ( k — 1), each/ the other hand k < 1, so that returns to scale
is h . d . f k — 2), and so on. Since
homogeneous functions crop up almost everywhere
in
are decreasing, ( ) shows that there will be some- impact of the euro on member economies. While
thing left over after all the purchased inputs have European financial markets and trade are far
been paid. more integrated than before adoption of the
What this residual really means is not clear. euro, that is the result of broader international
Some writers have interpreted it to be the returns trends. Factors inhibiting growth in the
(rent) to some non-marketed factor internal to the eurozone’s real economy prevent truly deep
firm. But in that case why isn’t the factor sold by its financial integration as well, despite the removal
owner to the firm (after all, we are in long-run of currency risk. The euro has delivered price
equilibrium, so that quasi-rents do not apply)? Or is stability and credible monetary policy, but not
there no external market for the factor? induced the convergence and reform necessary
This is not the place to go into such qsts, but it to improve European economic performance.
may be suggested that the incompleteness resides
more in the theory than in either the markets or the
factor payments. If k > 1 there are increasing Keywords
returns to scale, and ( ) then suggests that there will Currency unions; Euro; European Central Bank;
not be enough revenue to meet total factor European Monetary Union; Eurozone; Exchange
payments. But with increasing returns the hypoth- Rate Mechanism (EU); Exchange rate
esis of perfect competition in the product market uncertainty; Financial market integration;
has to be abandoned, so the passage from ( ) to ( ) is Inflation; Inflationary expectations; International
illegitimate and ( ) does not hold. capital flows; Money market integration;
Portfolio investment; Stability and Growth Pact
(EU)
Bibliography

Courant, R. 1936. Differential and integral calculus. 2 vols. JEL Classification

London: Blackie & Son. F
Flux, A.W. 1894. Review of Wicksteed (1894). Economic
Journal 4: 305-308.
The launch of the euro, the European Union’s
Steedman, I. 1987. Adding-up problem. In The new Pal-
currency (at least for 12 of the 27 current members),
grave: A dictionary of economics, ed. J. Eatwell, M.
on 1 January 1999, was a birth long foretold. From
Milgate, and P. Newman, vol. 1. London: Macmillan.
Wicksteed, P.H. 1894. An essay on the co-ordination of the
at least the 1992 Maastricht Treaty onwards, its
laws of distribution. London: Macmillan.
creation was at the forefront of the European overall
Young, L.C. 1969. Lectures on the calculus of variations and
integration agenda, and the meeting of criteria for
optimal control theory. Philadelphia: W.B. Saunders Co..
eurozone entry dominated macroeconomic
policymaking in Western Europe. The academic
and policy discussion of European Monetary
Union’s (EMU) potential advantages and
disadvantages began even earlier (see Canzoneri et
al. ; De Cecco and Giovannini ; De Grauwe ;
Euro Cecchini ; as well as the seminal European
Commission . Most of these studies concerned how
Adam S. Posen
best to make EMU work, taking the goal as a given,
or assessing the optimality of the EU as a currency
area.) New international reserve currencies, as the
euro has begun to be, do not come along every day,
Abstract or even every century. New currencies in general
The eiuo has been a limited success at home, but are launched usually out of
it has not challenged the dollar as a global
reserve currency. This reflects the limited
Euro, Fig. 1 Dollar-euro exchange rate and real GDP growth differential, 1999-2006 (Source: IMF, IFS Statistics)

need, due to replacement of a currency of Giavazzi and Spaventa ; and Weber See also the
hyperinflation-eroded value or to political frag- essays by eurosceptics in the face of mounting
mentation or secession; when currency unions are contrary evidence collected in C a t o
formed, they are usually done as pegs to a J o u r n a l .) Only as the euro passed its eighth
previously existing anchor currency of the largest birthday in wide usage, remained well past parity
and/or most stable member economy. The voluntary with the US dollar (see Fig. ) and experienced a
adoption of the euro by sovereign but not politically strong cyclical recovery in the eurozone has senti-
unified nations, and its replacement of already ment changed. Increasingly, the question is being
stable currencies (notably the Deutschmark), is thus raised whether the euro might appreciate against the
an extraordinary monetary experiment and policy dollar for an extended period, be the beneficiary of
undertaking. substantial international portfolio adjustments, or
While the euro certainly has had no shortage of even begin to supplant the dollar as the dominant
champions among economists - including beyond global reserve currency. (Recent examples include
Euroland’s borders the economists Bergsten ( ), Chinn and Frankel ( , ); Obstfeld and
Eichengreen ( ), Mundell ( ), and Rogoff ; and Summers .) The euro’s viability in its
Portes and Alogoskoufis ( ) - many monetary own large economic area may not be sufficient to
economists observing the euro have tended to be set it on a path to monetary leadership, but its
sceptical: first of the virtues of the goal of monetary existence now presents an alternative for capital
integration in Europe itself, then of the project’s markets to turn to should the dollar’s own appeal
political viability, and then of its economic sustain- diminish.
ability, in turn asserting that the euro was a solely The waiting for US missteps for the euro to rise
political project. (Notable examples of this scepti- in importance, however, is a critical commentary on
cism include, on the political side, Currie et al. ; the limitations of the euro’s importance to the
Walters ; and, famously, Feldstein ; and on the eurozone member economies’ performance in and
economic side Arestis and Sawyer ; De Grauwe ; of itself. When the euro was first proposed, a
Dombusch ; number of studies claimed that monetary
integration would bring significant direct benefits to The External Opportunities
the economic performance of member states. and Shortfalls for the Euro
Emerson et al. ( ) estimated that the elimina
tion of transaction costs from moving to a single The degree to which the euro comes into wider
European currency would yield direct benefits of up usage beyond intra-eurozone transactions, for exam-
to 0.4 % of EU GDP; the European Commission ( ple as an invoicing currency in world trade, is a
) estimated cost savings of 1.0 % of major issue because of the eurozone’s already large
GDP simply from eliminating transaction costs. The share of world output and trade (roughly
European Commission ( ) made the case comparable to that of the United States) and of the
that the reduction of nominal and real exchange rate established ‘domestic’ monetary stability of the
eurozone. Size does matter for international E
uncertainty would lead to significant growth in
intra-EU trade and investment. Financial markets in currency purposes. Yet insufficient integration and
particular were expected to benefit from the depth of European financial markets as well as
introduction of the euro - McCauley and White ( lagging economic performance remain constraints
) and the European Commission on the euro’s wider adoption and usage. Also
( ) forecast a rapid deepening and liquidity important is the lack of coherent institutional
increase in European bond and lending markets, and representation for the eurozone in international
perhaps even a ‘decoupling’ of European interest monetary forums. Compared with the EU’s one
rates from those of the United States. voice in global trade negotiations, tiie inability of
While empirical investigations to date of these the eurozone to speak as a single entity is striking,
effects remain mixed in interpretation, there is no especially given the unconsolidated
question that the real economic effects of the euro’s overrepresentation of the eurozone in the Bretton
launch on the eurozone member countries have Woods institutions.
been something of a disappointment. In particular, History also plays a role, however, in the global
European financial markets and trade integration are demand for currencies and their strength. Inertia and
far deeper today than they were before the adoption incumbency clearly contributed to the lingering of
of the euro, yet how much this represents the effect the British pound in a significant share of
of the euro on EU integration as opposed to the international reserves well after the Second World
broader international trends towards global War. Yet the combination of macro- economic
integraton that benefited non-euro members as well mismanagement and growth underperformance in
is in doubt (see Forbes ; Lane and Walti ; Mann and the United Kingdom from the 1920s to the 1980s
Meade ; and Rey ). The eurozone’s interest rates eroded that role, and it is worth remembering that
remain asymmetrically affected by US interest the passing of international monetary leadership
rates, at least through the early 2000s, as established from the pound to the dollar in the mid-twentieth
by Chinn and Frankel ( ). The century was in large part driven by these factors
effect of the euro on price convergence and on undermining the pound’s reserve status. The steady
macroeconomic discipline cannot be all that sub- accumulation of international debt by the United
stantial if on net there has been limited visible States since 1991 could contribute to a similar
improvement in either of these areas (see the switch now that the euro is available. An extended
assessments of price convergence in Bradford and dollar depreciation, the natural reaction to a multi-
Lawrence (2003, ); and Rogers year series of widening US current account deficits,
and of macroeconomic discipline in Posen ( , ). It could induce a persistent portfolio diversification
seems that the euro has proven on into euros by private and official holders of dollars.
net ‘irrelevant’ to real growth performance of large In Washington, Frankfurt and Bmssels, how-
Continental European economies, neither a harm ever, the widespread governmental opinion remains
nor a boon to them, as Posen ( ) forecast that the euro will not close the gap in usage with the
it would be. dollar until the eurozone closes the gap with the US
economy in per capita GDP
growth and employment on a sustained basis (Fig. eurozone occurred between 1990 and 1994, in
shows the growth differential of the USA over the response to the creation of the single market, and
eurozone). In a typical official expression of this not after 1999 and the introduction of the euro. As
sentiment, Quarles ( , 40) finds that for the global dimension, there has been tittle
‘too much attention is being focused on exchange change in the share of foreign exchange transac-
rate[s]... and too little on what seems... of far greater tions denominated in euros globally from that pre-
importance: namely, the more effective functioning viously denominated in Deutschmarks. Similarly,
of economies with regards to growth in output and the use of the euro as an invoicing currency is
employment’. Successive US governments have somewhat higher than that for the eurozone home
viewed both the short-term international adjustment currencies prior to EMU, but remains far from
process and the longer-term role of the euro vis-a- universal within Europe or even comparable to the
vis the dollar as driven by the gap in growth rates dollar’s usage (with the regional exception of some
between the USA and Europe - with the burden on of the newest members of the European Union).
European economies to catch up by raising their Even the spreading use of the euro in the EU’s
growth rates. EU officials’ disappointment with the new members in the east has been far less than
degree of structural reforms catalysed by the many might have expected. A critical part of this
introduction of the euro echoes this view, as does outcome has been the insistence on the part of the
the promotion of the Lisbon Agenda announced in European Central Bank (ECB) that all prospective
March 2000 for promotion of growth in the EU. eurozone members go through the lull Maastricht
Such an external relative focus overlooks one Treaty-specified process for qualification, including
achievement of the launching of the euro - ending not just fiscal discipline and nominal convergence
the succession of devaluations, competitive depre- but also a two-year period in the ‘waiting room’ of
ciations and currency crises that had beset the a new ERM-II mechanism. Early, expedited or
members of the Exchange Rate Mechanism (ERM) unilateral adoption of the euro in EU member
prior to 1999. Certainly, the experiences of intra- countries has in fact been discouraged by the ECB
European depreciations upon counties leaving the (with the exception of Estonia’s pre-existing
ERM, especially those of 1992-3, and their impact currency board with the euro). Arguably, this has as
on economic performance and political outcomes in much to do with the ECB’s desire for perceived
member states were in the forefront of European control over monetary developments, given the
policymakers’ minds when the run-up to the euro ECB’s Bundesbank-esque ‘two pillar’ strategy (of
was under way in the late 1990s. And, despite the looking at both monetary growth and inflation goals
divergence in histories of some eurozone members, when setting policy), and for keeping decision-
inflation and inflation expectations have remained making in the ESCB manageable, as with
stable and low in the eurozone. That could have maintaining necessary discipline on eurozone
been expected to assist in trade promotion among members (see European Central Bank). The ECB
the already interdependent eurozone economies (see has also been explicitly opposed to ‘euroization’
currency unions). (dollarization with euros) by non-EU member
Still there has been little or no expansion in countries, again partly for monetary control rea-
trade as aresult ofthe adoption ofthe euro - among sons, albeit acknowledging its contribution to
other evidence, the share of total eurozone exports stability in the post-conflict Balkan economies.
destined for other members of the eurozone did not
increase with the introduction of the currency, as
would have been likely if the common currency had The Limited Impact of the Euro on the
promoted trade (Baldwin provides an excellent Eurozone Financial Integration and
analytical summary of the evidence on this score). Performance
As shown in Rogers ( ), the bulk of
convergence in traded-goods prices within the
initial decline against the dollar, only to rebound despite the removal of currency risk. Thus, there
strongly since Autumn 2001 (see Fig. ). Europe has remains a striking contrast between the repo
failed to follow the creation of the euro with the (repurchase of safe assets at central banks) and
complementary policy reforms that were widely unsecured market in the degree of cross-national
expected, however. This leaves an underlying ten- differences in interest rates due to die ongoing lack
sion between the constraints on national economic of harmonization in legal and procedural treatment
policy measures such as those in the Stability and of financial instruments in the eurozone countries.
Growth Pact on fiscal policy (see stability and The costs of making cross-border securities trans-
growth pact) and the national frustrations with poor fers within the eurozone can still be ten times more
economic performance - a tension that raises than the cost of securities transfers within a given
E
recurrent doubts in eurosceptic financial markets eurozone country.
about the sustainability of the euro itself, despite its Given the surge in capital flows across borders
lack of obvious vulnerabilities or viable exit options worldwide, following the recovery from the 1997-
for any member country. 98 Asian financial crisis, almost half of which were
The euro was widely expected to transform two in the form of portfolio investment, one would
aspects of the eurozone economies: the integration expect greater influence of market opinion about
and depth of their financial markets, and the assets in a given currency or region upon the actual
conduct of their macroeconomic policies. Par- allocation of capital between regions. It seems that
ticularly with regard to the former, there has been prospects for economic growth drive the relative
beneficial change at least partly attributable to the demand for a region’s assets, mostly by determining
euro’s introduction and acceptance. Money market where trade and investment expands, which then in
integration, which is critical to the implementation turn sets the pace of stock market integration of that
of a single monetary policy for the eurozone, given region with the rest of the world. Given the
the need to transmit monetary policy in a medium-term outlook for European growth, this
decentralized fashion across the member appears to militate against an increase in investment
economies, has succeeded. It took European money and therefore in integration (and influence) of
markets less than a month in 1999 to Team’ how the European capital markets, which might be partially
new operational framework functioned, and to offset by some diversification incentives. In the
eliminate most of the volatility and cross-border long mn, though, a slow growth rate in Europe
dispersion in overnight interest rates. The evidence would also translate into a smaller share of global
of integration in the unsecured lending rates in the GDP, and less incentive for central banks to hold
European money market is similarly clear. Rey ( euro-denominated reserves. In this context, Forbes (
) finds that government bond ) and Lane and Walti ( )
markets have seen intra-eurozone interest rate independently investigate whether the euro’s launch
spreads virtually disappear, and benchmark secu- prompted greater co-movement of stock prices
rities of different countries have begun to emerge. within the eurozone across national borders,
Corporate bond markets went from ‘almost non- indicating greater financial integration as a result of
existent’ prior to EMU to 150 billion euro of EMU. Both investigations find that stock market
issuance in 2003, and the euro swap market has correlations of eurozone member markets with the
become the largest financial market in the world. United States increased after the introduction of the
Eurozone financial markets, however, still have euro more than those between the eurozone
a long way to go to become a global competitor countries.
with those based in London or New York. Factors
in the non-financial economy, such as legal differ-
ences, obstacles to more rapid real growth, trans- Prospects for the Euro
action costs, and institutional gaps in financial
supervision combine to keep the eurozone from
achieving truly deep, integrated financial markets,
functions it has been a resounding success, with no outside its borders. The euro, however, is not
problems in acceptance at home or abroad, or in the judged solely on its own merits, either by markets
payments system, and there has been convergence or by the international community, but rather is
in key eurozone money market interest rates. There judged also in relative terms against developments
has also been evidence of stable low-inflation in the dollar zone and elsewhere.
expectations for the varied eurozone membership as
a whole, which remains an outstanding achievement
of European central banking. None of the broader
See Also
forecasts of economic doom or internal political
conflict predicted by (mostly American) Chicken ► Currency Unions
Littles came to pass, and those predictions look less ► European ( ink
credible than they ever did. European financial ► luropean Mom my on
markets have significantly deepened and added ► stability and Gro vthPact
liquidity since the advent of the euro, particularly
for fixed-income securities. The sheer size of the
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Sovereign debt
 JEL Classifications less of its banking assets), in early 2010 financial
E60 markets reacted strongly to the prospect of a sov-
ereign insolvency. A first consequence of the real-
Introduction ization that Greece would not be solvent without
external financial support was that investors started
The euro zone crisis started in early 2010 when it to price more widely government solvency in the
emerged that the Greek government had for years bond market. As a result, the risk premia on the debt
doctored the official data on its deficits and debt. of other countries with weak fundamentals also
The figures for the deficit and debt level presented rose. But more important was a generalized increase
by the new government were so much higher than in risk aversion, which led to a fall in the prices of
the previous ones that rating agencies and many all risky assets in a similar vein (but of course a
market participants downgraded their assessment of much less severe magnitude) as after the collapse of
Greece’s ability to service its debt fully. As a result, Lehman Brothers in late 2008.
the cost of refinancing the Greek debt increased The European banking sector was particularly
sharply and the government could not secure the affected because it was widely believed that a
resources needed to fund its current deficit and roll number of banks would not survive a default by
over the portion of the debt coming due. By the end Greece. However, which banks held how much of
of April 2010 it had to be bailed out with a €110 Greek debt was not known. In an environment of
billion programme. widespread risk aversion and many highly lever-
The second stage of the crisis came about six aged banks this resulted in a drying up of parts of
months later when it emerged that the Irish govern- the interbank market, which performs a vital role in
ment had been 'misled' about the scale of the losses the financial system.
in its banks. As the Irish government had The German government reiterated on several
guaranteed all the liabilities of its banks it was now occasions its aversion to a bailout, stressing that this
itself on the brink of insolvency. Moreover must be only an u l t i m a r a t i o
(although this was not made public at the time), the mechanism. But when faced with the spectre of a
ECB had become uncomfortable with the huge ‘second Lehman crisis’ and the prospect of large
exposure it had to Irish banks, which had become losses in the weak German banks heavily exposed
totally dependent on central bank financing. The to Greece and other peripheral countries, it had no
ECB therefore pushed the Irish government to choice but agree to a rescue package of about hi 10
recapitalize its banks, but this could be done only billion. This is an EU/IMF rescue package
with outside help. The Irish government had thus according to which the IMF provides support under
little choice but to apply for external financial a three- year €30 billion standby arrangement (the
support. IMF’s standard lending instrument) while euro area
With the Greek and Irish bailouts, the euro zone members pledge a total of €80 billion in bilateral
has shown the world two pure specimens of finan- loans against the implementation of strict austerity
cial crisis: one originated by the mismanagement of measures monitored by the IMF. The sum agreed is
fiscal policy (Greece), the other by mismanagement supposed to fiilly finance Greece’s remaining
of a credit bubble and banking supervision deficits (and rollover obligations) during the fol-
(Ireland). The Portuguese crisis, which emerged in lowing three years. It was assumed then (on the
early 2011, seems to represent a hybrid specimen: a basis of experience with ‘normal’ IMF programs)
combination of a fiscal crisis (like Greece) and a that Greece would be able to access private capital
private debt crisis (like Ireland). markets at reasonable rates towards the end of this
period. However, in early 2011 it became clear that
A Brief Chronology the hypothesis was far too optimistic. In March the
terms and the conditions of the loans to Greece
Although Greece accounts for a small portion (less were reviewed to include an extension of the
than 3%) of the euro area GDP (and even maturity and lower interest rates.
 In the spring of 2010, Europe’s leaders also market. More generally, the publication of the stress
thought that Greece was a unique and special case tests was supposed to prove that the most important
and that no other country would ever need financial banks had sufficient capital to withstand even a so-
support. However, only a few days after the Greek called ‘adverse’ scenario. This should have
rescue, financial markets went into such a tailspin improved confidence in the banking system in
(risk premia rose, some markets ceased to function) general.
that a new and much larger financing mechanism Yet the objective of the exercise was achieved
had to be hastily created. only temporarily. During the summer of 2010 risk
During the dramatic weekend of 9 May 2010, premia on the government bonds of the four
two financing mechanisms were set up in order to ‘fiscally challenged’ countries (Portugal, Ireland,
E
allow the authorities to react to future financial Greece and Spain) started to increase again. This
crises in a more coordinated and organized manner. accelerated after a Franco-German agreement in
The headline figure of the total potential funding Deauville on economic governance and the decision
was €750 billion, to be provided by three different by the European Council of 28 October to establish
entities: €60 billion, guaranteed by the EU budget, a permanent crisis mechanism to safeguard the
coming through a newly created European Financial financial stability of the euro area. This decision
Stabilization Mechanism (EFSM); €440 billion, proved to be a watershed because it suggested a
guaranteed on a pro rata basis by euro area member change in the ground rules of peripheral euro area
states, coming through the also newly created debt markets: on that occasion all 27 Member
European Financial Stability Facility (EFSF); and States agreed on the proposal (then submitted to the
up to €250 billion from the IMF. European Council and implemented in early 2011)
Together with the ECB interventions in the euro for a limited, technical Treaty amendment to
area public and private debt securities markets provide a legal basis for establishing a permanent
(Seciuities Markets Programme) aiming at ensuring crisis mechanism. In March 2011, the European
liquidity in those market segments judged to be Council adopted the basic features of the new
‘dysfunctional’, this package did restore stability in device: the European Stability Mechanism (ESM).
the financial markets for a few weeks. The ESM, which will be operational as of mid-
In early June 2010, since tensions in the 2013, is based on the existing EFSF but, unlike the
interbank market persisted, member states and the EFSF, the provision of liquidity is conditional to a
European Institutions (Commission and Committee debt sustainability assessment (conducted by the
of European Banking Supervisors, CEBS) agreed to European Commission and the IMF, in liaison with
make public for the first time the results of ongoing the ECB). In the event that the analysis reveals that
stress tests for major European banks. a member state is insolvent, the country is expected
The rationale for the tests was to disclose infor- to negotiate a comprehensive plan with its private
mation about the state of the European banking creditors. Moreover collective action clauses
system in order to dissipate doubts about then (CACs) will be included in the terms and conditions
resilience. The Spanish supervisory authorities were of all new euro area sovereign bonds, starting in
particularly keen on this move because they hoped June 2013. These clauses should provide the legal
that by showing that their banks were ‘safe and basis for the negotiation process with creditors and
sound’, it would be easier for Spanish banks to enable them to pass by qualified majority a decision
regain access to the interbank agreeing a legally binding change to the terms of
payment. This could take different forms (standstill,
extension of maturity,

See, among others, Veron ( ) and Blundell-Wignall

and Slovik ( ).
interest-rate cut and/or haircut) depending on the allay concerns about the sustainability' of Irish debt
specific case, but clearly implies that if losses because the interest charged (close to 6%) on the
materialize they will be borne, at least partially, by EFSF loans is much higher than the growth rate
the private sector. Ireland could hope to achieve.
Financial markets did not welcome this The brief review of the chronology of the crisis
approach, and Ireland became the first victim of shows that Greece was just a trigger and the euro
deteriorating market conditions. Indeed, market zone crisis is in fact a complex tangle of sovereign
pressures on Ireland had started mounting in debt and banking crises.
October 2010, when the Irish government decided The Irish experience has shown that even a
to rescue some of its banks that had published government with a strong fiscal position (budget
losses that were considerably higher than estimated surplus during boom and low initial debt level) can
a few months earlier. The high costs of this bank become insolvent in the attempt to save insolvent
bailout program resulted in a deficit of 32% of banks. The sequence of events in Ireland is
GDP, and the risk premia on Irish government (and archetypal: a property bubble ending with a bust
bank) bonds shot up. As a consequence the Irish leaves a massive housing overhang. This leads to
government quickly had to ask for external support. huge losses in banks which had fuelled the bubble
On 28 November, an h85bn financial assistance with excessive lending. As often happens, the local
package was agreed and Ireland committed to a regulators pretend that there is no problem; but as
sweeping restructuring of its banking system and the losses mount investors pull the plug and the risk
even more sweeping budget cuts. According to the of collapse of the entire system increases. This is
rescue plan, the EU provides financial assistance for what happened during the late summer of 2010: as
€45bn, through the European Financial Stability banks were shut out of the interbank market and
Mechanism and the European Financial Stability depositors started to withdraw their funds, the Irish
Fund, together with bilateral loans from the UK government decided to stand behind the banks and
(€3.8bn), Sweden (€0.6bn) and Denmark (€0.4bn). put the entire nation at risk, transforming a banking
The IMF provides h22.5bn and the Irish sovereign crisis into the second sovereign debt crisis in the
€17.5bn through the Treasury cash buffer and euro zone. A third case of crisis has emerged in
investments of the National Pension Reserve Fund. early 2011. Portugal has not experienced a bubble
It was also agreed that more than one third of the as Ireland, neither its fiscal stance is as bad as the
total package (35bn) was to be destined to Greek one, but the overall financial position of the
recapitalization measures in support of the banking country is extremely weak. Both private and public
system. sectors have been accumulating excessive levels of
After some hesitation, the Irish parliament did foreign debt, which international investors are not
ratify the bailout agreement, but the government willing to finance at sustainable rates and hence
fell, new elections were set for 25 February 2011 increasing dramatically the probability of another
and resulted in the victory of the opposition who bail-out.
had promised to renegotiate the agreement.
The Irish bailout (as that of Greece) did not have The Sequence of the European Council
an immediate impact on risk premia and interest and Euro Group Statements in Response
rates did not fall (nor for other countries). If to the Crisis
anything, the Irish crisis had two major conse-
quences. First it discredited completely the results
of the banks' stress tests, as in July 2010 only six • 16 February 2010: The Council focuses
small banks had not passed the test and Allied Irish on the simation regarding government
Bank and Bank of Ireland, the two largest Irish deficit and debt in Greece, adopting:
banks, both passed the test (Anglo Irish Bank was (continued)
not included in the tests). Second, it did not
 - an opinion on an update by Greece of http ://www. consilium, europa. eu/uedocs/
its stability programme, which sets out ems_data/docs/pressdata/en/ec/l 17496.pdf
plans for reducing its government 28/29 October: The European Council
deficit below 3% of gross domestic agrees on the need to set up a permanent
product by 2012; crisis mechanism to safeguard the finan-
- a decision giving notice to Greece to cial stability of the euro area as a whole.
correct its excessive deficit by 2012, Eurogroup Ministers agree that the Euro-
setting out budgetary consolidation pean Stability Mechanism (ESM) will be
measures according to a specific time- based on the European Financial Stability
E
table, including deadlines for reporting Facility, capable of providing financial
on measures taken; assistance packages to euro area Member
- a recommendation to Greece to bring States under strict conditionality
its economic policies into line with the functioning according to the mles of the
EU’s broad economic policy current EFSF. Two further elements are
guidelines. key here:
http://www.consilium.europa.eu/uedocs/ - First, support will be available only on
cms_data/ docs/pressdata/ en/ ecofin/112 the basis of ‘a rigorous debt
912.pdf sustainability analysis conducted by
• 2 May: Eurozone finance ministers agreed the European Commission and the
upon a rescue package for Greece IMF’.
amounting to €110 billion: €80 billion in - Second, ‘an ESM loan will enjoy pre-
bilateral loans over three years and h30 ferred creditor status’.
billion coming from the International http ://www.consilium. europa. eu/uedocs/
Monetary Fund. cms_data/docs/pressdata/en/ecofin/l 180
• 9/10 May: The Council and the member 50.pdf
states decide on a comprehensive package 28 November: (Euro-group
of measures to preserve financial stability statement on the Irish rescue
in Europe, including a European Financial package) Ministers unanimously agreed
Stabilization Mechanism, with a total to grant financial assistance in response to
volume of up to €500 billion from euro the Irish authorities’ request on 22
area countries and European institutions November 2010. Ministers concur with the
and the IMF commitment to provide Commission and the ECB that providing a
funding up to EUR 250 billion. loan to Ireland is warranted to safeguard
http ://www.consilium.europa.eu/uedocs/ financial stability in the euro area and the
cms_data/docs/pressdata/en/ecofin/l EU as a whole. The total size of the
14324. pd / package is h85 billion, one-third of it
• 29 October 29: The European Council coming from the IMF.
endorses the report of the Task Force on http ://www. consilium, europa. eu/uedoes/
economic governance. The report also sets cms_data/docs/pressdata/en/ecofin/l 180
out the guiding principles for a robust 51 .pdf
framework for crisis management and 16 December: The Council agreed on
stronger institutions; this includes the the text of a limited amendment to the
involvement of the private sector in the Treaty on the establishment of a future
crisis mechanism. permanent mechanism to safeguard the
(continued) financial stability of the euro area. This
(continued)
 fragile because of the high level of leverage
amendment should enter into force on 1 accumulated over the credit boom.
January 2013. Heads of state reiterated Excessive leverage is an essential ingredient in
their commitment to reach agreement on any major financial crisis and this case is no
the legislative proposals on economic exception. In financial markets, leverage is defined
governance by the end of June 2011, as the ratio of debt to equity financing; when this
with the aim of strengthening the eco- ratio increases in general the capacity of a firm to
nomic pillar of the EMU. absorb losses declines and hence its fragility is
• 24/25 March: The Council endorses the boosted. In macroeconomic terms, leverage is better
features of the EMS decided by the euro defined as the ratio of debt to GDP and the concept
area Heads of State or Government and can be applied to all the sectors of the economy.
takes necessary steps to ensure that the Leverage defined this way increases when credit
effective lending capacity of the EMS is expands without a consistent adjustment in GDP.
of EUR440bn. Since regular cash flows are proportional to GDP,
http://www.consilium.europa.eu/uedocs/ this implies that many agents have issued promises
cms_data/docs/pressdata/ en/ ec/120296. to pay a certain nominal amount but do not
pdf necessarily have the ‘expected’ regular cash flow to
honour these promises (see Minsky ( ) for the
classical
description of leverage schemes leading systems
towards instability). It is not possible to establish an
The Root Causes of the Crisis: Leverage absolute benchmark for leverage, as different
and Bubbles financial systems can support quite different ratios
of credit to GDP. However, rapid and persistent
The euro zone crisis is certainly not the result of a increases in this ratio constitute alarm signals which
single cause but the outcome of a combination of have been identified as reliable predictors of
several factors and dynamics of macroeconomic, financial crisis. These signals were clearly blinking
regulatory and institutional nature. These include before 2007, but they were ignored. Table shows
irresponsible behaviour by several euro zone that over the last decade euro zone private debt
governments, the steady deterioration in peripheral relative to GDP increased by about 100 percentage
EMU Member States of macroeconomic points, more than it did in the USA. In addition, and
fundamentals to levels inconsistent with longterm unlike the USA, the increase took place in the
EMU participation, failures in financial market financial system, whose fragility became apparent
regulation at global level, shift in markets’ first in 2008 and then again in May 2010.
expectations induced by the financial crisis of 2007- The question is why and how this could actually
08 and finally, also, defects in the institutional have happened.
organization of the European Monetary Union.
All these factors are likely to have played a role
in originating the crisis, but even together they are
still insufficient to account for its systemic nature.
This feature can only emerge from the vulnerability 3
We leave aside the question of why the build-up of the credit
of the highly integrated European financial system. boom was ignored. Inflation targeting by central banks was
Had the Greek and Irish crises occurred when euro probably one key reason. According to Borio and Lowe (
zone banks were strong and/or not very ), a low-inflation environment increases
the likelihood that excess demand pressures show up in the
interconnected, the euro zone crisis would not have
form of credit growth and asset prices bubble rather than in
happened. But the European financial system was goods price inflation. If this is the case, inflation-targeting
(and still is) central banks with a ‘myopic behaviour’ could contribute to
financial instability (de Grauwe ; de Grauwe and Gros 10C ).
Euro area Non-ftnancial corporations Financial corporations General government Households
1999 67 66 74 49
2007 93 111 69 62
2010 102 127 87 65
US
1999 63 76 51 67
2007 74 113 51 96
2010 75 101 76 92
Financial corporations Non-ftnancial sector Households and non-financial corporations
Debt-to-GDP 2000 2007 2000 2007 2000 2007
Greece 132 162 175 219 55 105
Ireland* 450 1142 181 294 151 210
Spain 164 310 187 255 122 214
Germany Note: For273
the euro area 293 200 as sum of196
debt is computed 139
loans and securities other than shares,130
excluding financial derivatives E
(only loans in the case of HH). This definition broadly corresponds to the definition of the outstanding debt used in the US
flow of funds

Euro Zone Crisis 2010, Table 2 Leverage for euro zone selected countries and sector break-down (Source: Eurostat and
authors’ calculations)

Note: Debt is computed as sum of loans and securities other than shares, excluding financial derivatives, only loans in the case
of households and including also deposits in the case of financial corporations Non financial sector includes households, non
financial corporations and government *Data for 2000 are not available, those shown refer to 2001

Excess leverage in the banking sector was possible and magnified the availability of credit
probably encouraged by scant financial regulation, through leverage by generating a tight network of
but it would be too easy to blame car accidents for intra-sector exposures.
the absence of speed limits (despite speed limits Table shows the level of leverage and the break
helping to reduce accidents) or police control. The down by sector in the euro zone countries
main driver of growing leverage was of an embedding the most extreme conditions. Data
economic nature and tightly linked to large capital suggest that while leverage barely changed in
flows flying from core euro zone countries into the Germany over the prior decade, in the peripheral
periphery after the creation of the euro. The euro zone countries, and in particular in Spain and
peripheral euro zone economies (Greece, Ireland Ireland, the increase was dramatic.
and Spain) in their catching-up phase appeared to However, it turned out that growth was
core European Member States with large savings unsustainable because it was driven by a bubble,
and little domestic investment prospects as a great and when the bubble burst, banks, not only in the
investment opportunity: they seemed to offer the periphery but also in core countries, who were at the
opportunities of emerging economies, but without origin of the credit flows, found themselves weak
the exchange rate risk. (because of high leverage) and very exposed to
The capital inflows generated their own funda- large potential losses.
mentals: high growth rates driven by strong demand The magnitude of the losses was, and still is,
for consumption and constmction investment, potentially very large because some euro zone
supported by easy credit fed from abroad. In all this member countries (notably Ireland and Spain)
the financial system, banks in particular, played a experienced a real estate price bubble of the mag-
crucial role. They made the capital flows nitude of the USA. Figure provides evidence of
 180

USA Spain ■
160
Ireland Germany

140 EA

60

40

20

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s s s s s s s s s M » m o o o o o o < o o o o o c o < o ® f f i ® f f i ® ® ( i i f f l ® ® o o o o o o o o o O ' -
®0)010)0)®®®0)ffiO)C3)(3)(DC3)C3)C3)C3)®(3)®05050)0)ro0505050)00000000000
T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-T-CVjCVjCVjCVjCVjCVJCVJCVJCgCgCVJ

House prices: price-to- rent ratios.

Euro Zone Crisis 2010, Fig. 1 average (by GDP) of Belgium, Finland, France, Germany,
Source: OECD, March 2011, and author’s computations. Greece, Ireland, Italy, Netherlands and Spain
Note: Euro area index is defined as the weighted
this by showing the house price-to-rent ratios. This bubbles and busts will remain a challenge for
ratio, similar to the price/eamings ratio for stocks, monetary union for some time to come.
should be stable over long periods. From the chart it This argument is of course related to the so-
is apparent that since the mid-1990s house prices called ‘Walters critique’, which holds that a
have increased by almost exactly the same relative monetary union can amplify shocks because in a
amount, reaching an unprecedented level on both country subject to an inflationary pressures the real
sides of the Atlantic. The main difference between interest rate will be lower than in the rest of the
the USA and the euro area is that since 2006-07 union. This will fuel domestic demand, which in
house prices have declined more in the USA than in turn drives inflation even higher, thus lowering real
the euro zone. rates even further. This feedback loop is self
As shown in the Fig. , the euro area average amplifying and could even be explosive.
hides important differences between countries: However, it seems that in reality the importance
Between 1995 and 2006, while house prices have of lower real interest rates, defined as nominal
been declining or stable in Germany, they increased interest rates deflated by consumer price inflation,
by over 80% and more than 140% (more than in the has been overrated. In the case of Spain, consumer
USA) in Spain and Ireland respectively. price inflation was about 1.6% higher than in
Furthermore, as shown in Fig. , in these two Germany over the first 8 years of the euro, but
countries the average investment in constmction mortgage interest rates were actually over 1% point
relative to GDP reached 18% and 21% of GDP lower than Germany because they were indexed on
respectively against an EU average of about 11% short term rates and, even more importantly, house
(see Fig. ). This seems to suggest that those price inflation was 10% points higher than in
countries are destined to suffer for years the Germany. This suggests that difference in the
consequences of housing and debt overhangs, and characteristics of national financial markets (e.g. the
dealing with the legacy of national real estate availability of mortgages
 25

—Germany Ireland Spain

20

0 ,------,------,------,------,------,------,------,------,------,------,------,------,------,------,------,------,------,
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Euro Zone Crisis 2010, Fig. 2 Investment in construction % of GDP. Source'. European Commission Services (Ameco
database, Gross fixed capital formation at current prices: construction)

indexed on short-term rates, different loan-to- value Alcidi, C., and D. Gros. 2009. Why Europe will suffer more.
Intereconomics, July/August.
ratios etc.) meant that the easing of financial
Baldwin, R., D. Gros, and L. Laeven (eds.). 2010. Com-
conditions after the creation of the euro had quite pleting the Euro Zone rescue: What more needs to be
differentiated impacts on different member coun- done? e-book, VoxEU, June 17.
tries (Gros ; Baldwin et al. ; Calza et al. ) with the Blundell-Wignall, A., and P. Slovik. 2010. The EU stress test
and sovereign debt exposures. OECD Working Paper on
housing markets playing a key transmission
Finance, Insurance and Private Pensions 4, OECD Financial
mechanism in Spain and Ireland. Affairs Division.
Borio, C., and P. Lowe. 2002. Asset prices, financial and
monetary stability: Exploring the nexus. Working Paper
See Also 114, Bank for International Settlements.
Calza, A., T. Monacelli, and L. Stracca. 2009. Housing
► Ba C finance and monetary pohcy. ECB Working Paper 1069.
De Grauwe, P. 2009. Keynes’ savings paradox, Fisher’s debt
► ! ro deflation and the banking crisis. CEPS Working Document
► European Central Bank No. 319.
► European Monetary Union De Grauwe, P., and D. Gros. 2009. A new two-pillar strategy
► 2z~!eh: for the ECB. CEPS Policy Brief No. 191.
Eichengreen, B. 2010a. The euro: Love it or leave it? VoxEU,
May 4.
Bibliography
Eichengreen, B. 2010b. Ireland’s rescue package: Disaster for
Agnello, L., and L. Schuknecht. 2009. Booms and busts in Ireland, bad omen for the Eurozone. VoxEU, December 3.
housing markets: Determinants and implications. ECB
Gros, D. 2009. Comments on Charles Wyplosz, ‘Ten years of
Working Paper No. 1071, European Central Bank,
EMU: Successes and puzzles’. In Spain and the
Frankfurt.
 euro: The first 10 years, ed. J.F. Jimeno. Madrid: Banco Zurich. Transactions may be determined in these
de Espana. centres. The formal completion of transactions may,
Gros, D. 2010. Adjustment difficulties in the Gipsy Club.
CEPS Working Document No. 326, Brussels. however, be registered in ‘off-shore’ places such as
Minsky, H. 2008. Stabilizing an unstable economy. London: the Cayman Islands and the Bahamas in the
McGraw-Hill. Caribbean. By completing transactions in various
Veron, N. 2010. The EU has not yet solved its banking centres external to the United States, such as those
problem. VoxEU, October 26.
index php’c = : : . c 7 1 ‘
in the Caribbean, US banks avoided restrictions on
their portfolios such as the locking up of assets in
non-income earning reserve requirements. The US
authorities bowed to the realities of this situation
when in 1981, they established International
Eurodollar Market Banking Facilities in the United States. Extra-
tenitorial recognition to these activities was given
W. P. Hogan while keeping them on-shore.
With the origins of eurodollar activity in a
period of rigorous exchange controls, it might have
been expected that the market would stagnate, and
The Eurodollar Market is the term still commonly possibly wither, when exchange controls were
used to describe international financial activities by whittled down or abandoned altogether as was the
intermediaries whereby deposits are accepted and case by the late 1970s in many industrial
loans made in currencies other than the currency of economies. This was not the case. However, dis-
the country in which the participating intermediary tinctions between the Eurodollar Market and
is located. The geographical focus was originally in transactions in the national currency of the country
Europe, especially London, but activities are now in which intermediaries were located, were blurred.
located in centres around the world.
The origins of the Eurodollar Market lay in
exchange control restrictions on the use of national
currencies for capital transactions, including the Size and Structure
financing of trade between third parties. Banks and
other financial intermediaries having longstanding Estimates of the size of the Eurodollar Market or
involvement in the financing of such international more conectly the Eurocurrency Market are com-
trade, sought other means of maintaining their piled by the Bank for International Settlement,
position in this sphere. Funds were canvassed in the Morgan Guaranty Trust Company of New York and
one capital market where exchange controls did not the International Monetary Fund. The IMF series
apply, namely the United States. Thus dollars were was not published until 1984 so that most attention
borrowed and used to finance exports and imports has been given to the other two. The series of
between countries other than the country in which estimates provided by the Bank for International
the financing intermediary was located. Given this Settlements (BIS) has been the basis for most
circumstance it was inevitable that the US dollar analysis. The differences between the BIS series
became the currency of denomination for these and those provided by Morgan Guaranty are
transactions. Thus the term Eurodollar Market bears explained largely by timing and coverage.
witness to the origins of this international financing The BIS series is compiled on gross and net
arrangement. Nevertheless it remains a fair bases, the difference being depositing and lending
description as more than 70 per cent of all between participating intermediaries. As is evident
transactions continue to be denominated in that from the estimates in Table , the growth of lending
currency. was spectacular for many years during the 1970s.
London remains the largest centre for Eurodollar Only in recent times, with the onset of the debt
activity, followed by New York, Frankfurt and crisis in 1981/82, has lending slowed.
 Gross Net
Year Value %increase Value %increase
1972 203.7 - 120.6 -
1973 291.4
Eurodollar Market, Table 1
43.1 172.1 42.7
Amounts outstanding at the end of year
1974 Euroftnance363.6
lending, 24.8 214.6 24.7
1975 1972 to 1983442.4
(U.S. $ 21.7 254.6 18.6
1976 billions) 548.0 23.9 324.6 27.5
1977 671.3 22.5 435.0 34.0
1978 856.4* 28.9 530.0* 21.8
1979 1120.3 30.8 665.0 25.5
1980 1335.4 19.2 810.0 21.8
1981 1550.2* 14.1 945.0* 16.0
1982 1694.5 9.3 1020.0 7.9
1983:1 1757.0 0.4 1085.0 6.4
1983:11 2097.9 - 1240.0 -
1984 2153.9 2.7 1280.0 3.2

Source-. Bank for International Settlements, various annual reports and reviews.
Note-. *Change in series due to alteration in coverage of countries and transactions. Where the
series breaks the estimated rate of growth is based on the old series for that year while the new
series is the base for estimating growth in the subsequent year. This is illustrated in
1983 where both series are shown.

The difference between the gross and net series liabilities. The financial intermediaries are con-
for loans outstanding reflects mainly transactions stantly seeking new deposits or the rolling-over of
between intermediaries in the Eurodollar Market, existing deposits. Given the size of the Eurodollar
often referred to as ‘interbank transactions’. The Market and the frequency with which new funding
significance of these transactions lies in the pro- is required, foreign exchange transactions have
vision of liquidity within the market. Intermedi- come to be dominated by these capital transactions.
aries, by borrowing and lending amongst A modest estimate would be a turnover of US $150
themselves, could meet liquidity needs arising from billions per day and, in all likelihood, closer to
the mismatching of maturities between liabilities double that estimate. The scale of these transactions
and assets. Loss of confidence in the asset quality of far outweighs transactions related to trade in goods
intermediaries brought illiquidity from 1982 and services.
onwards. Many intermediaries, were not prepared to
place funds with other intermediaries, a feature Mechanisms
evident in the different rates of growth of gross and Analyses of the workings of the Eurodollar market
net lending. remain controversial. Initially the market was
Estimates of the maturity structure of liabilities treated as an extension of a national monetary
and assets are provided by the Bank of England for system; given the predominance of transactions
activities in London. About 40 per cent of liabilities denominated in US dollars, this was viewed as an
have had a maturity of less than a month with over adjunct of American banking. This general
20 per cent less than eight days. Assets have a approach for explaining the growth of the Euro-
longer maturity, about 32 per cent with maturities of dollar Market was matched by the belief that the
less than a month and more than 22 per cent over function of this market was to ‘recycle petrodol-
one year. Maturity mismatching increased during lars’. What that expression meant was simply the
the 1970s and 1980s. functioning of the Eurodollar Market to take up the
Vital to any understanding of the impact of this balance of payments surpluses of the
market is the short maturities of these deposit oil-exporting countries after 1973, and then
again in 1980, to fund the deficits of mainly oil- Impetus to expansion in the Euromarket was
importing countries. maintained during the late 1970s and early 1980s by
These interpretations do not stand inspection. the narrowing of margins over the cost of fluids to
The Eurodollar Market is not bound by the actions participating intermediaries and slender capital/
of any one national supervisory authority. Equally, assets ratios. Although the dangers of such develop-
it is not supported by the activities of any central ments were recognised quite early in the 1970s, the
bank. The participating intermediaries, even though Bank for International Settlements was unable to
they may be called banks, do not have recourse to make effective its efforts to get coordination
lender of last resort facilities. They cannot, as yet, amongst national bank supervisory authorities about
write cheques on themselves; rather they must write activities being pursued in the Euromarket. Efforts
cheques on accounts in banks within a national by the Bank of England and the Swiss authorities,
banking system. They accept deposits with a while valuable within their national boundaries, did
specified term to maturity, often veiy short, and not gain that wider recognition which, with
lend for specified periods with provisions for hindsight, was all too obviously needed.
adjusting interest rates. Lending rates are most An explanation for this failure to gain interna-
frequently quoted as some margin over LIBOR - the tional coordination is the lack of recognition of
London Inter-Bank Offered Rate. The participating problems likely to arise with the system. Attention
intermediaries bid for deposits from business, was focused on individual failure either of a par-
governments, banks, monetary authorities and ticipating intermediary or a borrowing country.
wealthy individuals all being resident within Only in the 1980s did the systemic problem become
national monetary systems, and from other clear. By then modest arrangements for
participating intermediaries. They lend amongst coordination proved inadequate, most obviously
themselves and to final users of funds, with the collapse of Banco Ambrosiano in Italy
predominantly governments, banks and business in with repercussions for affiliates in Luxembourg and
various countries, most often those with trade and Switzerland.
payments deficits. The rapid escalation of debt problems for
The Eurodollar Market is not an extension of chronic borrowing countries in Eastern Europe,
national banking systems. It is a market in debt, not Latin America and Africa brought Euromarket
money. The functions performed by the par- activities to a virtual halt by late 1982. Debt rene-
ticipating intermediaries are central to an under- gotiation strained the capital structure of many
standing of the impact of that market for not only participating intermediaries and their parent banks.
the substantial debts incurred by many countries but Most were forced to improve capital ratios and
also the balance of payments adjustment and hence liquidity', a not surprising development in
exchange rate relativities. view of debt rescheduling stretching the maturity
structure of assets.
Direct lending by the participating intermedi-
Issues aries meant that the quality' of the borrower was not
subject to market tests. That lending activity was
The stability of the Euromarket mechanism rested
opaque, not transparent. By maintaining the flow of
upon the capacity' of borrowers to meet their obli-
funds to chronic deficit countries, adjustment
gations. But in providing a means whereby deficit
problems for those countries were deferred, but the
countries could maintain those deficits and not
strains were transferred in part to the participating
adjust to worsening balance of payments, the par-
intermediaries. The inherent weakness of this
ticipating intermediaries accumulated an increasing
financing system was revealed when rising interest
proportion of their assets in the obligations of a
rates, shifts in exchange rate relativities and weak
relatively few countries. Portfolio risk could not be
commodity' markets in the early 1980s found the
spread.
chronic debtor countries unable
to service their borrowings and, in many instances, This article explains the background to these
meet repayments. initiatives and weighs the progress towards their
One repercussion of the harsh strains on par- completion.
ticipating intermediaries has been to restore activity
in international bond financing. That financing, Keywords
being directly subject to market tests, is confined to Banking crisis; Bank resolution; Bank super-
countries not facing chronic debt problems. vision; Economic and monetary union; Euro-
Moreover, governments and companies from those pean Union; European deposit guarantee;
countries are superior credit risks quite often to Financial crisis; Financial integration
many participating intermediaries now bearing the
penalties of lending to chronic debtors. Those same
intermediaries have been willing to foster new JEL Classifications
techniques of financing, such as note issuance G01; G18; G28; 052; E61
facilities and revolving credits, to maintain
participation in international capital transactions.
These new techniques offer possibilities for future
strains no less than what emerged through direct European Banking Union
lending.
European banking union (henceforth banking union
or BU) introduces for the first time an integrated
approach in supervision and resolution of European
See Also banks, representing an important step towards
enhancing economic and monetary union. The aim
► itcmati
of banking union is to deliver absolute consistency
of implementation of new regulatory rales across
the euro area (at the time of writing 129 banking
groups, representing more than 80% of the euro
area banking sector’s assets; ECB ( )), ensuring
European Banking Union that the financial institu
tions of all member states will be subject to a single
Corrado Macchiarelli
supervision, a single resolution and a common
deposit insurance system. The need for a banking
union emerged in response to the 2007/ 08 global
financial crisis and the ensuing sovereign debt crisis
Abstract in the eurozone. In particular, the sequence of
The sovereign crisis that has characterised the events highlighted the costs of the vicious link
eurozone since 2010 has highlighted the poten- between public and private sector debt, and how
tially vicious circle between banks and sover- these can easily overflow national borders and
eigns, adding an extra dimension to the 2007/ 08 cause systemic risk and failures.
financial crisis. This is why the EU heads of The banking union proposal dates back to June
state and government committed to a European 2012; it covers a preventive stage (regulation and
banking union in June 2012; a vision that was supervision), and a crisis management stage
further developed in the European Commis- (resolution and safety nets) (European Commis-
sion’s blueprint. The aim of the banking union is sion ; IMF ).
to ensure that the financial institutions of the - The first two components of BU, a single Euro-
for now - 19 member states will be subject to a pean supervisor (the Single Supervisory Mecha-
single supervision, a single resolution and a nism; SSM) and a single resolution authority (the
common deposit insurance system.
Single Resolution Mechanism; SRM) have been inception of the euro (Constancio ). The fact that the
agreed. The third element of BU, however - a BU vision was further developed in the European
European deposit insurance scheme covering eli- Commission’s blueprint for economic and monetary
gible individual deposits in all participating union (Juncker et al. ) reveals the Eurozone’s
countries - has been stalling, largely because of willingness to continue to deepen integration and to
political opposition from some creditor member put in place a framework making member states’
states (Germany in particular). participation in the eurozone ‘sustainable’ (see also
The SSM has been in place since 4 November Pisani-Ferry ). However, with an established
2014; this is the date from which the European supervisory authority, a resolution mechanism on
Central Bank assumed responsibility for bank the way and a delayed agreement on a common
supervision. The SSM is a key ingredient of the BU, deposit insurance scheme, it remains to be asked
but it is not the only one. In particular, a European whether the European banking project can be
approach to the resolution of banks - with the SRM credible without a fully fledged fiscal backstop.
centred on the idea of a Single Resolution Board
(SRB) and a Single Resolution Fund (SRF) - needed
to follow. The EU adopted a Bank Recovery and Background to Financial Supervision
Resolution Directive (BRRD) together with an in Europe
agreement on the SRM from December 2013. This
agreement - following on from the SSM already Financial market regulation under the Basel
agreed - was significant because it meant that two Accords, as well as the system of EU financial
of the three components of BU have been opera- supervision before 2010, were generally
tional since 2015. Nonetheless, both elements of characterised by the lack of mutual recognition. The
BU have been somewhat watered down from their existing Lamfalussy Process envisaged a largely
original conception. The SSM will d e j u r e delegated legislation and enforcement system with
not be supervising the whole European banking an explicit legislation in co-decision procedures (see
system, with national authorities continuing to also ECB ). The implementation and transposition
supervise smaller financial institutions. of detailed rules on supervision and resolution were
Furthermore, unlike the SSM, the SRM will be delegated to three Committees - the so-called 3
‘single in name only’ (Posen and Veron ) as the Level Lamfalussy (3 L3) Committees: the CESR
framework that sets up the resolution mechanism (Committee of European Securities Regulators), the
foresees a significant degree of continuing CEBS (Committee of European Banking
autonomy for national authorities (see the section Supervisors) and the CEIOPS (Committee of
below on European Insurance and Occupational Pensions
Supervisors). Day-to-day supervision was left to
’) - particularly on the issue of national supervisory agencies, with a strict
funding - at least for the next eight years. Progress separation of supervision from central banking, both
has been very uneven on the third element of BU as geographically and functionally (see also
well, with a common approach to deposit insurance Masciandaro et al. ).
having been sidelined during the first stages of the After 2010, such an approach to financial
negotiations. Despite a first legislative proposal for supervision and regulation changed, under the
a euro-area wide protection for bank deposits that pressure of the systemic nature of the crisis and the
came as late as 24 November 2015, negotiations are de Larosiere report. On the legal side, there was a
currently stalling. The lack of this third element is significant tightening of the regulation of banks,
critical because it means there will ultimately be no with Basel III raising minimum capital ratios and
European backstop for depositors in the event of a redefining riskiness of assets. Furthermore, the de
new banking crisis. Larosiere Report (de Larosiere Group ) established
If implemented properly, the original vision for a Eiuopean Systemic
BU may be the most far-reaching reform since the
Risk Board (ESRB), chaired by the ECB’s President remaining under their direct supervision (the so-
and Vice-President, with the aim of providing called ‘less significant financial institutions’).
macroeconomic supervision of the financial system Guidance on the design of an effective super-
as a whole. (For a discussion of the governance of visory mechanism for Europe was provided in the
the ESRB see Gerba and Macchiarelli ( ).) Basel Core Principles (the so-called ‘Core Princi-
The ESRB was created at the end of ples for Effective Banking Supervision’;
2010 as a part of a new two-pillar system of According to
financial supervision, the European System of these principles, a number of preconditions and
Financial Supervision (ESFS). The report also gave prerequisites were to be met at the euro area level,
recognition to three Eiuopean Supervisory including (1) the implementation of coherent and
Authorities (ESAs) to cover micro-pradential sustainable macroeconomic policies; (2) a clear
supervision, representing the ESFS second pillar. framework for financial stability policy; (3) an
These three EU-level bodies, being effective as of 1 effective crisis management and resolution frame-
January 2011, were not created e x n o v o , but work to deal with bank failures and minimise
they upgraded the existing 3 L3 Committees. In disruptions; (4) an adequate safety net to deal with
particular, confidence crisis while minimising distortions; (5) a
well-developed public infrastructure; and (6)
• the CEBS was upgraded into the Eiuopean effective market discipline. On the other hand, as
Banking Authority (EBA); underlined by IMF ( ), prerequisites
• the CEIOPS was upgraded into the Eiuopean to establish a sound basis for the SSM included: (1)
Insurance and Occupational Pensions Authority its operational independence; (2) clear objectives
(EIOPA); and finally and mandates; (3) legal protection of supervisors;
• the CESR was upgraded into the Eiuopean (4) transparent processes, sound governance and
Securities and Markets Authority (ESMA). adequate resources; and (5) accountability (see also
IMF ; Gerba and Macchiarelli ). As we shall discuss
This change in governance structure marked not
in the following sections, after the comprehensive
only the beginning of a greater (than in the rest of
assessment performed by the SSM at the end of
the world) involvement of the central bank in
2013, with extensive granular balance-sheet facts
Eiuope, but also the start of a two-pillar strategy
being provided and a higher degree of transparency
ensiuing - by means of institutional separation and
and availability of information to the public, the
coordination with national supervisors - a system of
SSM seems to meet these criteria.
checks and balances between macro- and micro-
prudential supervision (see also Goodhart and
Schoenmaker ; Masciandaro et al. ; Eijffinger ;
Goodhart ).
The first agreement on banking union came in The European 'Doom Loop'
September 2012. The European Parliament’s final
‘go-ahead’ for the ECB to be fully entrusted with The crisis highlighted the importance of having in
responsibility for the supervision of banks in the place a framework for dealing efficiently and in a
framework of the SSM came after extensive nego- timely manner with the resolution of cross-border
tiations between various stakeholders. This hap- financial entities (Obstfeld ), avoiding the long-term
pened one year after the first agreement, on 12 implications on fiscal sustainability of having
September 2013. The 2012 EU Council agreement national governments and banks dangerously tied
appropriately confened broad investigatory and together (see, i n t e r a l i a , Reinhardt and
supervisory powers on the ECB, which - as of Rogoff ; Gennaioli et al. ). These ties essentially
November 2014 - is responsible for the effective intensified during the eurozone’s crisis for two
and consistent functioning of the SSM. National reasons. First, banks engaged in c a r r y -
authorities remain responsible for the banks t r a d e by using ‘cheap’ central bank liquidity
to purchase government bonds (Acharya and
Steffen
European Banking Union, Fig. 1 A
stylised representation of
the European ‘doom-loop’

). (Central bank liquidity came mainly in the i. e. guarding against government failure by
form of three-year long-term refinancing operations simply agreeing on strict fiscal rules (e.g. the
(LTRO), with the interest rate fixed at the average Stability and Growth Pact) and letting markets find
rate of the main refinancing operations at the time their equilibria (Fuest and Peichl ). (A key reason
(1% p.a.) and full allotment of the bids (for further for the failure of international capital markets to
technical details see ECB ).) Second, there was a differentiate sufficiently between countries
rapid rebalancing of banks’ international portfolios according to the state of their public finances was
towards ‘home’ assets and bonds (Battistini et al. ; that the ‘no bailout rule’ was just not credible (Fuest
Valiante ). The latter was possibly the result of risk- and Peichl ). In other words, before 2010 financial
shifting (Gennaioli et al. ; Farhi and Tirole, ; markets simply did not set incentives to limit
Acharya et al. ); discrimination (Broner et al. ); and government debt in the Eurozone, and very small
financial repression (Chari et al. ; for a general borrowing premia were to be paid over German
discussion see also Reinhart et al. ). s a f e - h a v e n rates.) The sovereign debt
Government guarantees to banks at the expense crisis that followed confronted almost all non-AAA-
of higher debt and the inability of regulators to stall rated euro area countries (Greece and Ireland first,
the crisis, together with a ‘faulty’ design of the followed by others by 2012) with a liquidity dry
currency union - centred on a single central bank out, as the result of a flight-to-quality of capital -
and multiple Treasuries (see De Grauwc ) - are facilitated indeed by the single currency - towards
known to be amongst the weighty factors at the root their ‘safer’ EMU peers. This translated into higher
of the private-public European ‘doom loop’. public borrowing costs, a frailer banking system and
In the euro area, in particular, together with the overall larger bailout charges e x p o s t .
impossibility of monetising debt (an explicit pro- Figure proposes a stylised representation of the
vision contained in the Lisbon Treaty on the Func- aforementioned European doom-loop. This
tioning of the EU - the ‘no bailout rule’ - art. 125), representation does not consider contagion or
as of 2010 countries had d e f a c t o to spillover effects from, or to, other countries, being
compete ‘internally’ over capital flows (Valiante ). broadly related to recent literature on doom loops in
This was the reflection of an institutional setup built closed economies (see e.g. Acharya et al. ). In this
on the idea of ‘tying one’s hands’ - representation, whatever the
entry point is (private sector leverage, Aid policy, with the aim of preserving an EU
unsustainability of public finances, lack of struc- integrated financial market. Before the Commission
tural reforms) there is a self-reinforcing effect launched a bank recovery proposal, a number of EU
relating to the classical problem of (ir)rational runs countries, including Austria, Belgium, Denmark,
in which the market can push an economy into a France, Germany, Ireland and the UK had already
‘bad’ equilibrium (see also De Grauwe and Ji ). put in place new mles for the resolution of their
This amplification within the EMU had to do, distressed banks. Such repeated bailouts not only
firstly, with a collapse of confidence in certain increased sovereign debt, but also imposed a large
markets and institutions at the same time, and the encumbrance on taxpayers. The state aid measures
broader fragility of financial systems, because of that were used, in the form of recapitalisation and
increased counterparty risk or asymmetry of asset relief measures between October 2008 and
information (see also IMF ). Secondly, it was linked December 2012, amounted to €591.9 billion or
to the distressed financial sector inducing 4.6% of EU 2012 GDP, with the highest share
government bailouts (or private sector belonging (in order) to Ireland, the UK and
d e l e v e r a g i n g ; see Acharya et al. ). Germany (European Commission State Aid
The latter, in particular, created a vicious interaction Scoreboard’s (2013) figures. Available at
between asset prices (via banks’ balance sheets) and
borrowing constraints (Borio and Zhu ; Including
Brunnermeier and Pedersen ; De Grauwe and approved aids and guarantees, this figure jumps to
Macchiarelli ), where - simplifying - the fire sale of over 12% of EU GDP for the period 2008-12 only.
government bonds in some countries (as the result In the euro area, 37% of capital injections and 63%
of confidence loss and excessive debt taking) of the asset relief measures were granted to the
increased sovereign credit risk, in turn weakening three largest financial institutions (see also Gros and
the financial sector, with an ensuing liquidity dry Schoenmaker ).
out and freezing of lending to the real economy. Beyond government upkeep, central banks
Overall this eroded bond holdings and the value of provided unprecedented liquidity support to illiquid
government guarantees, requiring further support, (and insolvent) banks as well. Specifically, the
and so on. European Central Bank during the first stage of the
crisis focused its programme - albeit not exclusively
- on direct lending to banks (see the preceding
Why a Banking Union for Europe? section), reflecting the bank-centric structure of the
euro area financial systems (see also Gabor ; ECB
The governments’ last-resort guarantees to then-
2014). This was different from the Federal Reserve
own financial institutions were initially granted in
and the Bank of England, which expanded their
an uncoordinated manner within the EU.
respective monetary bases largely by purchasing
Government asset support mainly took two forms
bonds in the first place.
(see also Gros and Schoenmaker ): asset insurance
Looking at the recent history of bailouts, the
schemes, which maintained the assets in the banks’
advantage of a permanent bank supervision and
balance sheet, and asset removal schemes, which
resolution framework, as compared to the a d
transferred the assets to a separate institution (bad
h o c measures that were employed during the
bank). Purchases of impaired assets often occurred
crisis, primarily resides in its transparency
after earlier government capital injections. In the
regarding the list of eligible institutions and the
case of bank debt guarantees, approximately half of
conditions of access to funding. Second, it
those that received capital injections also received
introduces a limitation to free-riding derived from
government guarantees for their bank debts.
unlimited recourse to public money, allowing
Coordinated support happened only later and was
overall a balanced burden-share between private
led by the European Commission in the context of
investors and taxpayers, possibly resulting in lower
its State
funding
costs e x p o s t . At the same time, the BU EU regulation and ensured that banks hold a suf-
proposal recognises the systemic nature of risk ficient buffer to withstand potential losses.
facilitated by the single currency, and the potential
dangers and domino effect that ‘systemically 2. The proposal for strengthening the Deposit
important’ financial institutions would have, given Guarantee Schemes Directive (DGSD)
their cross-border reach, within the E(M)U (see also (Revision of Directive 94/19/EC).
Obstfeld ; Gros and Schoenmaker ; Goodhart ).
The aim of the latter was to harmonise and
Finally, the proposal acknowledges the issue of the
simplify deposit guarantee rales in the EU and
moral hazard of national governments both over
improve the functioning of the existing guarantees
time - with a tendency to offload the costs of
across the board, with protection of deposits up to
restructuring the domestic banking sector to future
€100,000 (from the existing €20,000 limit).
governments - and across countries - particularly,
According to the directive, all credit institutions
relying on the ECB’s and European Stability
will be required to join the DGS instituted at the
Mechanism’s last resort support. The latter two
national level. The Council has reached a political
points relate to the literature analysing the
agreement with the European Parliament on the
combination of limited commitment on the part of
revised directive, with the Parliament formally
the government e x a n t e , and the
adopting this revision in April 2014.
possibility of bailouts e x p o s t (see, among
others, Acharya and Yorulmazer ; Chari and 3. Bank Recovery and Resolution Directive
Kehoe ; Farhi and Tirole ). In particular, this (BRRD) (Directive 2014/59/EU).
literature highlights a mechanism by which gov-
ernment bailouts are provided only when a suffi- This directive gives powers to authorities across
cient number of financial institutions are in trouble the EU to act effectively to prevent bank crises and
e x p o s t , so that strategic to ensure orderly restructuring and resolution in the
complementarities in financial risk-taking arise: i.e. event of bank failure. The aim is to avoid negative
individual financial institutions may engage in effects on financial stability and to reduce recourse
higher financial risktaking e x a n t e the to taxpayers’ money, avoiding replicating the
higher the collective risk-taking, as this increases scenario seen during the first stage of the crisis. The
the likelihood of a government bailout e x directive followed a Commission proposal in June
p o s t . The existence of such complementarities 2012. The European Parliament and the member
and systemic risk thus provides a rationale for states reached an agreement on 11 December 2013.
macro- and European measures. (Broner et al. ( These new rales, which entered into force on 1
) put forward another rationale for a January 2015, established that the costs of bank
BU: a BU is thought to reduce discrimination failure will in the first instance be borne by bank
between domestic and foreign investors.) shareholders and creditors, according to a clearly
defined hierarchy, and thereafter met from dedi-
cated resolution funds held by each member state.
Legal Underpinning

The legal foundation of BU is contained in a single Progress Towards Achieving A Banking

rule book made up of three main elements. Union
l.A set of rules on capital requirements Common Bank Supervision
(Capital Requirements Directive - CRD IV).
A European single supervisor (SSM) became
These rales entered into force on 1 January operational in November 2014 (see section on
2014, and replaced the original Capital Require-
ments Directives (2006/48 and 2006/49), trans-
posed the international Basel HI agreement into
 ’). Under the SSM, responsibility for bank Mechanism: Most small banks are German (and
supervision in the euro area was shifted from Austrian and Italian)’, 22 September 2014.) The
national authorities to the European Central Bank. current SSM design represents an adequate com-
The ECB is in charge of supervising ‘sys- temically promise given the existing trade-off between
important’ banks directly (equal to more than 80% political feasibility and economic ‘first-best’ in
of euro-area banking assets, including banks with Europe. In addition, achieving a truly single market
over €30 billion in assets or 20% of national GDP, in banking services will possibly require more time
or ‘if otherwise deemed systemic’). National than a couple of years, with further supervisory
authorities will continue to supervise smaller initiatives, as well as regulatory and legislative
financial institutions. (In September 2014, the ECB steps, having to be adopted in the future (see also
published the list of significant supervised entities. Schoenmaker and Veron ).
The latest release (31 May 2016) with change in
significance for some banks is published here:
The Single Resolution Mechanism
.) The
latter arrangement was essentially a political one, The SRM was first proposed by the European
championed by some member states - Germany Commission in July 2013. This mechanism came to
primarily - wanting to keep direct monitoring of complement the SSM as of 1 January 2015.
‘local’ institutions. The federal approach that Countries joining the SSM are to join the SRM too,
emerged as a concession to local banks’ lobbies which means that the SRM applies to banks in the
highlights how banks’ management in some euro area member states under the SSM, plus those
countries cultured a strict affiliation with the polit- EU countries wishing to opt in. The SRM is built on
ical establishment and local electorate (Valiante ), the national resolution authorities established by the
largely through ‘not-for-profit’ credit institutions BRRD. The SRM aims to ensure that if - despite
such as foundations (e.g. the Spanish Cajas and the SSM supervision - a bank faces serious difficulties,
German Landesbanken). Overall, however, while its resolution would be managed in a centralised
smaller banks were d e j u r e exempted from manner, with minimal cost to taxpayers and the real
direct SSM supervision, the €30 billion threshold economy; which is one of the focal points of BU.
has d e f a c t o left the majority of the The SRM consists of a resolution authority (or
eurozone banking assets under the SSM’s umbrella Single Resolution Board - SRB) and a Single
- including almost all German Landesbanken (Posen Resolution Fund (SRF). The SRB became opera-
and Veron ). Furthermore, the ECB will set and tional in January 2015, but it started to work at fiill
monitor supervisory standards and work closely capacity one year later, on 1 January 2016, the date
with the national competent authorities for these when the SRF was also on the schedule. The
banks, with the option of expanding its remit and Finance Ministers of the member states have
supervising them directly in order to ensure that decided to keep some elements of the functioning of
SSM standards are applied consistently (ECB , ). the future SRF in the form of an intergovernmental
To conclude, while the design of a common agreement, which complements the SRM
bank supervisor is far from faultless, given the regulation. According to the terms of reference of
challenge to financial stability that small financial the agreement, the fund is to be financed by bank
institutions may pose, these challenges in terms of levies raised at the national level. As a general rule,
supervision are, for the moment, not large. (It is banks taking higher risks will pay higher
worth noting that the majority of ‘local’ banks in contributions. Contributions, initially consisting of
the EMU are concentrated in Germany, and, to a national compartments, which will be progressively
lesser extent, Austria and Italy; see Veron’s blog mutualised and eventually merged into a single
entry on Bruegel: ‘Europe’s Single Supervisory fluid administrated by the Board, start with 40% of
resources in the first year. National
 BRRD fee SRM fee
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0% -------------------------------------------------------------------------------------------------------------------------------------------
1 st Year 2nd Year 3rd Year 4th Year 5th Year 6th Year 7th Year End Year

Evolution of phasing-in (—out) of contributions to SRF (from national target levels in accordance to
European Banking Union, Fig. 2
the BRRD) (Source: ECB (2015) data)

compartments would cease to exist when the fund (accessed August 2016)). Bailing-in would
reaches the target funding level of 1% of covered apply until at least 8% of banks’ total assets had
deposits in the participating member states or after been used. After this threshold, the resolution
an eight-year transitional period - i.e. by 2024. authority may grant the bank the right to use the
Under the SRM Regulation, the SRB is required resolution fund, up to a maximum of 5% of the
to calculate the contribution from each individual bank’s total assets. Some have observed how the
bank to the SRF each year. Contributions are actual procedures for bailing-in may not only risk
determined by applying the method detailed in a cutting credit in already fragile economies, but
Commission delegated act and the specifications could also reduce the willingness of lenders to
provided for in a Council implementing act, extend new credit, having overall a negative effect
adopted respectively on 21 October and 19 on the financial conditions of that country.
December 2014. The establishment of the SRF will Bank contributions to the SRF began in January
thus entail a shift from national to European 2016. However, a plan on bridge financing was put
resolution, which has the implication that each in place in the context of the Five Presidents’
member state’s banking sector will progressively Report (Juncker et al. ) in order to avoid a situation
contribute more to the European resolution fund in which the SRF would run out of monies while
with respect to what they will be contributing to the bank contributions were being consolidated. The
national fund under the BRRD. This is summarised agreement, which was reached by the Council of
in Fig. . Ministers in December 2015, introduced public
The SRF has an overall target level of €55 support through the establishing of national credit
billion. While this amount may seem small in lines that would provide a loan to the SRF in the
principle - given the need to signal to the markets case of capital shortfalls before 2024. As well as
that a reliable backstop exists (see also Macchiarelli providing support where needed, the establishment
; Gros and Schoenmaker ) - one should consider of credit lines is intended to enhance the standing of
that the fund has been given the ability to borrow the SRF. Importantly, a common backstop to the
directly from the market, if decided by the Board SRF itself should follow before the end of the
(ECB ); transitional period, as a last resort measure, in order
the terms and conditions of this have not been to ensure the durability of the BU project as a
disclosed yet. Secondly, explicit provisions for whole, as the Five Presidents’ Report also
bailing-in exist, as detailed by the revised BRRD recognises (Juncker et al. ). (See also
(SRF website, Communication
from the Commission to the European Parliament, mentioned above, leaving resolution funding and
the Council, the European Central Bank, the Euro- safety nets predominantly at the national level or,
pean Economic and Social Committee and the equally, limiting the BU’s ‘federal’ reach and
Committee of the Regions, ‘Towards the comple- burden-sharing capacity, would mean perpetuating
tion of the Banking Union’ COM (2015) 587. the bank-sovereign doom loop, which is what the
Available at BU is intended to break. Alternative arrangements
CELEX:52015DC0587.) exist, but it remains to be seen whether these are
This will be difficult to achieve in the short term as convincing.
it will require a more far-reaching fiscal agreement Figure (a) highlights a role for the European
among the member states (for an extended discus- Stability Mechanism (ESM), as a last resort support.
sion see the following section). The ESM was primarily created with the purpose of
providing a fiscal backstop for member countries
and (more recently) their banking systems. How-
Banking Union and Fiscal Backstops ever, the stability of banking systems can be assured
only if investors know that such a backstop is not
While it is widely recognised that the proposals and limited e x a n t e . This is why many
compromises reached to deal with deposit insurance commentators have defined the ESM as a ‘poor
and resolution represent an exceptional step surrogate’ for a last-resort lender (De Grauwe ). The
forward, many member states underscore that a main reason why the European banking sector
well-functioning BU will require an unlimited needs a common backstop is fundamentally
burden-sharing mechanism, where fiscal authorities macroeconomic and has to do with the very nature
have to be involved. As highlighted above, the of systemic risk (Gros and Schoenmaker ; see also
current design of the BU still leaves a role for an Allen et al. ). Once all of the above is in place (SRF
intergovernmental agreement, particularly in plus EDIS), in the great majority of cases no public
deciding the role and functioning of the future SRF support will be needed. But in exceptional
- as a complement to the SRM regulation - before circumstances, for relatively large shocks, addi-
its final consolidation by 2024. Furthermore, the tional resources might be necessary, and clear
Commission’s deposit insurance mechanism (EDIS) arrangements on backstops should be made. Thus,
is still on the negotiating table. Hence the stage in the stability of banking systems can be assured only
the governance framework that is lacking is the if investors know that such a European backstop
fiscal backstop. exists, and the current ESM capacity can hardly be
The existing national DGSs and resolution funds credible (see also Gros and Schoenmaker ).
- before a common backstop is created - may Secondly, there are agency costs to consider, as
quickly ran out of money and need last-resort the ECB/SSM may itself be trapped in a fiscal
support from sovereigns. This, however, was the dominance game (see also Goodhart and
origin of the so-called doom loop, pushing even Schoenmaker ; European Parliament ). The
countries with a sound fiscal record into a wrecking existence of a transition period before the SRM and
spiral, as the cases of Ireland and Spain show. the EDIS (whose deadlines for full functioning are
Should this be the case, the sovereign will then need aligned) makes it possible that, until resources are
a backstop itself. In Fig. , we have used the ‘doom fully mutualised, the SSM will have an incentive to
loop’ representation of Fig. to summarise this offload the fiscal cost of any problem to national
discussion. The figure particularly compares (a) the authorities if it thinks that any given bank is
current state of BU with a representation of (b) insolvent and needs to be restructured or closed
frilly fledged BU in the context of the GEMU. down. The SSM would do this on the basis of its
The current state of BU is an incomplete bank- comprehensive assessment of the viability of the
ing union which could create coordination failures bank and any danger it might constitute for
and be costly overall (Posen and Veron ). As financial stability. By contrast,
 a

off mot ©wwigli

<■

European Banking Union, Fig. 3 (continued)

national authorities in charge of bank restructuring deposits ratio is considered (author’s computa-
would have a tendency to minimise their own costs tion from Cannas et al. ( ) data).
by keeping the bank (even if illiquid) solvent • Deposits of natural persons and SMEs above
through ECB support. This leaves some grey areas €100.000 will benefit from preferential treat-
in the crisis management capacity of the BU (ECB ment (they will not suffer any losses before
2015), with this type of conflict being prevalent other unsecured creditors do).
between now and the start of the new system, when
mutualisation is low. The endgame would be The Deposit Guarantee Schemes Directive
accelerating the process of consolidation of (DGSD), which was transposed by the member
European deposit insurance and resolution schemes, states into national law in July 2015, concentrated
thus minimising potential costs and avoiding on harmonising existing national deposit guarantee
providing the SSM and national authorities with the schemes without any common funding element.
wrong incentives. (Other inter-agency conflicts and While regulators agreed to an increase in the
fiscal dominance may arise in the context of minimum coverage of insured deposits from
keeping two different coffers for European deposit €20,000 to €100,000 and an increase in the speed of
insurance and resolution, respectively (for an repayment for insured depositors, the most worrying
extended discussion see Gros and Schoenmaker ).) gap is that of the unification of deposit insurance
The nature of fiscal backstops beyond resolution within the banking union.
and safety nets will be a crucial issue to define in In November 2015 the Commission put forward
the coming years. a legislative proposal to fill this gap, i.e. a European
deposit insurance scheme (EDIS), taking a concrete
step towards completing the third leg of BU. This is
Safety Nets a very significant proposal, as the absence of a
union’s deposit guarantee that could credibly back it
Authorities are now equipped with a broad set of underscores the dangers of incompleteness. A DGS
tools to ensure that the costs of bank failure will, in funded at the European level would, in this case,
the first instance, be allocated to bank shareholders make a material difference because it would provide
and creditors following a clearly defined hierarchy an external loss absorption device that would be
(bailing-in), and only later involve dedicated independent of the fiscal position of that sovereign
resolution funds held at the national level (bailing- (Posen and Veron ). Yet the EDIS has still to be
out). (Higher coverage will be granted for deposits approved, and it is currently stalling owing to
related to certain transactions (e.g. real estate political opposition.
transactions and payment of insurance benefits). The DGSD stipulates new thresholds for the
See ECB (2015).) In particular, as far as deposit financing of the national Deposit Guarantee Scheme
protection goes: • (DGS), notably by requiring a significant level of
e x a n t e funding (0.8% of covered deposits -
or, where viable, a target level of 0.5% of covered
deposits for highly concentrated banking systems)
• Citizens’ covered deposits up to €100.000, to be built up by 2024 by each member state. By
representing about 48.6% (47.3%) of total euro that date, the Commission’s proposal envisages that
area (EU) deposits, will be exempt from any resources will be mutualised in the EDIS. With the
loss. This number goes up to 70.9% (66% ) for EDIS, the protection of deposits
the euro area (EU) if the eligible over total

< --------------------------------------------------------------------------------------------------------------------------
European banking place (green); measures to be adopted during the transition union, (a) Current state
European Banking Union, Fig. 3
of European banking union; (b) to a BU (orange), and measures not yet in place (red). They
European banking union in the context of the GEMU - in do not consider measures which are temporary in nature theory
{Note: The figures include the main reforms of the such as unconventional monetary policy)
European economic governance framework already in
 Participating DGS funds EDIS funds

Evolution of EDIS funds compared to the funds of a participating DGS (in case MS/DGS chooses to compensate)

European Banking Union, Fig. 4 Evolution of EDIS and participating DGSs funds in the Commission’s proposal
(Source: European Commission website - European deposit insurance scheme)

would be fully guaranteed at the European level, mutual borrowing between DGSs from different EU
supported by close cooperation with national DGSs countries (ECB 2015), the viability of which has
(Fig. ). Given that national DGSs may remain still to be tested, particularly given the possibly
vulnerable to idiosyncratic shocks, the purpose of competing interests of debtor and creditor countries.
EDIS would be to ensure equal protection of Should national backstops not be sufficient,
deposits in a centralised manner. instruments at the European level may finally be
In die period elapsing between now and the enabled, including the ESM, consistent with the
EDIS, harmonised national deposit guarantee ESM’s agreed procedures. On the latter point, the
schemes will be necessary, meaning that member Eurogroup agreed that the ESM would have the
states concerned by a particular resolution plan will possibility to recapitalise ‘systemic and viable’
have to provide bridge financing from national banks directly, with maximum exposure for direct
sources (ECB 2015 ). In particular, if capital short- bank recapitalisations capped at €60 billion (equal
falls are identified, the Council clarified on 15 to 12% of the ESM’s maximum lending capacity).
November 2013 the order of the backstops. In the Given the uncertainty about the full viability of
case of insufficient e x a n t e funds, the DGS the project in the medium to long term, information
must collect e x p o s t contributions from the to markets and depositors should be prepared and
banking sector. Exceptional contributions should coordinated.
not exceed
1. 5% of covered deposits per year. In the
first instance, banks will thus have to raise capital in Managing 'The Outs'
the market or raise capital from another private
source. Should this not be sufficient, public money One issue with the current approach to the European
could be engaged at the national level in line with BU is that it minimises the importance of cross-
state aid rales and, if needed, through the provision border externalities of bank failures across the EU.
of public backstops. Here, the DGS may have Given the skewed design of the BU towards the
access to alternative funding arrangements, such as euro area member states, the problem of funding is
loans from public or private third parties. The likely to be more severe when it
DGSD also establishes a voluntary mechanism of
involves guarantees to or resolution of banks which challenges will be how to manage the transition
are systemic in both euro area and EU-non-euro until 2024. The alternative explanation is that polit-
area countries. For that reason, some of the ‘outs’ ical resistance to burden-sharing will mean that
may make use of their option to opt-in to BU going only an incomplete banking union can be attained
forward (Gros and Schoenmaker ), provided that in fact. As mentioned above, leaving resolution
European resolution and deposit insurance schemes funding and safety nets predominantly at the
will be available. In this respect, the UK’s vote to national level - i.e. the current state of BU - or,
leave the EU will place both the EU and the UK in equally, limiting the BU’s ‘federal’ reach and
uncharted waters, given the large presence of burden-sharing capacity, would mean perpetuating
important European banks in London, and in the the bank-sovereign doom loop; which is what the
absence of clear rales on cross-border banking BU is intended to break. The nature of fiscal back-
supervision and resolution under BU across EU and stops beyond resolution and safety nets will be a
non-EU member states. crucial issue to define in the coming years.

See Also
Final Remarks

A European banking union centred on the idea of ► 3.

single supervision, single resolution and a common ►

deposit insurance system may be the most far- ► v3

reaching reform to date since the inception of the ► ::
euro (Constancio ), if successful. Overall, however,
the political resistance of creditor countries may
restrain the effectiveness of crucial elements of BU, Acknowledgments The author wishes to thank, without
implicating, Iain Begg for his constructive comments on this
such as resolution and safety nets. A credible
entry.
banking union would entail moving responsibility
for potential financial support from the national to
the supranational level, implying transfer of
Bibliography
resources and risk, and, henceforth, requiring an
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step in the broader context of the European Financial Economics 115: 215-236.
Acharya, V., andT. Yomlmazer. 2007. Too many to fail-An
governance framework (see ►
analysis of time inconsistency in bank closure policies.
), in particu- Journal of Financial Intermediation 16(1): 1-31.
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Pisani-Ferry ; Gros and Schoenmaker ; Posen and victory? Bank bailouts and sovereign credit risk. Journal of
Finance 69(6): 2689-2739.
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Allen, F., T. Beck, E. Carletti, P. Lane, D. Schoenmaker, and W.
being, political resistance mainly focuses on the Wagner. 2011. Cross-border banking in Europe:
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Battistini, N., M. Pagano, andS. Simonelli. 2014. Systemic
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 countries Bulgaria, Czech Republic, Denmark,
European Central Bank Estonia, Cyprus, Latvia, Lithuania, Hungary, Malta,
Poland, Romania, Slovakia, Sweden and the United
Michael Binder and Volker Wieland Kingdom are, as of 2007, not member countries of
the ECB. These countries for the time being either
have opted out of becoming member countries of
the ECB (Denmark, Sweden and the United
Abstract Kingdom) or have - according to the judgement of
The establishment of the European Central Bank the EU Council - not yet achieved the necessary
(ECB) and with it the launch of the euro has degree of economic convergence.
arguably been a unique endeavour in economic The launch of the ECB was the culmination of a
history, representing an experiment of hitherto process of monetary and economic integration that
unknown magnitude in central banking. This dates back at least to the efforts of the French
article aims to describe the main aspects of the government official Jean Monnet and others in the
set-up and the responsibilities, strategy and 1950s and gained decisive momentum with the
operations of the ECB. It also aims to April 1989 report of a committee headed by the then
summarize some of the main lessons learned President of the European Commission, Jacques
from the establishment of the ECB for monetary Delors, which drew up a blueprint for the
economics, and to sketch some of the prospects progressive realization of the Eiuopean Economic
for the ECB and the euro. and Monetary Union (EMU). The establishment of
the ECB and with it the launch of the euro (the
currency of the ECB member countries for which
Keywords
banknotes and coins first went into circulation on 1
Budget deficits; Business cycles; Economic and January 2002) has arguably been a unique
Monetary Union (EMU); Euro; European endeavour in economic history, representing an
Central Bank (ECB); European System of experiment of hitherto unknown magnitude in
Central Banks (ESCB); Euro area; Exchange central banking. In what follows, we shall describe
Rate Mechanism (ERM); Globalization; Har- the main aspects of the set-up and the
monized Index of Consumer Prices (HIPC); responsibilities, strategy and operations of the ECB,
Inflationary expectations; Maastricht criteria; discuss what appear to be the lessons learned from
Monetary transmission mechanism; Open mar- this experiment for monetary economics, and sketch
ket operations; Price stability; Reserve require- some of the prospects for the ECB and the euro.
ments; Standing facilities

JEL Classifications Lesson One: How to Converge?

E58; E5; F3; G1
There can be little doubt that the European Coun-
The European Central Bank (ECB) was established cil’s June 1989 decision to pursue the Delors
on 1 June 1998 and since 1 January 1999 has been Committee’s blueprint of a feasible path towards
responsible for the conduct of a single monetary monetary union for its member countries was
policy for its member countries, namely, Austria, primarily driven by political considerations, view-
Belgium, Finland, France, Germany, Ireland, Italy, ing monetary union as a building block towards
Luxembourg, the Netherlands, Portugal and Spain tighter political and economic integration of the
(with Greece subsequently becoming a member member countries of the EU. However, given the
country on 1 January 2001 and Slovenia on 1 broad consensus among economists and
January 2007). Among European Union (EU) policymakers that, ideally, economic similarity
member rather than political boundaries should define the
geographic area spanned by a common currency, completion of the EMU have to keep the fluctua-
the Dolors report put considerable emphasis on tions of the value of their currency within the bands
realizing economic convergence before the estab- provided for by the European Exchange Rate
lishment of a single European central bank. Key Mechanism (ERM) and in particular not initiate any
elements of the three stages to realization of the devaluation of their currency against that of any
EMU as envisioned by the Delors Report were other member countries. Finally, with respect to the
level of long-term interest rates, member countries’
• Stage I (I July 1990): improvement of economic average long-term interest rates (on government
convergence; abolition of restrictions on cross- bonds or comparable securities) in the year
country flows of capital; increased cooperation preceding completion of the EMU were to fall
between national central banks. within a two per cent interval of average long-term
• Stage 2 (I January 1994): strengthening of interest rates in the three member countries
economic convergence; establishment of the displaying the highest degree of price stability.
European Monetary Institute (EMI) as prede- Of course, economic similarities desirable for an
cessor of the ECB to strengthen cooperation optimal currency area do not end with these four
between national central banks and increase criteria, but inter alia also include similarities in the
coordination of monetary policy. monetary transmission mechanism, the coherence
• Stage 3 (I January 1999): completion of the of the shocks and of the propagation mechanisms
necessary economic convergence; irrevocable driving national business cycles as well as
fixing of currency conversion rates; single similarities in the prospects for trend output growth.
monetary policy to be conducted by the Euro- These latter criteria were not part of the Maastricht
pean System of Central Banks (ESCB). criteria, though it was widely hoped that the
economic convergence process prior to or
It was envisioned in the Delors plan (and
immediately after the formation of the ECB would
enacted in the Maastricht Treaty, which established
result in these latter criteria being approximately
the EU, as signed in February 1992) that only those
met as well.
countries should become member countries of the
Despite the relatively modest requirements for
EMU that were successful in accomplishing
economic convergence in the Maastricht Treaty, the
economic convergence. The convergence criteria
goal of EMU was jeopardized during the 1992-3
(Maastricht criteria) were meant to specify a
crisis of the ERM when foreign exchange market
sufficient degree of economic similarity of member
participants widely viewed the ERM’s margins of
countries with respect to price stability,
fluctuation of two and a quarter per cent as not
sustainability of fiscal policy, exchange rate
sustainable in the light of at best limited
stability and the level of long-term interest rates. In
coordination of monetary policy, especially in
particular, with respect to price stability member
Germany, with that in several other countries in the
countries’ average rate of inflation in the year
EU, specifically that in Italy and in the United
preceding completion of the EMU was to fall within
Kingdom. The fact that despite the widening of the
a one and a half per cent interval of average
ERM’s margins of fluctuation to 15 per cent in
inflation in the three member countries displaying
August 1993 the goal of EMU was maintained
the highest degree of price stability. With respect to
appears to have been due to the commitment of
sustainability of fiscal policy, member countries
some of the then political leaders of the EU -
were supposed not to carry an ‘excessive deficit’ -
perhaps most notably the then German Chancellor
which would occur if the actual or planned
Helmut Kohl - who saw their vision of building a
government deficit to GDP ratio exceeded three per
united Europe jeopardized. Owing to this political
cent or if the ratio of government debt to GDP
commitment as well as the fact that markets
exceeded 60 per cent. Concerning exchange rate
increasingly gave weight to complying with the
stability, member countries would in the two years
Maastricht criteria as a signal for sound
preceding
monetary and fiscal policy, convergence as outlined stability the ECB shall support the general eco-
by the Maastricht criteria was sufficiently advanced nomic policies in the Community with a view to
in May 1998 for the heads of state and government contributing to the achievement of the objectives of
of the EU to decide to proceed with Stage 3 of the Community as laid down in Article 2.’ Article 2
EMU as planned, if only for the 11 initial member specifies these objectives to be a high level of
countries of the ECB. employment as well as sustainable and
While it is a valuable lesson to have observed in noninflationary growth. (The Maastricht Treaty
the context of the establishment of the ECB that the refers to the ESCB rather than the ECB since it
prospect of a monetary union may itself help to envisioned that all member countries of the Euro-
induce partial economic convergence, it appears key pean Union would eventually adopt the euro and
to keep in mind that the process of formation of the that even before this was to happen all national
ECB would probably not have been successful central banks of member countries not part of the
without the strong desire of the member countries’ euro area would be bound by the same objectives.)
political leadership to see commonalities in cultural While the Maastricht Treaty does not specify a
heritage also reflected in increasingly cohesive precise quantitative definition of price stability, the
institutional entities, busting that a common ECB, particularly on the basis of the argument that
European currency would help the emergence of a such quantification would strengthen its commit-
single European identity. ment to its primary objective as well as strengthen
Structural economic diversities between euro its accountability, in October 1998 defined price
area member countries continue today (in 2007). stability as a year-onyear increase in the Harmo-
Among these diversities perhaps most notable are nized Index of Consumer Prices (HICP) for the euro
persistent differences in trend output growth rates. area of below two per cent over the medium run.
The widely voiced hope expressed at the time of the While this definition of price stability does exclude
signing of the Maastricht Treaty - that formation of deflation as being consistent with price stability and
the ECB would significantly spur convergence of leaves the ECB with no degree of freedom to
trend output growth rates for euro area member potentially remove more volatile and/or temporary
countries through alignment of structural reforms of components of overall consumer prices in order to
labour and product markets - has so far proven to be declare price stability, the definition does leave the
wishful thinking. While some critics of the ECB ECB some flexibility in that a time horizon as to
have argued that this is due to the mandate of the what would constitute the medium run was not
ECB being too narrowly focused on price stability, established.
it may have been exactly this focus that allowed the In its pursuit of price stability, the ECB decided
ECB to successfully establish itself as a credible to base its monetary policy framework on two
safeguard of price stability, an issue which we will pillars: ‘monetary analysis’ and ‘economic analy-
discuss further below. sis’. In declaring monetary aggregates as providing
information valuable to the objective of price sta-
bility that should be separated from other economic
and financial variables, the ECB has so far
maintained that monetary aggregates do not just
Lesson Two: How to Design offer incremental information relative to such other
and Implement a Monetary Policy variables for purposes of projecting inflation, but
Strategy that at longer horizons (stretching beyond those
typically adopted by central banks for the compu-
The starting point for any discussion of the ECB’s
monetary policy strategy has to be the mandate that tation of their inflation projections but still essential
for medium-run price stability) monetary aggregates
the ECB was given by the Maastricht Treaty.
Article 105 of that treaty specifies: ‘The primary provide information qualitatively different from that
which other economic variables can provide. The
objective of the ESCB is to maintain price stability.
Without prejudice to the objective of price ECB in this context has so far also
maintained that money demand (as measured by the Governing Council noted that it aims to maintain
monetary aggregate M3) for the euro area has been inflation rates below, but close to, two per cent over
stable at least over longer horizons, with some the medium run. A number of arguments in favour
short-run instabilities being due to an exceptionally of tolerating a low rate of inflation - and not aiming
prolonged (but still temporary) period of high asset at zero inflation - were acknowledged, among
price volatility. Finally, the ECB has so far which the most important are the need for a safety
maintained that conventional macroeconomic anal- margin against potential risks of deflation and the
ysis is not sufficiently advanced to combine the ‘zero bound’ on nominal interest rates. While this
analysis of real economic phenomena with mone- ‘zero bound’ renders central bank interest-rate
tary trends within a single pillar framework. Driven management less effective at low rates of inflation,
by these considerations, the ECB therefore initially ECB studies argued that inflation rates below, but
decided to announce annual reference values for the close to, two per cent would provide a sufficient
growth rate of M3 as a benchmark for keeping safeguard against these risks. Second, the
monetary growth in line with the objective of price Governing Council emphasized that the ‘monetary
stability. analysis’ pillar was meant to serve mainly as a
The ‘economic analysis’ pillar of the ECB’s means of cross-checking, from a medium- to long-
monetary policy framework aims at identifying and term perspective, the short- to mediumterm
quantifying short- to medium-term nonmonetary indications provided by the 'economic analysis’
risks to price stability. Variables entering this pillar. To underscore the longer- term nature of the
analysis include (a) gap measures of the reference value for monetary growth, the practice of
discrepancy between actual output as well as its an annual review of the latter was discontinued.
factors of production on the one hand and their It will be interesting to observe whether even-
medium- to long-run equilibrium values on the tually the monetary pillar comes to be viewed as
other hand; ( h ) labour cost measures; (c) having been of importance only in the early years of
exchange rates for the euro and international prices; operation of the ECB when the ECB had to
and ( d ) asset prices other than exchange rates, establish its credibility' by being as committed to
particularly yield curve measures. Reflecting the price stability as the Deutsche Bundesbank (the
sizeable degree of persistence of consumer price German central bank) had been prior to 1999 and
inflation in the euro area, considerable weight in the when the ECB was confronted with sizeable prob-
economic analysis is also given to recent consumer lems regarding the measurement of harmonized
price dynamics. euro area-wide real economic aggregates, or
The ECB’s two-pillar strategy has been heavily whether ECB-style cross-checking by means of
criticized and remains controversial. Critics argue monetary analysis will become a common practice
that monetary aggregates such as M3 - specifically of central banks around the globe.
due to the lack of sufficient stability of money The operational framework used by the ECB to
demand - lack the degree of reliability needed to implement its monetary policy strategy is less
separate information in such monetary aggregates controversial than the strategy itself and includes
from other economic and financial variables. These three main instruments: open market operations,
critics inter alia also argue that, if the transparency standing facilities and reserve requirements. Among
and accountability of the ECB’s decisions were to the open market operations of primary importance
be improved, this would be helped most by the are the ‘main refinancing options’ that provide the
publication of inflation forecasts by the ECB as bulk of refinancing to the financial sector and,
well as the publication of the minutes of the through signalling the ECB’s monetary policy
meetings of the ECB’s Governing Council (for stance, are supposed to steer market interest rates.
more on the latter, see below). The two-pillar The ‘main refinancing options’ are executed by the
strategy was reaffirmed in a broad internal national central banks of the euro area member
assessment by the ECB in 2003, but two countries on a weekly basis through
clarifications were provided. First, the
a tender procedure spanning three working days. arrived at by the Governing Council. Indeed, more
‘Standing facilities’ aim at providing and absorbingthan half the euro area member countries at present
overnight liquidity, and ‘minimum reserve have an economic weight (as measured by the ratio
requirements’ (the ECB imposes minimum reserves of their national GDP to euro area GDP) that is
on all credit institutions in the proportion of two per
smaller than their voting weight within the
cent of the reserve base) aim at stabilizing market Governing Council. This is quite different from the
interest rates. structure of, say, the US. Federal Reserve, which is
By way of evaluating the overall success of the significantly more centralized. While
ECB in terms of it being able to adhere to its pricedecentralization of the implementation of the
stability objective, we may observe that inflation ECB’s monetary policy arguably is useful, partic-
rates in the euro area since 1999 have on an annual ularly as long as there are important differences
basis on average been slightly above two per cent among national financial markets and institutions in
(in the range of up to 30 basis points above two perthe euro area, the decentralized institutional set-up
cent). Also, given that surveys of average long-termof the ECB has risks, particularly during episodes
inflation expectations in the euro area have of real divergence. It will be interesting to see
consistently measured such expectations as below, whether the ‘one person, one vote’ principle for the
but close to, two per cent, its track record has quite
Governing Council will be maintained after
firmly established the ECB’s credibility with regardpossible enlargement of the euro area to incorporate
to safeguarding price stability. (some of) the EU member countries not presently
member countries of the ECB. Even if the ‘one
person, one vote’ principle is to be maintained,
Lesson Three: One Central Bank there appears to be considerable scope for future
for Many Countries: How to Organize revision of the organizational system of the ECB,
Decision-Making such as requiring approval of nominations of new
central bank presidents by the Executive Board of
The most important decision-making body of the the ECB.
ECB is its Governing Council, which is made up of
the Executive Board of the ECB (which in turn is
made up of its president, vice-president and four Lesson Four: Common Currency and
other members) as well as the governors of all the Monetary Policy: Gains and Losses
national central banks of euro area member coun-
tries. It is the responsibility of the Governing In general, the principal advantages of a common
Council to formulate monetary policy for the euro currency are widely held to include the reduction of
area, including decisions about intermediate transaction and information costs implied by the
objectives and key interest rates. The Executive use of a common medium of exchange as well as
Board is in charge of implementing the monetary the stimulus the common currency provides for the
policy decisions taken by the Governing Council, convergence of organizational principles used in
and to this purpose cooperates with the national business, in turn stimulating trade in goods and
central banks through open market activities. Each services and of cross-country flows of capital. The
member of the Governing Council has one vote. principal disadvantages of a common currency for
Given that at present slightly more than two-thirds multiple countries are widely held to include the
of the votes in the Governing Council, therefore, loss of shock-absorber properties of flexible
belong to national central banks, the latter have a exchange rates and of independent national mon-
strong influence on the ECB’s monetary policy etary policies. Furthermore, if a single monetary
decisions. policy is accompanied by a diverse set of national
This organizational structure implies an asym- fiscal policies, inappropriate fiscal policy in one
metry between the economic size of euro area country will - through its effect on interest rates -
member countries and their influence on decisions directly spread to other countries in the
monetary union. Thus macroeconomic stability by well over ten per cent to approximately one-third
could be affected for the worse. of the global market (through holdings tend to be
How has the euro area so far fared on these concentrated in countries neighbouring the euro
counts? Trade within the euro area increased from area).
approximately 26.5 per cent of (euro area ) GDP in In the equity and retail banking markets inte-
1998 to approximately 31 per cent of GDP in 2005; gration has progressed more slowly. For example,
one and a half per cent of this increase was due to despite a decrease in the number of credit institu-
trade in services. Taking into account the limited tions in the euro area member countries by almost
time span, it is difficult to assess, however, to what 50 per cent between 1997 and 2006, less than one-
extent this increase in trade was indeed driven by third of the mergers and acquisitions driving this
the creation of a single currency and to what extent consolidation process have been crossborder. Also,
it may instead have been driven by the process of the cross-country standard deviation of interest rates
economic globalization. We do know, in fact, that on consumer credit from 2004 to 2006 has still been
trade with trading partners outside the euro area close to one per cent.
over this same time period rose by a slightly larger While, just as for trade, it is difficult to disen-
margin than intra- eiuo area trade, from tangle the euro’s contribution to the process of
approximately 24 per cent of GDP in 1998 to financial integration in euro area member countries
approximately 30 per cent ofGDP in 2005. from the global trend towards financial integration,
Regarding financial markets, for which the the euro surely has greatly facilitated the task of
volume of transactions is probably still more sen- bringing the European financial system closer to US
sitive to even small costs and risks associated with standards in terns of market depth and liquidity'.
the use of multiple currencies, by a variety of Further improvements in this direction, including
measures deeper, broader and more liquid markets the creation of a single payment system for the euro
have emerged for the eiuo area member countries area member countries, are likely to intensify the
since establishment of the ECB. On the money debate about the potential role of the euro as a
market, issues of their interpretation aside, cross- complement or competitor to the US dollar as an
country standard deviations for average overnight international reserve currency.
lending rates fell from 130 basis points in January Finally, to turn to macroeconomic stability and
1998 to three basis points one year later, and since the potential cost of losing flexible exchange rates
then have decreased to approximately one basis and independent national monetary policies as
point. Cross-country standard deviations for rates at shock absorbers, some such costs clearly have been
longer maturities (one and 12 months) for observed since 1999. While the cross- country
unsecured money market instruments have fallen to standard deviation of consumer price changes has
less than one basis point also, with the spreads still fallen from approximately six per cent in the late
somewhat larger in the collateralized repurchase 1990s to one per cent with the launch of the euro,
agreement (repo) market (due to continued and has been rather stable at this level in the
differences in legal structures across euro area following eight years, there have been persistent
countries). In the interest rate derivatives market, deviations from euro area average inflation rates for
the euro interest rate swap market at a daily volume some countries, implying sizeable (and potentially
of 250 billion euro was in 2006 one and a half times destabilizing) differences in real interest rates. For
as large as the corresponding US dollar market. In example, for a sizeable part of the time period since
the government bond market also, spreads have 1999, real interest rates have been significantly
fallen to low levels, suggesting - in the likely lower in a booming Irish economy than in a German
absence of major changes in default risks - a economy experiencing weak growth. When it
significant fall of liquidity risk. The holdings of comes to assessing the implications of the
euro-denominated debt securities overall since 1999 establishment of the ECB for macroeconomic
have increased stability, these costs have to be subtracted from
benefits owed to factors such as
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Washington: Institute for International Economics.
counts (such as the monetary policy strategy and the
organizational set-up) there is as of 2007 no
consensus as to whether the ECB adheres to best
international practice in central banking, it would
appear rather questionable to label the establishment
of the ECB and with it the introduction of the euro
European Central Bank
and Monetary Policy in the Euro Area
as anything but an enormous success. The ECB has
successfully mastered the technical challenges of Vitor Gaspar and Otmar Issing
establishing a new common currency across a set of
countries comprising one of the largest economic
regions in the world, has in a short period of time
established a strong track record of success in
preserving price stability, and has on many counts, Abstract
particularly in the area of financial markets, helped Since 1 January 1999 the European Central
lead the way to a stronger integration of European Bank (ECB) has had sole responsibility for
markets. While it is undisputable that this inte- monetary policy in the euro area Its main aim is
gration of markets along with structural reforms to maintain price stability over the medium
needs to proceed much further, the key decisions term. It is completely independent. The ECB has
that could facilitate such integration and structural been successful in maintaining price stability
reforms fall outside the core domain of and well-anchored inflation expectations. The
responsibility of the ECB and, for that matter, euro is now a well-established international
should probably remain so for any central bank currency and a symbol of European integration.
primarily entrusted with maintaining price stability. The financial and economic crises of 2007-
2011 made the tension between the single mon-
etary policy and national responsibilities for
See Also economic policies and financial stability visible.
This is the main challenge going forward.
► ro
► ropean Monetary J on
Keywords
► feral Reserve S;
Euro; European Union; European Central Bank;
► Deflation Targeting
► lity and Growth I act Monetary policy; Price stability; Expectations;
Credibility; Finance

JEL Classifications
E52; E58; E61; F55
A single monetary policy covering all the sovereign and budgetary policy, in particular, remained
states participating in the euro area replaced the unchanged. The combination of an independent and
separate national policies on 1 January 1999. The supranational monetary authority, with Member
date is also a milestone in the history of States largely responsible for the conduct of
international monetary integration. For the first time economic policies, implies an original tension that
a group of advanced countries has chosen to entrust remains unsolved. Many observers were sceptical
the exclusive competence for the conduct of their about the outcome. After a few years the pendulum
monetary policy to an independent and supra- swung the other way and most observers started
national monetary authority: the European Central taking the success of the euro for granted, forgetting
Bank (article 3 and article 127 of the Treaty on the how difficult it had been to prepare the launch of
Functioning of the European Union - EU). The euro the new currency, to establish the credibility of the
area started with the participation of 11 EU Member ECB and to put in place a new monetary policy
States: Austria, Belgium, Finland, France, strategy and operational framework. The degree of
Germany, Ireland, Italy, Luxembourg, the uncertainty associated with the transition to the
Netherlands, Portugal and Spain. Since then, it has single monetary policy was enormous. Issing ( )
expanded to include 17 countries with the writes:
participation of Greece (2001); Slovenia (2007), As a central banker directly involved in monetary
policy making, I have been dealing with uncertainty
Cyprus and Malta (2008), Slovakia (2009) and
and its consequences for a large part of my profes-
Estonia (2011). Euro banknotes and coin became a sional life. From my experience as a member of the
physical, day-to-day reality on 1 January 2002. Board of the Bundesbank, I have vivid memories of
At the time of writing (2011), the euro is the challenges posed by German reunification and the
turbulence surrounding ERM crises. But never have
currency of almost 330 million people in 17 dif-
I felt the impact of uncertainty as acutely as in the
ferent European countries. Most of the remaining weeks that preceded and followed the introduction of
EU Member States intend to adopt the euro in the the euro and the birth of the single monetary policy.
future and, with the exception of the UK and
Denmark, have a treaty obligation to do so. The According to the Treaty on the Functioning of
euro is the second most important currency in the the European Union the primary objective of the
global economy (after the US dollar) and the euro European System of Central Banks (ESCB) is to
area is the monetary area with the second largest maintain price stability (article 127.1 and 282.2, and
economy (after the USA). In contrast with the also article 2 of the Statute of the European System
economies of the participating countries, which can of Central Banks and of the European Central
mostly be characterized as small open economies, Bank). The ESCB is governed by the decision-
the euro area is a large and relatively closed making bodies of the ECB (article 129.1 and 282.2
economy. Aggregate differences, in the structure of of the Treaty and 9.3 of the Statute): the Governing
production by sector, relative to the USA are Council and the Executive Board. The
relatively small. For the conduct of monetary pol- independence of the ECB and of the ESCB is
icy, an important difference relative to the USA is protected by the Treaty and the Statute (respectively
that in the euro area the financial system is dom- by article 130 and by article 7). Without prejudice
inated by banking. This contrasts with the pre- to the objective of price stability, the ESCB shall
dominance of market financing in the USA. For support the general economic policies in the Union
more information on the global role of the euro, the with a view to achieving their objectives, as
economic weight of the euro area and further specified in article 3 of the Treaty on European
references see, for example, EMI ( ), ECB Union. These include:
(1999), Issing et al. ( ) and Buti et al. ( ). • balanced growth;
The transfer of powers from the participating • a highly competitive social market economy,
Member States was limited to monetary policy.
aiming at full employment and social progress;
Their competences in economic policy, in general,
• the promotion of scientific and technological academic literature, starting with Kydland and
advance; Prescott ( ) and Barro and Gordon ( ).
• equality between women and men; This important issue has been revisited recently, in
• solidarity between generations; the context of the standard new Keynesian model,
• the protection of the rights of the child; by, for example, Clarida et al. ( ),
• economic, social and territorial cohesion; and Woodford ( ), Gali ( ) and Walsh
• solidarity among Member States. ( ). This literature stresses that an independent
central bank, with a clear mandate, should be able to
The ESCB is composed of the ECB and the maintain low and stable inflation and to anchor
national central banks of the Member States of the inflation expectations. Credible policy relies on a
European Union. The Eurosystem is made up of the well-understood strategy, implying a systematic and
ECB and the national central banks of the Member predictable pattern of response to the current state
States that have adopted the euro as their currency. and prospects for the economy.
These definitions are provided in article 1 of the Figure shows inflation in the euro area, mea-
Statute. sured in accordance with the 12 month change in
Most of the preparatory technical work was the Harmonized Index of Consumer Prices (HICP)
carried out by the European Monetary Institute and long-term inflation expectations following the
(EMI) and the participant national central banks Consensus forecasts and the ECB’s own Survey of
during the second stage of Economic and Monetary Professional Forecasters (SPF). In the period from
Union (1994-1998). During this period the January 1999 to December 2010, average inflation
foundations for the proper functioning of the single was 1.97%, which is below (but close) to 2% and
currency were conceived. These included a basic set therefore in line with the ECB’s definition of price
of analytical tools; statistical information; internal stability. Importantly, the same applies to the long-
organization rules for the new central bank; a new run inflation forecasts according to the Consensus
pan-European interbank payment mechanism; and forecasts and the SPF. For example, according to
the operational framework for implementation of the latter average, long-term inflation expectations
the single monetary policy. The technical work was have always remained well-anchored within a nar-
already mature when the ECB was established (on 1 row range from 1.8% to 2.0%.
June 1998) and the final six months of the Figure also makes it clear that year-on-year
preparatory period started (see, for example, EMI , , inflation has been above 2% most of the time. In
). June and July 2008 it peaked briefly at 4% (twice
The institutional provisions described in the the upper limit in the ECB’s definition of price
previous paragraphs underline the importance of stability). Equally, for most of the period, average
price stability as a central element in the economic annual inflation has been close to but not below 2%.
constitution of monetary union in Europe. However, Only recently, in the context of the Global Financial
all institutional guarantees notwithstanding the most Crisis and the associated Great Recession, have
basic questions at the beginning were: would the very low - or even, for a brief period, negative -
ECB deliver price stability? Would the ECB be inflation rates pushed average inflation below the
credible in fostering well-anchored inflation 2% limit.
expectations? How could the ECB be credible in the In Buti et al. ( ), Geraats, Neumann and
absence of a track record? How could the ECB deal Smets look back at the performance of the ECB
with the uncertainties associated with monetary during the first decade of the euro. They emphasize
unification and financial integration? the behaviour of inflation expectations and credibil-
The importance of credibility for the conduct of ity. For example, Smets ( ) looks at the first
monetary policy is a common feature of virtually all decade of the euro. He excludes the first year (1999)
models that emphasize the endogenous character of on the ground that given transmission lags the
private sector expectations. Expectations outcome cannot be attributed to the ECB. Hence,
management is strongly emphasized in the for the period available to him, HICP
 5.0

4.0

3.0

CD 2.1
0.

1,0
HICP year-on-year rate

0,0 Survey Professional Forecasters (4-5 years)

Consensus (average next 10 years)

-1,0 4 ------1 ----1 ----1 ----.-----.-----.-----.------1 ----1 ----1 ----.-----1 ----1 ----1 ----1 ----1 ----.-----1 ----1 ----1 ----1 ----.----
Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Sources: Consensus Economics,
ECB and Eurostat.
European Central Bank and Monetary Policy in the Euro Area, Fig. 1 Euro area inflation (HICP) and long-term
inflation expectations

inflation, for the euro area, averaged 2.2%. Smets Financial Studies (CFS) at Frankfurt University.
argues that the deviation is mostly due to These conferences, unique in the world of central
unforeseen and large oil and other commodity banking, provide a very full picture of the ongoing
prices disturbances. In fact, excluding eneigy and debate between the ECB and its critics (the pro-
unprocessed food prices, the average inflation rate gramme of the first 12 editions of the conference
was 1.8% in the same period. But mostly he and a wealth of additional information can be
stresses, as already mentioned above, that while obtained from the CFS website:
headline inflation has fluctuated significantly long- ). Whereas the mone-
term inflation expectations remained anchored, in tary policy decisions were mostly welcomed, the
line with the ECB’s definition of price stability. initial criticism concentrated on the ECB’s mone-
European monetary unification has been debated tary policy strategy. However, the critical tone
since the establishment of the so-called Wemer lessened somewhat over time. In the context of the
Group (1969). The discussion intensified after the financial crisis, even early critics have seen the
publication of the Delors Report in 1989. In the ECB less critically than other major central banks
academic world, the vast majority of commentators (see, for example, Buiter ( )).
have been highly sceptical and critical (see Issing (
) and Jonung and Drea ( ) for
reviews and references). Even before the start of the The Stability-Oriented Monetary Policy
single monetary policy several groups of econ- Strategy of the ECB
omists organized ECB watching activities. The title
of the first of these reports, CEPR’s ‘ECB: safe at The environment relevant for the conduct of mon-
any speed?’, published in 1998, is representative of etary policy is characterized by pervasive uncer-
the prevailing tone at the time. Since 1999 the ECB tainty. As argued above, this general point was of
has been meeting annually with academics and particular relevance for the ECB at the time of the
professionals from the financial sectors at ‘ECB and launch of the euro. Moving from national currencies
Its Watchers Conferences’. Thee meetings are and monetary policies to a common currency and a
organized by the Center for single monetary policy implied a deep
regime shift with a huge potential for structural elements: (1) a quantitative definition of price
breaks (Lucas ). However, knowledge about the stability: (2) economic analysis and (3) monetary
structure and the functioning of the economy and of analysis. The latter two are used to organize an all-
the financial system is always imperfect. The encompassing assessment of price prospects and
structure and functioning themselves are constantly risks to price stability. The two perspectives are
changing, which limits the usefulness of past data. systematically used for cross-checking (see Fig. ).
Therefore it is the case that the monetary Versions of Fig. , differing in some details, have
transmission mechanism is always uncertain. been used over time by the ECB to convey a
Moreover, economic data are contaminated by schematic representation of the monetary policy
measurement error. In this environment it is crucial strategy. It was presented for the first time in an
that monetary policy does not itself become an E C B M o n t h l y B u l l e t i n
additional source of uncertainty. A monetary policy article in 2000 (ECB ).
strategy helps to dispel such uncertainty, first by It is important to clarify the status of the defi-
structuring a well-ordered internal decision-making nition of price stability within the monetary policy
process; second, by providing a consistent and strategy. In fact, as already referred to above, price
coherent framework for communication; and third, stability is set as the primary goal of the ECB in the
by contributing to the credibility and predictability Treaty on the Functioning of the European Union
of the single monetary policy. itself and the ECB does not, as some critics have
The stability-oriented monetary policy strategy suggested, have independence in setting its goal.
of the ECB was disclosed immediately after a Rather, price stability as the overriding goal of
decision by the Governing Council, on 13 October monetary policy is taken as given by the ECB
1998 (ECB ). The strategy comprises three (Issing ). Instead, the ECB’s decision was to

PRIMARY OBJECTIVE OF PRICE STABILITY

Governing Council decides on monetary polity based on their

overall assessment of prospects and risks to price stability

n i k

Economic Analysis Monetary Analysis

Wide suite of models including structural Frameworks ,o analyze mone.ary and credit
econome.ric models. VARs. ... developmen.s
Wide range of economic and financial Money demand models
indicators Analysis of .he mone.ary transmission
Analysis o1 economic dynamics and driving mechanism
forces CROSS-CHECKING Assessment of financial market and
Macroeconomic projections intermediation spreads
Prospects and risks Prospects and risks

t t
FULL INFORMATION SET

European Central Bank and Monetary Policy in the Euro Area, Fig. 2 The stability-oriented monetary policy
strategy of the ECB
a n n o u n c e a precise and operational staff, as an input to Governing Council delibera-
definition of price stability based on a specific tions, at a quarterly frequency. Twice a year they
statistical indicator. Such an announcement is, in stem from a broad exercise involving not only the
itself, an important form of commitment and a key ECB but also the national central banks of the
for the communication of the central bank with the Eurosystem. Twice a year they are conducted under
general public (Issing et al. , Chapter 4). the sole responsibility of ECB staff. Economic
In October 1998, the Governing Council decided analysis focuses, to a large extent, on the interaction
that ‘Price stability shall be defined as a year-on- between aggregate supply and aggregate
year increase in the HICP, for the euro area, of less expenditure and the role of factor costs on pricing
than 2 per cent. Price stability is to be maintained behaviour. Economic analysis uses a vast array of
over the medium term’. About five years later, on 8 structural econometric models, including new
May 2003, when announcing the results of its Keynesian Dynamic Stochastic General Equi-
evaluation of the monetary policy strategy, the librium Models. The ECB has been pioneer in this
Governing Council confirmed the definition, but area of research through the work of Smets and
clarified that it aimed to maintain inflation below Wouters ( ). At the time of writing the new
(but close) to 2% over the medium term. The area-wide model (NAWM), developed by the
clarification was justified by the benefits of making Econometric Modeling Division, to be used in the
explicit a safety margin against the risk of deflation. broad macroeconomic projection exercises and
The Governing Council spelled out that it regards policy simulations, constitutes an important element
low and stable inflation as compatible with price in the ECB’s modelling toolbox. It is a micro-
stability. Inflationary and deflationary departures founded, open-economy model for the euro area. It
from the benchmark are both undesirable departures relies on a neo-classical core and incorporates a
from price stability. Therefore the definition is number of important frictions including wage and
clearly symmetrical. price rigidities; habit persistence in consumption
The definition of price stability provides a behaviour; and adjustment costs in investment. It
benchmark against which to evaluate the perfor- incorporates some open economy extensions of
mance of the ECB. It provides an anchor for these frictions, including domestic currency pricing
inflation expectations and therefore serves to reduce and costs associated with the adjustment of trade
uncertainty about price developments over the flows (Christoffel et al. ).
longer term. The NWAM follows the area-wide model (AWM)
Pervasive uncertainty also recommends a focus that was developed and made available in the early
on robustness. Seeking robustness involves a years of the ECB (Fagan et al. ).
willingness to consider different ‘views of the Monetary analysis starts from the fundamen-
world’. In the ECB’s stability-oriented monetary tal insight that inflation is ultimately a monetary
policy strategy such diversity is symbolized by ‘two phenomenon (according to Milton Friedman).
pillars’, supporting decision-making by the Inflation, that is persistent increases in the price
Governing Council: economic analysis and mon- level, is ultimately determined by monetary trends.
etary analysis (Fig. ). Although many factors may affect price behaviour
Economic analysis spans a wide range of in the short to medium term, only monetary trends
indicators which are relevant for risks to price can account for lasting inflation (see, for example,
stability over the short to medium term. This Romer , p. 407). The money-price relationship is
includes overall output, demand and labour market confirmed by a wide variety of empirical studies
conditions, fiscal policy, and exchange rate using times series, cross-country and pooled data,
developments, as well as financial market indicators spanning different monetary regimes and
and asset prices. Economic projections are an definitions of monetary aggregates. A central bank
important element of economic analysis as they with the mandate to maintain price stability cannot
synthesize a very rich information set. They do not, ignore its responsibility for monetary
however, constitute a sufficient statistic. The developments. By giving ‘money’ a prominent
projections are produced by
role, in its monetary policy strategy, the ECB has at the reverse link. Money and, in particular, credit
recognized this role and, at the same time, avoided growth in excess of what is needed for sustainable
some of the shortcomings of inflation targeting. growth begets asset price bubbles and financial
Therefore monetary analysis contributes to cross- instability. Therefore they are associated with boom
checking economic analysis from a long-term per- and bust and, from a medium-to long-term
spective. Monetary analysis may also be relevant at perspective, with price instability. Alessi and
shorter horizons through, for example, the mon- Detken ( ) have found that the global private
itoring of credit developments, financial spreads credit gap is a leading indicator of asset price booms
and the monetary transmission mechanism. More that will be followed by costly episodes of
generally, cross-checking the results from economic macroeconomic instability and ultimately price
and monetary analysis provides the foundation for instability'.
monetary policy decisions, which take into account A volume recently published by the ECB
all relevant information, seen from two different (Papademos and Stark ) presents studies on various
angles (see Fig. ). aspects confirming the importance of a thorough
Beck and Wieland ( ) show that, when the monetary analysis while providing subjects for
central bank misperceives the output gap, further research (summaries are provided in ECB (
supplementing interest rate prescriptions, derived ) and Amisano et al. ( )).
from Keynesian or new Keynesian models, with The monetary policy strategy of the ECB was
estimates of trend inflation derived from monetary designed in a way that, notwithstanding basic
analysis, substantially improves inflation outcomes. principles, is open to new insights from research and
From the beginning monetary analysis was not actively seeks to identify structural changes in the
restricted to broad definitions of money such as M3 financial system as well as in the real economy.
and its relation to the reference value, but took into This approach is confirmed by this statement
account ‘developments of a wide range of monetary (Papademos and Stark , p. 11): ‘Developing a better
indicators, including M3 and its components and understanding of the behaviour of monetary and
counterparts, notably credit and various measures of credit aggregates and their influence on the
excess liquidity’(ECB ). economy has given rise to new questions and
Over time, monetary analysis was broadened and challenges which will influence our future work on
deepened (Issing ). both monetary analysis and other approaches.
In the context of the Global Financial Crisis, Reciprocally, improvements in other approaches
starting in 2007, links between liquidity and asset will again need to be considered from the perspec-
price dynamics have become evident, stressing the tive of monetary analysis. Both to crosscheck their
relevance of monetary analysis also for identifying results and to maintain the encompassing nature of a
risks to financial stability. There is much ongoing robust monetary policy strategy. Such is the nature
research at the ECB and elsewhere. Recently Beyer of progress. Such is also the nature of science. And
( ) has estimated an empiri such should be the nature of a robust monetary
cally stable, small macroeconomic model for the policy strategy if it is to ensure effectiveness,
euro area. It considers the broad monetary aggre- accountability and transparency’.
gate, M3, of real GDP, annual inflation, the nominal
growth of housing wealth and interest rate measures
(specifically the annualized three- month interest The Operational Framework
rate and the annualized own return on M3). The for Monetary Policy Implementation
model is able to track closely trend velocity since
the late 1990s. While the money demand model The Eurosystem implements monetary policy
identifies the influence of wealth variables on through financial markets. The operational frame-
money demand another strand of research, building work is the set of instruments and procedures
on insights from Hyman Minsky (see, for example, through which the Eurosystem intervenes in markets
Minsky ), looks with a view to determining the monetary
 Source: Thomson Reuters

European Central Bank and Monetary Policy in the Euro Area, Fig. 3 ECB policy rates and EON1A

policy stance, in accordance with decisions made by Under normal circumstances, the first step in the
the Governing Council. The Treaty and the Statute monetary transmission mechanism is the control, by
contain relatively few provisions about the the central bank, of an overnight interest rate. The
instruments of monetary policy. Furthermore, those ECB does so through a ‘corridor system’ (see
provisions are of a general nature. For example, Fig. ). In a ‘corridor system’, reserve requirements
article 127.1 of the Treaty on the Functioning of the operate as a device to create a structural demand for
European Union (article 2 of the Statute) prescribes central bank money and a buffer to smooth demand
that the Eurosystem ‘shall act in accordance with for reserves and reduce the volatility of interest
the principle of an open market economy with free rates. Overnight interest rates (in Fig. represented
competition favoring an efficient allocation of by the Euro Overnight Index Average (EONIA) )
resources’. The operations of the Eurosystem are are bound by two standing facilities provided by the
specified in chapter IV of the Statute (articles 17- central bank: a deposit facility and a lending
24). For example, the Eurosystem may operate in facility. Banks can deposit excess funds at a
financial markets (article 18), and impose minimum predetermined interest rate. Banks can also have
reserves on credit institution, including penalties for recourse to a credit facility, accessing funds at a
non-compliance (article 19). Importantly, article 20 predetermined interest rate, securing the operation
states: ‘The Governing Council may, by a majority through the pledging of eligible collateral (see
oftwo thirds of the votes cast, decide upon the use ‘Marginal lending facility’ in Fig. ). Within the
of such other operational methods of monetary corridor, the Main Refinancing Operation (MRO)
control as it sees fit... Therefore, the Treaty and the minimum bid rate is the most important policy rate,
Statute provides the ECB with ample room to adapt as it serves as the reference for overnight market
its instruments as required by unforeseen interest rates (for details see Bindseil ( )
circumstances. Naturally, discretion in this area is, and ECB ( )).
as in all other areas, constrained by the primary goal Issing ( ) offers an overview of the process
of maintaining price stability, as prescribed by of development of monetary policy instruments by
article 2. the Eurosystem).
ECB Policy in Action: Simple Rules Ai = 0[(n — 7i*) + (Ay — Ay*)]
as Benchmarks
The Orphanides rule departs from the Taylor
In the models used by monetary policy researchers, mle in that, by using first-differences, it eliminates
the rules summarizing the systematic response of the dependence of the mle on the unobserved level
interest rates to the state ofthe economy are central. of the natural interest rate, r*, and also on the level
In forward-looking models under perfect foresight of potential output, y * . Following in Taylor’s
or rational expectations, the model cannot be solved footsteps, Orphanides proposes 0 = 0.5. Smets
in the absence of such rules. Focus on systematic estimates the mle and finds that the estimated
(rule-like) behaviour is not, however, the most coefficients on inflation and output growth
common way of discussing the practice of monetary deviations are not significantly different from 0.5.
policy. Many people fail to distinguish between The coefficient on lagged interest rate is close to 1
actions taken in the context of a systematic practice (but the estimated coefficient is 0.89 and the
and the characterization of the features of the difference from 1 is statistically significant).
practice itself. Nevertheless, it is a fundamental The Orphanides mle may be derived from a
distinction. The stability-oriented monetary policy quantity theory of money framework (Orphanides ).
strategy of the ECB induces systematic, rules-like Indeed, the ECB derives the reference value for
behaviour on the part of the ECB. It is therefore money growth from the equation of exchange:
interesting to assess how closely simple mles are
able to account for the past behaviour of the EC- B. Am* = n* + Ay* + Av*
Close tracking is direct evidence of systematic
behaviour. Significant departures are episodes that as explained in Issing ( ). In order to derive
demand explanation and clarification on the basis of the interest rate mle it suffices to use the simplest
the strategy itself. money demand equation - which relates deviations
In normal times, the Eurosystem conducts of velocity from long ran trends to the relevant
monetary policy through control over money market interest rate and transitory departures from trend -
interest rates. Therefore the most straightforward and to ignore temporary disturbances.
example of a simple policy instrument rule is to The NAWM includes a Taylor-type monetary
express the interest rate as a function of a small set policy reaction function that includes interest-rate
of relevant variables. Review reveals relatively little smoothing, the deviation of aggregate output from
evidence that hosting the Games produces the trend implied by permanent technology shocks
significant economic benefits for the host eityTaylor as the measure of the output gap and an inflation
rule (Taylor ) that expresses the interest rate as: objective that may temporarily deviate from its long
run value.
i = r* + n + 6n + (n - %*) + 6y(y - y*) Issing et al. ( , p. 42) state:
Simple rules, in particular of the Taylor type, appear
where the interest rate is i ; r * is the natural to provide ex post a good description of policies
rate of interest; n is the rate of inflation; JI* is the actually followed by central banks in the eighties and
the nineties (though with notable exceptions such as
inflation rate deemed compatible with price stability
the period of ERM crisis in Europe).... In spite of
andy* is the level of potential output (in logs). these good descriptive properties, simple rules are
Taylor originally proposed r * = 2.0 and 0re 0V rarely advocated as prescriptive policy tools, even by
0.5. their proponents. A total commitment to a simple
In empirical studies it is common to consider rule could lead to sub-optimal policies since, by
assumption, they do not take into account all
also a term with the lagged interest rate on the right- potential sorts of information that can, from time to
hand side so as to reflect interest rate smoothing. time, be relevant for monetary policy (for example,
Another simple rule has been proposed by financial crisis or asset market bubbles).
Orphanides ( , , ). It has
the form:
European Central Bank
and Monetary Policy 1.5
in the Euro Area, ^
Fig. 4 Decomposition of
output growth into the 05
shocks (Source: Christoffel Q
et al. ( ), updated by
courtesy of the authors of "^^
the NAWM) -1
-1.5
-2
-2.5
-3
-3.5

The simple difference rule, proposed by bound on nominal interest rates (see ‘Monetary
Orphanides, and the Taylor rule used in the NAWM policy measures during the Global Financial Crisis’,
are two examples (among many possible) of rales below). Orphanides ( ) comments on the
that track well ECB monetary policy decisions same episode on the basis of the similar indications
made in the period 1999-2010. Nevertheless, both obtained from the simple first-difference rule.
identify episodes of significant deviations. Most The discussion makes clear that a variety of
interestingly the relevant periods include the Global simple rules do help to convey the systematic
Financial and Economic Crises. character of monetary policy making. They do
In the NAWM deviations of actual policy rates account e x p o s t for a substantial part of
(captured in the model by the Euro Interbank monetary policy decisions taken. Nevertheless, it is
Offered Rate (EURIBOR)) from the levels implied important to avoid the mistake of thinking that they
by the rale were positive during 2008 and the can substitute for the monetary policy strategy
beginning of 2009. In other words, policy rates itself. As the above quote makes clear, the relevant
were higher than implied by the rule. It can be seen considerations in a particular situation cannot be
from Fig. , which decomposes the contributions known in advance. No simple rale can come close
ofvarious shocks to growth, that from 2008:2 to to summarizing the full set of relevant con-
2009:1 there is a negative contribution of deviations siderations. The stability-oriented monetary policy
of monetary policy from benchmark to GDP strategy of the ECB strives to include the full set of
growth. However, during this period, the three- relevant information filtered through a diversity of
month EURIBOR reflected a substantial risk pre- analytical perspectives.
mium, while the EONIA became substantially
lower than the MRO rate during the period (see Fig.
). Time-varying risk premia and financial Communication, Accountability
intermediation spreads explain departures from the and Transparency
stylized transmission mechanism that obtains in
models with a single interest rate. Those departures Communication, accountability and transparency
are particularly important in times of financial are today of crucial importance for central banking.
stress. Moreover, the monetary policy rale captures This is the case for two basic reasons. First, in a
only monetary policy stance as far as it is reflected democratic society independence goes together with
in interest rates. During this period the ECB intro- accountability. In the euro area, the ECB has full
duced non-standard measures aiming at compen- independence in the pursuit of price stability. At the
sating for the malfunctioning of some aspects of the same time it is made accountable for the results
monetary transmission mechanism and the zero achieved through a number of statutory
requirements (in article 284.3 of the Treaty on the President and the Vice-President after the first
Functioning of the European Union and article 15 Governing Council meeting of each month and the
of the Statute). These include the obligation publish M o n t h l y B u l l e t i n . The
an annual report on monetary policy and other introductory statement read out by the president
activities of the system. The report is presented, by provides a summary of the policy-relevant
the President of the ECB, to the European assessment of economic developments in line with
Parliament and to the Economic and Financial the ECB’s monetary policy strategy. This
Affairs Council (ECOFIN). The ECB must also assessment is agreed by the Governing Council and
prepare quarterly reports and weekly consolidated contains the core message for communication with
financial statements for the ESC- B. Second, the the markets, the media and the public. This
transmission of monetary policy to prices and assessment is typically reflected in numerous
economic activity depends on private sector statements and speeches by Council members. The
expectations. A central bank controls only very introductory statement is immediately followed by
short-term interest rates. However, what matters questions and answers. A transcript of the statement
most for the transmission of monetary policy is published in all EU languages within a few hoius.
impulses to the economy are longer-term interest A week later the ECB publishes its M o n t h l y
rates that are determined by financial markets. B u l l e t i n , which includes a thorough
Those longer-term rates and financial prices reflect analysis of developments in the euro area and the
market expectations of future short-term interest global environment. It contains also all relevant
rates and premiums for uncertainty. In an uncertain statistical data.
and complex environment, monetary policy The ECB also publishes economic projections
decisions do not necessarily convey the central regularly (see above). Detailed information on the
bank’s overall assessment of the current state of, models used in the projection exercises and in
and future prospects for, the economy. Hence policy analysis is also released and made available
monetary policy actions can only be properly through the ECB’s web site.
understood within the broader context of the An early and constant critique of the ECB’s
monetary policy strategy. Such requirement implies communication policy refers to the fact that voting
a constant effort of communication on how records are not published (Buiter ( ); for a
individual decisions and the monetary policy stance rejoinder see Issing ( ), which also includes
contribute to the achievement of the mandatory a survey of practices of major central banks). As a
goals. By stabilizing market expectations good matter of fact, monetary policy decisions of the
communication and transparency help to reduce Governing Council are taken by consensus. This
uncertainty and volatility in financial markets. This underlines the collective responsibility of the
reduces risk premia in real interest rates to the decision-making body. Any attempt to make
benefit of overall economic welfare. individual policymakers personally accountable
The ECB went much beyond the statutory entails the risk that the public may attach more
accountability requirements and communication importance to individual opinions than to the rel-
constitutes a central element of ECB monetary evant economic arguments. Particularly in a mon-
policy-making. As an important example we have etary union constituted of many countries, the
already emphasized above the ECB’s decision to behaviour of national central bank governors might
inform the public comprehensively before the start be interpreted from a ‘national’ perspective
about its monetary policy strategy including a (Issing ).
quantitative definition of price stability, based on a Blinder et al. ( ) show that there is no
specific statistical indicator (HICP for the euro consensus on best practices in central banking
area). communication. Ehrmann and Fratzscher ( )
Monetary policy decisions are communicated in focused on the specific experience of the ECB, with
real time. The key elements of the ECB’s commu- press conferences as vehicles for explanation of
nication policy are the press conference held by the monetary policy decisions. They looked at evidence
from financial markets. They found
that press conferences provided substantial addi- 1. Adjustment in key interest rates: interest rates
tional information to financial markets and with were lowered 325 basis points from October
relatively low effects on volatility. 2008. For example, the minimum bid rate was
lowered from 4.25% to 1%.
2. Liquidity support mechanisms; adjustments in
Monetary Policy Measures During the operational framework:
the Global Financial Crisis a. Extended use of fine-tuning operations;
b. Conduct of fixed rate tenders with full
The global nature of the crisis made its first
allotment;
appearance on Thursday 9 August 2007. In the
c. Expansion of the list of eligible collateral;
morning, traded volumes fell sharply in money
d. Temporary narrowing of the interest rate
markets, while interest rates suffered a sudden and
corridor;
significant increase to elevated levels, well above
e. Lengthening of maturity for Long-Term
the ECB’s minimum bid rate. In this context, the
Refinancing Operations.
ECB was the first central bank to take action: it
3. Acquisition of selected assets: purchase of euro-
immediately provided liquidity through a fine-
denominated covered bonds (under the Covered
tuning operation. The ECB distinguishes the
Bond Purchase Programme (CBPP)) and
monetary policy stance from monetary policy
interventions in euro area public and private
implementation. The former, in normal cir-
debt markets (under the Securities Markets
cumstances, can be gauged on the basis of a money
Programme (SMP)).
market interest rate. Monetary policy
4. Joint action with other central banks on October
implementation, in contrast, is performed in the
2008 to announce a reduction in interest rates.
context of the operational framework, and is used,
5. Cooperation with other central banks in the
for example, to maintain orderly money market
management of liquidity in foreign currencies.
conditions and adequate provision of liquidity to
banks. This episode suggests that the Eurosystem made
On 3 July 2008, the ECB announced that it had use of the ample flexibility afforded by the
decided to increase its key interest rates by 25 basis operational framework to meet the special chal-
points. The decision was based on the ECB’s lenges associated with the crisis.
assessment of the prospects for price developments
and risks to price stability. The exchange of views
between Petra Geraats and Frank Smets (Geraats ; Challenges Going Forward
Smets ) highlights the importance of private sector
inflation expectations in this context. In this article we have argued that the conduct of
However, the situation and prospects changed monetary policy has been effective in the first years
rapidly over the summer. Clear signals of a sharp of the euro area. Nevertheless the ongoing crisis has
economic slowdown in the USA and elsewhere brought into sharp focus a number of fundamental
became apparent. More dramatically, from Sep- questions that will mark developments going
tember 2008, a perverse feedback spiral between forward. These include (for a longer list see Gaspar
economic and financial developments threatened to ( )):
take hold. The failure of Lehman Brothers on 15
• Will the ECB manage successfully the exit from
September 2008 became the emblematic event,
its current exceptional stance and continue its
marking the transition to the acute stage of the
Global Crisis. impressive record in maintaining price stability
Again the ECB reacted rapidly and forcefully. over the medium term?
It is possible to summarize all measures taken by • Will the framework for financial supervision and
the ECB under five points: regulation prove effective? Will the new
 European Financial Stability Risk Board and the Beyer, A. 2009. A stable model for euro area money demand:
European System of Financial Supervision work Revisiting the role of wealth. ECB Working Paper 1111.
http://www. sob /pi df/ccp wpc/
well? How will the ECB, in particular, and ecbwp 1111 .pdf
central banks, in general, adapt to the new Bindseil, U. 2004. Monetary policy implementation.
systemic risk management framework? Oxford: Oxford University Press.
Blinder, A., M. Ehrmann, M. Fratzscher, J. De Haan, and D.J.
• Will the single currency continue to be an
Jansen. 2008. Central bank communication and monetary
important driver of deeper integration in the policy: A survey of theory and evidence. ECB Working Paper
single market? Series 898. pub/pdf/scpwps/ec't wp898 pdf Buiter, W.H.
• Can rales and procedures, aiming at fiscal dis- 1999. Alice in Euroland. Journal of Common Market Studies
37(2): 181-209.
cipline in the eiuo area, effectively mitigate the Buiter, W. H. 2009. Central banks and financial crises. Paper
deficit bias in government finance and ensure presented at Maintaining Stability in a Changing
sound public finances in view of the ongoing Financial System, Jackson Hole, 21-23 August 2008. htt "
demographic transition and of the need to pro- pvw.kans . so g/pui .. /200
Buiter.03.12.09.pdf
vide for fiscal space? Buti, M., S. Deroose, V. Gaspar, and J. Nogueira Martins.
• How to protect financial stability, of the euro 2010. The euro: The first decade. Cambridge: Cambridge
area as a whole, in the face of turmoil in sov- University Press.
Christoffel, K., G. Coenen, and A. Wame. 2008. A new area
ereign debt markets?
wide model for the euro area: A micro-founded open-
economy model for forecasting and policy analysis. ECB
In more general terms, the challenge derives Working Paper 944.
from the combination of a single market and a ecbwp944.pdf?35c2909‘ f£2£220119ec24d3a5394ebd
single currency with national responsibilities in the Clarida, R., J. Gall, and M. Gertler. 1999. The science of
areas of economic policy and financial stability. monetary policy: A new Keynesian perspective. Journal of
Economic Literature 37: 1661-1707.
Ehrmann, M., and M. Fratzscher. 2007. Explaining monetary
policy in press conferences. ECB Working Paper 767. :p
See Also //wv
EMI. 1997a. The single monetary policy in stage three:
► Central Bank Communication Specification of the operational framework.
.
► Central Bank Independence EMI. 1997b. The single monetaiy policy in stage three: Elements of
► European Central Bank the monetaty policy strategy of the ESCB.
► fry l or Ru es - v,b 77..t/:: :.:7: : 7/:::■ g/77.:onetarypolicy
C 7 77 " 777. 77:77 7 7 7 7 7 7 /7 oliC'/C7 7 77/ 771 1
99777 7 77
EMI. 1997c. Annual report.
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"V. - y . t y-rr, i71 r.cfvgS111 r.tZ V > d:
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df Taylor, J. 1993. Discretion versus policy rules in
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also step in. One important consideration is the
economies of scale applied to finances: the EU can
European Cohesion Policy
mobilize and provide greater funds under far better
Willem Molle conditions than poor Member States. Moreover, it
can offer long-term predictability about the
availability of resources to all beneficiaries. This
means that investors will be more inclined to invest
and growth is therefore likely to be enhanced. The
Abstract second important factor is regulation: the EU sets
One of the main objectives of the EU is cohe- rules to limit internal competition between Member
sion, namely a decrease in the disparity of States which offer state aid. Moreover, the EU
wealth between its constituent parts. A consid- determines the architecture and operation of the
erable part of the EU budget is earmarked for delivery system while leaving Member States to
this policy. The policy should also support the oversee the application of the eligibility criteria and
EU 2020 strategy, which focuses on smart, the selection of projects within the EU priorities.
inclusive and sustainable growth. Over the past (For an elaborate systematic analysis of all stages of
decades the EU has been able to realize to some the policy and for detailed references to the relevant
extent its ambitions. Effectiveness can be further literature, see Molle ( )).
stepped up by making improvements in the
delivery system.
Definition and Measurement
of Cohesion
Keywords
Convergence; Competitiveness; Coordination; Cohesion is a concept that has been introduced into
Disparity; Effectiveness of intervention; Reg- EU policy without a precise definition. Over time a
ulation; Principles; Structural Funds practical definition has been developed. Cohesion
has increasingly become understood as the degree
to which disparities in social and
JEL Classifications
Rl; R53; R58
economic welfare between the different regions or The objective discussed under 1 is generally
groups within the European Union are politically referred to as the c o n v e r g e n c e
and socially tolerable. Whether cohesion is objective. The regions that fall under this objective
achieved is largely a political question. have a GDP/P level below 75% of the EU average.
Cohesion is measured by the change in disparity They are the main beneficiaries of the policy. The
from one period to another. A decrease in disparity EU has decided to let all other regions also benefit
(convergence) means improved cohesion, whereas from cohesion policy; the main objectives here are
an increase in disparity (divergence) means less the improvement of competitiveness and social
cohesion. In general one uses simple indicators to inclusion (these regions are therefore generally
measure disparity; the most common one is regional called c o m p e t i t i v e n e s s regions).
Gross Domestic Product per head. Another common (Up till the present programming period the former
indicator is (un-) employment. Moreover, a series of type regions were formally called objective 1
other indicators are used, such as the risk of regions and the second type objective 2.)
poverty, health, and access to broadband Internet.

Instruments
Objectives of the Policy
The main instruments by which the cohesion policy
The EU has set a number of objectives for its is put into effect are:
cohesion policy. The fundamentals have remained
fairly constant over time, although the specifics 1. The provision of financial means (see the fol-
have constantly been adapted to new challenges lowing section). The EU does this by allocating
(Begg ). The main ones are: 12 funds to the disadvantaged regions to improve
their economic structure and to social groups to
improve their employability and to avoid their
social exclusion. Both should lead to increases
1. To improve cohesion (that is convergence of in competitiveness.
wealth levels) on three dimensions: 2. The setting of rules and the coordination of
• economic - i.e. the conditions for economic actions (see ‘Regulation and coordination’,
growth such as innovation below). As cohesion is a matter of shared
• social - i.e. employment and social exclusion responsibilities between the Union and national
(e.g. poverty) authorities, such coordination is vital for effec-
• territorial - i.e. specific types of regions (such tiveness. This applies equally to national cohe-
as urban), elements directly related to spatial sion policies and to other EU and national
planning (e.g. infrastructure) and the policies, such as environment.
environment (Duehr et al. ).
2. To contribute to other EU objectives, for
instance: Financial Support
• facilitating major advances in economic
integration, such as enlargement or the pass- The main instrument of cohesion policy is financial
ing on to higher stages of integration (e.g. support paid by the EU budget. As a first step, a
Economic and Monetary Union) share of the budget (some 40%) is earmarked for
• contributing to major policy targets such as cohesion. In the next step, funds are allocated to the
the increase in competitiveness, the decrease different Funds (see next paragraph). In the third
of social exclusion or the stimulation of envi- step the former are allocated to the various cohesion
ronmental sustainability. (The latter has nota- objectives. Convergence regions (defined as those
bly come to the fore with the so called Lisbon with an average wealth level of less than 75% of the
strategy, launched in 2000, and the new EU mean) get the lion’s share
Europe 2020 strategy (EC ).)
Stage in the policy cycle European National governments Regional
Commission (Council) authorities
Basic design strong dominant weak
Financial packages Definition of objectives and of modest dominant weak
(three quarters). They are mostly located in the new of additionality prescribes that major contributions
ehgibility criteria
Member States and in the Mediterranean South. to the financing have to be made by the national and
Institutional framework and delivery system strong strong modest
The rest is for regions anywhere else in the EU to or regional governments too. The lower the wealth
Implementation weak variable strong
Evaluationimprove their competitiveness and forstrongterritorial levelvariable
ofthe region, the higher,variable
inpercentage terms, is
cooperation. This step also defines the allocation of the EU contribution.
resources over countries. In the fourth step a
selection is made of the programmes and projects
that are eligible for support. Main Actors
Spending on cohesion operates mainly through
The EU is not the only body responsible for cohe-
two types of fund:
sion. Member States also play an important role.
• The European Regional Development Fund Moreover, according to the partnership principle the
(ERDF) and the European Social Fund (ESF). policy involves local governments and repre-
These funds are called ‘structural’ because they sentatives of the third and private sector. This multi-
support measures that aim at the improvement level governance of the EU cohesion policy is
of the structural aspects of the regional meant to increase participation and coordination and
economy. There is a certain specialization hence consistency and effectiveness. The
between the two funds: the ERDF concentrates competences of the three main actors, and hence the
on economic cohesion and finances mainly power balance between them, changes in the course
infrastructure and innovation; the ESF concen- of the policy cycle (see Table ).
trates on social cohesion and finances mainly A whole administrative and institutional system
training and education. has been set up to deliver the policy. This consists
• The Cohesion Fund (CF). Beneficiaries are the first of Management Authorities, which are respon-
member countries with below EU average sible for the programming and execution of the
(actually 90%) GDP per head figures, with a various projects, such as the building of roads and
programme of economic convergence to EMU the training of people. They also guide the work of
conditions. The Cohesion Fund finances envi- the Monitoring Committees, which are the respon-
ronmental and transport projects in a framework sibility of the Member States. They are the highest
that is different from the Structural Funds; it decision-making bodies of each Operational Pro-
delivers national, not regional funding and the gramme. They are charged with surveillance ofthe
programming is simplified compared to the progress of the work; reporting to the European
ERDF and the ESF. Commission and making proposals for adjustments.
The financial disbursements are done by so-called
Note that these funds provide only financial Certifying Authorities, while control on spending is
support to projects and programmes. The principle done by Auditing Authorities.

European Cohesion Policy, Table 1 Changing roles ofthe major actors during the policy cycle (adapted from Molle ( ),
P- 127)
Regulation and Coordination that the policies of the EU that are fundamental for
the functioning of the internal market (such as
The EU cohesion policy also uses the instrument of freedom of movement) and Monetary Union (such
regulation to set uniform rules that govern the use as the Stability and Growth Pact) are spatially blind;
of financial instruments (the Structural Funds; see their potential negative effects on cohesion have to
Instruments, above) and to set the framework for be compensated for by an increased focus on
the coordination among partners (see previous cohesion policy in the affected areas.
section) to realize mutual consistency of objectives,
priorities and concrete projects.
Moreover, the instrument of regulation is used Integrated and Territorial Approach
where one can assume that the coordination
instrument is insufficiently effective at controllingThe coordination of sectoral policies in a multilevel
certain negative effects of independent national and government framework is particularly difficult
regional policy making. This applies notably to state(Meijers and Staed ). Indeed, the search for
aid. The main principle of EU competition policy compromises at the EU level on cross-cutting issues
sets a complete ban on state aid. However, this ban tends to lead to vertical inconsistencies at the
can be lifted in the case of regional structural national and regional levels, and other compromises
weaknesses. The degree to which this is possible between sectoral policies may have been worked
has been made dependent on the level of out. Vertical policy integration by sector may
development of the Member States: restricted in the complicate the solution of intersectoral conflicts on
case of rich Member States and somewhat more the EU, national or local levels. As part of a
lenient in that of poor Member States. This rule solution to these simultaneous problems the EU has
serves the purpose of effectiveness; subsidy wars decided to make Impact Assessments of its policy
would always be won by the richer Member States, proposals and put some accent on territorial impact
as they have the resources to outbid the poorer assessments. Moreover, it has opted for integration
Member States, which would render ineffective the of its policies at the regional and local levels, as at
EU support given to the latter. this level things move from the abstract into the
concrete; indeed general objectives have to be
translated into concrete projects on the basis of
Consistency with Other EU Policies
priorities that are selected with a view to their local
The EU pursues a large number of policies, some of potential (Barca ; EC )•
which can have a significant influence on the
distribution of economic activity, which in turn can
Evaluation of Effectiveness
have an adverse effect on cohesion. To avoid such
problems the design and implementation of major The performance of the EU cohesion policy (that is
EU policies have to be coordinated. This is notably realization of its objectives) is difficult to evaluate
the case for policies with a strong spatial or due to methodological and practical insufficiencies.
territorial dimension, such as transport and Over the past decades much effort has been made
environment, but also for policies dealing with both by academics, consultants and policy makers
research and the information society. Indeed, to improve the situation (Basle ; Mairate ; Martin
innovation being one of the main determinants of and Tyler ). However, these have not resulted in a
competitiveness and hence growth, EU-wide consensus as to its effectiveness. On the contrary
policies and national and regional policies in this one sees two almost opposite views.
domain have to be dovetailed to achieve maximum
effect (Molle ). It is to be noted here
 The d o m i n a n t v i e w i s We may mention the dependency on aid of the
p o s i t i v e . Those who hold this view have convergence countries, the welfare loss incurred in
found that in the past the EU cohesion policy has transferring money from rich member states back to
been effective in decreasing the wealth gap between their regions via the ‘competitiveness’ route, the
its member countries and regions (Bomschier et al. ; rigidity of pre-fixed quota and priorities, the high
Ederveen et al. delivery cost for atomized projects notably of the
; Martin and Saenz ; Tselios ). Moreover, due European Social Fund, etc.
to the interrelations between different member To remedy such problems many proposals have
countries the net payers have benefited also because been made for a renewed structure of the EU cohe-
their industries have been the main suppliers of sion policy. Some of them are not new; indeed, the
investment goods to the projects executed under the inadequacies of the basic architecture of the policy
cohesion policy. Next, they indicate the have been apparent for some time (Bachtler and
contribution to a series of side objectives, such as Mendez ). The most far-reaching proposals include
the environment (ENEA ). Finally they stress that the abolition of the ‘competitiveness’ objective or at
the EU has increased effectiveness by setting up a least the redirection of these funds to the respective
better intervention and delivery system than the budget headings (implied in the subsidiarity tests as
national ones (Lion et al. ; Gualini ), geared to local given in, for example, Begg ( ) and
needs and capacities (Leonardi ). These results are ECORYS ( )). Another proposal is
embraced by the Commission (EC ). the abolition of the quota system of the competi-
There are also (h i g h l y ) c r i t i c a l tiveness objective and its replacement by a system
v i e w s . Some find that cohesion policy is not of competitive bidding for EU priority projects
appropriate: a good set of other policies producing (Ederveen et al. ; Tarschys ). Finally, proposals
the conditions for healthy growth would also lead to have been made to remedy the potential negative
convergence of wealth levels. Others find that effects on aid dependency by much stricter
cohesion policy is not effective; they observe that conditionality in matters of administrative capacity
during the years that the EU cohesion policy was (Molle ).
still very limited, disparities decreased, while they Much like in the previous round of reforms of
have increased since the huge increases in EU the cohesion policy the European Commission has
cohesion spending (Boldrin and Canova maintained as an essential feature of the policy that
; Dall’Erba and Gallo ). Others find that the all regions may benefit. The reasons are of a
policy is inefficient; the actual management of the political nature. First, the regions of rich Member
policy takes up too large a share of resources. States are not inclined to give up access to EU
funds. Second, the Commission is not inclined to
give up its influence in all regions of the EU, the
Conclusions and Future Developments less so because it considers that the EU 2020
strategy justifies continuation of the
Although there is no clear-cut conclusion from
competitiveness objective - this notwithstanding the
empirical research as to the performance of the
general view that the use of the cohesion policy
policy, there is much evidence to support the view
instruments for such purposes is a rather distorted
that over the past decades the EU cohesion policy
way of matching objectives with instruments.
has been conducive to the attainment of major EU
So, the proposals of the Commission for adap-
policy objectives. This applies in particular to the
tation of the policy in the period 2013-2020 focus
convergence objective and some side objectives,
on delivery aspects such as the strategic program-
such as the internal market and the EMU. All is not
ming (see also Barca ). They follow certain of the
rosy however; in the course of time certain weak
proposals mentioned earlier by critics, such as
points have become apparent that need adaptation.
thematic concentration, conditionality of
support, evaluation of impact, the use of new EC. 2010b. Regional policy, an integrated approach. Pan-
financial instruments (not only grants but also orama Info regio, 34.
EC. 2010c. Investing in Europe's future: Fifth report on
loans), streamlining of the financial management economic, social and territorial cohesion. Brussels: EC.
and control systems and finally strengthening of the EC. 2010d. Conclusions of the fifth report on economic,
institutional capacity of the recipients (EC ). social and territorial cohesion: The future of cohesion
policy, (SEC 2010) 1348 final. Brussels: EC.
ECORYS/CPB/Ifo. 2008. A study on EU spending, Final
report. Rotterdam (available from the website of the EU
See Also Commission).
Ederveen, S., J. Gorter, R. de Mooy, and R. Nahuis. 2003.
► iuropeaj leCc'-::; Markets Funds and games; the economics of European cohesion
► iuropeax. 1 ./> :■=. aiy on policy. ENEPR1 Occasional paper no. 3. .
► .egional E eve ... :nt, Ge .graphy of
ENEA. 2006. The contribution of structural and cohesion
► Regional Distribution of Economic Activity funds to a better environment (available via the EC
► .egional E' c:: .ca website).
► Spatial Economics Gualini, E. 2004. Multi-level governance and institutional
change: The Europeanization of regional policy in Italy.
Aldershot: Ashgate.
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 1972 that it was decided to use the European Social
European Employment Policy Fund to support “the carrying out a co-ordinated
policy for employment and vocational training,...
Robert Strauss improving working conditions and conditions of
European Commission, Brussels, Belgium life, ... closely involving workers in the progress of
firms” (European Communities ). A European
employment policy was emerging containing three
Abstract pillars: a legislated rights pillar comprised of
The European Employment Strategy (EES) was European employment legislation; “law via
included in the 1997 Treaty of Amsterdam to collective agreement” based on social partners’
accompany the newly completed Single Market agreements; and thirdly, coordination of national
and the advanced preparations for the European employment policies (Rhodes ). Employment
Monetary Union. It constitutes the core of policy coordination became the basis for the
European employment policy. The entry European Employment Strategy, provided for in the
examines how and why the EES came into being Amsterdam Treaty (TEU ).
and the employment policy challenges it has Included in the revised Treaty, to accompany
focused on since its inception until today. It the newly completed Single Market and the
looks at some of the labour economics advanced preparations for the European Monetary
underpinning it and at what the EES but also Union (EMU), the European Employment Strategy
other employment policies have been able to (EES) constituted the crux of what is understood to
achieve in the EU, especially since the economic be a, or the, European employment policy. It is
and financial crisis of 2008. buttressed by the legislative side, the first two
pillars mentioned above, and the financial support
provided by the European Social Fluid. This entry
Definition will focus on how and why the EES came into
being and the employment policy challenges it has
European employment policy is the set of actions focused on since its inception. In doing so, it will
taken at the level of the European Union to enhance attempt to discuss some of the labour market
the quantity and quality of jobs in all the Member economics underpinnings of the evolution of the
States. EES. It will also look briefly at what it and other
employment policies have or have not been able to
achieve in the EU, especially since the economic
Introduction and financial crisis of 2008.

Employment has been a key concern and indeed an

objective of the European integration process since
the Treaty of Rome establishing the European
Economic Community was signed in 1957. In its The European Employment Strategy
preamble its signatories declared that they are
“resolved to ensure the economic and The Delors White Paper and the Essen
social progress of their countries______ affirming Process
as the essential objective of their efforts the constant The content of the Amsterdam Treaty establishing
improvement of living and working conditions ” the European Employment Strategy did not come
The European Social Fund pro out of the blue. It was the result of the Delors White
viding financial support for improving workers’ Paper on Growth, Competitiveness and
mobility and employment opportunities in the Employment (Delors ) and the Essen European
common market was also established (EEC ). But it Summit of December 1994. And these two
was only at the Paris Summit of milestones had been preceded by several actions in
the 1970s and 1980s with both legislative and
Social Dialogue aspects to the fore
(Goetschy ). The Delors White Paper sought to Member States were urged to translate these
offset the potentially deflationary convergence recommendations into a long-term programme in
criteria of maximum shares of GDP of 60% for the light of their specific economic and social
public debt and 3% for the fiscal deficit for the circumstances and were required to submit an
EMU enshrined in the Maastricht Treaty. In the annual progress report. The Commission, in con-
employment field it pushed for greater use of active junction with the Economics and Financial Affairs
labour market policies (ALMPs) to complement Council (ECOFIN) and the Labour and Social
increased labour market flexibility. ALMPs could Affairs Council, was to synthesise these national
be financed (unlike passive measures including reports into an annual assessment submitted to the
unemployment benefits) from the Social Fund and December European Council. On this basis, the
the academic world was increasingly underlining European summit would review the employment
their benefits (see e.g., Layard et al. ). guidelines, issue further recommendations to
In Europe the employment situation had been Member States and decide new initiatives at Com-
deteriorating sharply. Between 1990 and 1994 the munity level.
soon-to-become EU 15 saw six million net jobs lost. “This procedure was intended to have a three-
The unemployment rate rose from a cyclical low of fold effect. First, the annual report would help
7.7-11.1%. Unemployment was at the top of the improve the efficiency of national employment
political agenda in many countries. The Essen policies by exposing these to public examination
summit of December 1994 certainly did not only and facilitating explicit comparison of the perfor-
focus on labour market issues, the accession process mance of each Member State. Second, the pre-
for Central and Eastern European countries was the scribed cooperation between ECOFIN and the
key topic, but it did lay the groundwork for the Social Affairs Council in drafting the annual report
EES. It agreed to set up a multilateral employment might facilitate greater integration of economic and
monitoring procedure closely modelled as the employment policy, [essentially at a European
economic monitoring procedure contained in the level]. Third, it was hoped that multilateral
Maastricht Treaty. Member States were employment monitoring would encourage greater
recommended to take measures at national level in convergence of employment policies in the Member
five areas: States along the lines of the Essen
recommendations” (Goetschy
• Improving employment opportunities by pro- pp. 121-122).
moting investment in vocational training
(especially for the young) and encouraging The Amsterdam Treaty
lifelong learning The Amsterdam Treaty revising that of Maastricht
• Increasing the employment intensity of growth, made “full employment” an explicit priority of the
particularly through a more flexible organisation EU and “a question of common concern.” There
of work and working time, wage restraint, job was a realisation that the good or bad employment
creation in local environmental and social situation of one Member State affected or had spill-
services overs on another. The Community acquired new
• Reducing non-wage labour costs to encourage powers to develop “a coordinated strategy for
employers to hire low-skilled workers employment” which should in particular promote “a
• Developing active labour market policies skilled, trained and adaptable workforce and labour
through the reform of employment services, markets responsive to economic change.”
encouraging occupational and geographical The employment chapter of the Treaty covered:
labour mobility and developing incentives for first, the integration of employment in the
the unemployed to return to work formulation and implementation of other Com-
• Targeting measures to help groups particularly munity policies; second, the establishment of
affected by long-term unemployment mechanisms for coordinating employment policies
at Community level. These mechanisms
reflected practices already in operation as part of the designed to encourage cooperation between
Essen monitoring procedure, but also borrow Member States and to support their action in the
extensively from the economic policy coordination field of employment.” Such measures can involve
model setup by entry 103 of the Treaty of the dissemination of best practice, the evaluation of
Maastricht. The main difference, and it is signifi- experiences and the launch of pilot projects. The
cant, is that recommendations issued on employ- provisions of the Amsterdam Treaty came into force
ment matters lack any binding effect. in May 1999, cementing practices known in
In four significant respects, however, the Brussels circles as the Luxembourg process.
Amsterdam Treaty involved an advance on the Furthermore, the employment and labour ministers
Essen process. First, the “annual guidelines for at the OECD in the 1997 ministerial meeting had
employment” were established as the driving force endorsed “the need to shift public spending on
and the key component of coordination. Second, the labour market policies from passive to active
Council carries out an annual examination of measures” (OECD ).
measures taken by Member States to implement the
guidelines. The Council’s evaluation is based on the The Luxembourg Process, the
annual report that each Member State must submit European Employment Strategy and
to the Council and the Commission, and on the the Lisbon Strategy
opinion of the Employment Committee. The In November 1997, as unemployment remained
requirement to submit an annual programme was high, an extraordinary ministerial Jobs Summit was
thus “hard” law and ultimately if not done could held in Luxembourg. It launched the European
lead to fines being levied by the European Court. Employment Strategy (EES) as set out in the
The quality of such programmes was not however Treaty, complemented by features which made it
specified. If necessary, in the light of this into the first open method of coordination (OMC ) -
examination, the Council “acting by a qualified the Luxembourg process. This process was the basis
majority on a recommendation from the or model for similar soft law instruments in other
Commission, may, if it considers this to be social areas such as social protection, social
appropriate, make recommendations to Member inclusion and certain aspects of education and
States.” Such recommendations to individual states training. The key features of the EES were an
deemed not to have followed the guidelines would annual coordination and monitoring of national
have no legally enforceable effect but are employment policies based on Member States’
symbolically powerful. This implied a strengthen- commitments to establish a set of common
ing of influence at Community level. objectives and targets. To its supporters, the EES
Third, the Treaty establishes an Employment ensured that the objective of a high level of
Committee with advisory status, formally ratifying employment saw the same political importance as
an initiative taken by the Council in December the (other) macroeconomic objectives of growth and
1996. The Member States and the Commission each economic stability.
appoint two members of the Committee. It has a The EES added a dimension. The existing leg-
dual purpose: to monitor the employment situation islative pillar was about minimum standards, the
and employment policies in the Member States and EES was about policy directions, from stimulating
the EU, and to formulate opinions (at the request of employability to considering labour taxation.
the Commission, the Council or on its own Employment coordination at the EU level meant -
initiative) and to prepare the Council’s work. In for the first time - a structured and systematic
fillfilling its mandate it is required to consult the debate about labour markets at the EU level, and
social partners. working towards and arriving at agreement about a
Finally entry 5 of the Treaty allows the Council common agenda and policy directions. This is a
to adopt, by a qualified majority and after consult- prerequisite if one is to set common goals such as
ing the Economic and Social Committee and the the employment guidelines and arrive at a more
Committee of the Regions, “incentive measures integrated social-economic
agenda. It specifically saw three components: productivity and employment in Europe. Four pri-
building of, and agreement on a common set of ority actions were needed: increasing adaptability of
indicators to track progress/problems; under- workers and entrepreneurs; attracting more people
standing different systems, e.g., the role of social to the labour market; investing more and more
dialogue; and, understanding different policy out- effectively in human capital; and, ensuring effective
comes and the possibilities/limits of the transfer of implementation of reforms through better gov-
good practices. ernance. The first three actions stemmed from a
As the EES was becoming more and more hard-headed analysis of the economic workings of
embedded in European and national employment Europe’s labour markets. It provided the analytical
policy-making, the Commission launched an ambi- and political underpinnings of the major policy
tious, wide-ranging programme to make the EU priority of the EES - enhancing flexicurity. This,
“the most competitive and dynamic knowledge- with ups and downs linked with the economic and
based economy in the world, capable of sustainable financial crisis, has remained a core element of
economic growth with more and better jobs and European employment policies until today. Simi-
greater social cohesion.” This programme was larly, the employment guidelines became and have
agreed at the Lisbon European Council in March remained much more integrated with the BEPGs
2000 giving rise to the Lisbon Strategy (Lisbon with finance ministers in recent years often the
European Council ). With its commitment to “more major champions of flexicurity.
and better jobs,” European employment policies and Getting Member States to agree on the princi-
in particular the EES were to be a key part. The ples of flexicurity was not easy. The trade unions
employment guidelines, discussed with and adopted were suspicious and fearful believing most of the
by Member States each year, contained detailed labour market reforms would increase flexibility
guidance as to how they would obtain more and with reduced employment protection legislation
better jobs. The employment guidelines for 2001 (EPL) and little in the way of increasing employ-
saw 18 separate detailed aspects of how to do this ment security. One reason for such doubts was that
including some quantitative targets - key aspects of flexibilisation usually cost the public purse nothing
the Lisbon Strategy - such as an employment rate of while investing in ALMPs, more comprehensive
70% overall including at least 60% for women and training or better social protection was expensive at
50% for older workers by 2010 (European least in the short term for public budgets and
Communities ). finance ministries (that in any case often seemed to
believe the less EPL the better). While the Com-
The Kok Report "Jobs, Jobs, Jobs" Begats mission was trying to convince Member States of
Flexicurity the benefits of flexicurity, the European Trade
Though subject to annual revisions, Member States Union Institute noted, in early 2007, “the permanent
displayed increasing dissatisfaction with the way place flexicurity is acquiring in the Commission’s
the EES was being run. It was seen as too bureau- employment pohey.... There has been little attention
cratic not sufficiently focused on the key challenges paid to the broader EES which now seems to stand
and not always coherent with the Broad Economic in the shadow of the more confirsed flexicurity
Policy Guidelines (BEPGs). In March 2003 the approach” (Keune and Jepsen ).
European Council invited the Commission to Employment ministers agreed the principles of
establish a European Employment Taskforce to be flexicurity in late 2007 (Council ). It did dominate
headed by former Dutch Prime Minister Wim Kok. the EES until the crisis, but the aspects of lifelong
It was charged with carrying out an independent in- learning and skills saw a particular emphasis in
depth examination of key employment-related 2008/9. This manifested itself as a determination to
challenges and to identify practical reform equip workers displaced by changing technology
measures. It reported in November 2003 (Kok ) and and globalisation with the light (new) skills for the
its key findings were that increased efforts needed new jobs the EU would need to create. Human
to be made to boost capital investment had
long been seen as a vital component of more and caused first and foremost by its construction bubble
better jobs. Workers were more productive but also bursting, saw a much steeper increase in
more adaptable with a good skills basis. Getting joblessness. This divergent response of labour
new skills for new jobs was also something both markets to the crisis continued into aftermath and
employers and trade unions could agree on, one suggested that although macroeconomic conditions
aspect of flexicurity that saw relatively non- were very determinant for the levels of
conflictual social dialogue. The Commission’s unemployment, labour markets and employment
Communication highlighting the importance of and policies that affected their working could also play a
means to achieve new skills for new jobs (European major role.
Commission ) was published in late 2008 as it was During the crisis the EES had focused on brak-
becoming clear that the EU was not seeing a normal ing the rise in unemployment through the use of
economic downturn but a major recession, short time working schemes in which the state paid
originating and largely imported from the USA but part of the income of workers put on shorter hours.
now global in nature. Germany was a major user of such schemes and
Belgium, France, the Netherlands and Italy also
The Crisis and Stressing Short Time used them significantly. Not only did it ensure
Working better incomes and thus more aggregate demand in
The financial and economic crisis saw output fall the economy (and political support) compared with
quite dramatically in most European countries as more workers simply being put on the dole, but
banking systems imploded and export markets keeping workers at work and providing training in
collapsed. Unemployment, with the usual lag, some of the hours they were not working would
started to increase after 6 or 7 years of sustained reduce the risk of permanent loss of skills and
falls across the EU. Most policy-makers thought a hysteresis. The German “Kurzarbeit” scheme was
large part of this decline was due to good employ- seen as a useful complement to the Hartz reforms
ment policies being implemented, sometime with and fully in line with the flexicurity paradigm.
politically difficult straggles. Germany, with its (Short time working was a form of internal
hard-won Hartz reforms, was seen as the leading flexicurity.) The OECD and Commission worked
example of what had needed to be done. The key together on identifying the best employment
features included i n t e r a l i a more active policies to confront what many were already calling
support including vocational training for the the Great Recession (see European Commission ).
unemployed, “mini-jobs” with much lower social
security contributions and less generous Prolonged Crisis, the Europe 2020
unemployment benefits. These increased the Strategy and a Focus on Youth and the
adaptability of labour markets by increasing Long-Term Unemployed
flexibility of jobs but also security for employment The crisis and a new Commission wanting to make
As the crisis deepened, it was tackled by most its own mark rendered the Lisbon Strategy obsolete
Member States with conventional Keynesian in its final months. It was superseded by a more
increased fiscal spending under the Commission’s focused programme, the Europe 2020 Strategy to
European Economic Recovery Plan. It proposed a achieve smart, sustainable and inclusive growth
coordinated economic stimulus of 11/2% of EU with European and national targets in five domains:
GDP with budgetary spending supposed to be research and development expenditure;
timely, targeted and temporary (European environmental improvement; employment;
Commission ). Nevertheless, educational attainment; and poverty reduction. The
EU unemployment rose steadily although less fast last three areas found themselves in the four
than in the USA. Nearly all Member States saw a employment guidelines the Council adopted in
rise but some much more than others and such rises October 2010; they also contained the EU targets
were often uncorrelated to the amount that output for 2020: an employment rate of 75% for men and
had fallen. Germany saw a big fall in GDP as
exports crashed but little rise in unemployment.
Spain, with a similar GDP decline and