Paradoxes of Economics

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Economic ParadoxesDiscuss some major paradoxes in EconomicsSubmitted To :: Mam Zubaria Andalib Submitted By :: Najeebullah Khan Dated Semester :: 23 March 2010 :: 2nd

Department of Economics | FUUAST, Islamabad

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Table of Contents Topics Page

:: Arrows Impossibility Theorem . :: Bertrand Paradox . :: Dollar Auction . :: Easterlin Paradox . :: Gibson's Paradox . :: Giffen paradox . :: Icarus paradox . :: Jevons Paradox . :: Rebound Effect (conversation) .Department of Economics | FUUAST, Islamabad

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:: Saint Petersburg Paradox. :: The Paradox of Thrift . :: The Paradox of Value . :: The Productivity Paradox . 25 26 31 32


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Arrows Impossibility Theorem:Kenneth Arrow investigated the general problem of finding a rule for constructing social preferences from individual preferences. As an introduction to the problem suppose we wanted to find the social preferences for the three ice cream flavors, vanilla, chocolate and strawberry. One possible method for determining the social preference is by majority voting on choices between each pair of flavours. A set of preferences are said to be rational or transitive if when A is preferred to B and B is preferred to C then A is preferred to C. Suppose the population is evenly divided between three groups, X, Y and Z. the rankings of the three ice cream flavours for each of the groups are given below. For example, Group X people rate vanilla as their number one choice, chocolate as their number 2 Choice and strawberry as their third choice. Ice Cream Flavour Preference Group X Y Z Vanilla 1 2 3 Chocolate 2 3 1 Strawberry 3 1 2

Now consider how the vote would go among the three possible pairs of flavours. In a vote between two flavors it is assumed that people vote for the one to the Two which is high-test in their preferences, even though their number one choice may be different from the two being considered. In a choice between vanilla and chocolate, the X groups would vote for vanilla, the YDepartment of Economics | FUUAST, Islamabad

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group would also vote for vanilla and the Z group would vote for chocolate. So vanilla would win two-thirds of the votes and we could say that vanilla is socially preferred to chocolate. In a choice between chocolate and strawberry the X group would vote for chocolate, the y group would vote for strawberry and the Z group would vote for chocolate so chocolate would win. So chocolate is preferred to strawberry. Rationally we would expect that this would imply that vanilla would be preferred to strawberry. But consider a social choice by majority voting between vanilla and strawberry. The X group would vote for vanilla, the Y group would vote for strawberry and the Z group would vote for strawberry. So strawberry is social preferred to vanilla. Thus we have the irrational result that socially vanilla is preferred to chocolate and chocolate is preferred to strawberry but strawberry is preferred to vanilla.

Kenneth Arrows Impossibility TheoremKenneth Arrow examined the problem rigorously by specifying a set of requirements that should be satisfied by an acceptable rule for constructing socially preferences rom individual preferences; i.e. Social preferences should be complete in that given a choice between alternatives A and B it should say whether A is preferred to B, or B is preferred to A or that there is a social indifference between A and B. Social preferences should be transitive; i.e. if A is preferred to B and B is preferred to C then A is also preferred to C. If every individual prefers A to B Then socially A should be preferred to B. Socially preferences should not depend only upon the preferences of one individual; i.e. The dictator.


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Economic Paradoxes Social Preferences should be independent of irrelevant alternatives; i.e. the social preference of A compared to B should be independent of preferences for other alternatives.

What Kenneth Arrow was able to prove mathematically is that there is no method for constructing social preferences from arbitrary individual preferences. In other words, there is no rule, majority voting or otherwise, for establishing social preferences from arbitrary individual preferences. This was a major result and for it and other work Kenneth Arrow received the Nobel Prize in economics. There is one way out of this impasse for making social decisions through the political process. If the individual preferences have some commonality then social preferences can be constructed. If the alternatives can be represented as being elements of a spectrum and the preferences of the individuals exhibit single peakedness then social preferences can be constructed.

Bertrand Paradox:Suppose two firms, A and B, sell an identical commodity, each with the same cost of production and distribution, so that customers choose the product solely on the basis of price. It follows that neither A nor B will set a higher price than the other because doing so would yield the entire market to their rival. If they set the same price, the companies will share both the market and profits. Commodity is a term with distinct meanings in both business and in Marxian political economy. ... Marketing Distribution is one of the four aspects of marketing. ... On the other hand, if either firm were to lower its price, even a little, it would gain the whole market and substantially larger profits. Since both A and B know this, they will each try to undercut their competitor until the product is selling at zero economic profit. This is the pure-strategy Nash equilibrium. Recent work has shown that there may be additional mixed-strategy NashDepartment of Economics | FUUAST, Islamabad

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equilibrium with positive economic profits. In game theory, the Nash equilibrium (named after John Forbes Nash, who proposed it) is a kind of solution concept of a game involving two or more players, where no player has anything to gain by changing only his or her own strategy unilaterally The Bertrand paradox rarely appears in practice because real products are almost always differentiated in some way other than price (brand name, if nothing else); firms have limitations on their capacity to manufacture and distribute; and two firms rarely have identical costs. In marketing, product differentiation is the modification of a product to make it more attractive to the target market. ... This article is about brands in marketing. ... Bertrand's result is paradoxical because if the number of firms goes from one to two, the price decreases from the monopoly price to the competitive price and stays at the same level as the number of firms increases further. This is not very realistic, as in reality, the price goes down as the number of firms increases. The empirical analysis shows that in the most industries with two competitors, positive profits are made. In economics, a monopoly (from the Latin word monopolium - Greek language monos, one + polein, to sell) is defined as a persistent market situation where there is only one provider of a product or service. ... Competition is the act of striving against another force for the purpose of achieving dominance or attaining a reward or goal, or out of a biological imperative such as survival. ... Some reasons the Bertrand paradox does not strictly apply:

Capacity constraintsSometimes firms have not enough capacity to satisfy all demand. Product differentiationIf products of different firms are differentiated, then consumers may not switch completely to the product with lower price.


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Economic Paradoxes Dynamic competitionRepeated interaction or repeated price competition can lead to the price above MC in equilibrium. Money for higher priceIt follows from repeated interaction: If one company sets their price slightly higher, then they will still get about the same amount of buys but more profit for each buy, so the other company will raise their price, and so on (only in repeated games, otherwise the price dynamics are in the other direction).

Oligopoly If the two companies can agree on a price, it is in their long-term interest to keep the agreement: the revenue from cutting prices is less than twice the revenue from keeping the agreement, and lasts only until the other firm cuts its own prices.

SHUBIK'S DOLLAR AUCTION:In their free time, Martin Shubik and colleagues at RAND and Princeton tried to devise new and unusual games. According to Shubik, the central question was, "Can we get certain pathological phenomena as well-defined games?" They wanted games you could actually play. "I don't believe any game that can't be played as a parlor game," Shubik told me. In 1950, Shubik, John Nash, Lloyd Shapley, and Melvin Hausner invented a game called "so long sucker." This is a vicious game, played with poker chips, where players have to forge alliances with other players but usually have to betray them to win. When tried out at parties, people took the game seriously. ("We had married couples going home in separate cabs," Shubik recalls.) Shubik posed the question of whether it was possible to incorporate addiction in a game. This question lead to the dollar auction. Shubik is uncertain who thought of the game first or whether it was a collaboration. In any case, Shubik published it in 1971 and is generally credited as the game's inventor. In his 1971 paper, Shubik describes the dollar auction as an "extremelyDepartment of Economics | FUUAST, Islamabad

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simple, highly amusing and instructive parlor game." A dollar bill is auctioned with these two rules: (As in any auction) the dollar bill goes to the highest bidder, who pays whatever the high bid was. Each new bid has to be higher than the current high bid, and the game ends when there is no new bid within a specified time limit. (Unlike at Sotheby's!) the second-highest bidder also has to pay the amount of his last bid and gets nothing in return. You really don't want to be the second-highest bidder. Shubik wrote, "A large crowd is desirable. Furthermore, experience has indicated that the best time is during a party when spirits are high and the propensity to calculate does not settle in until at least two bids have been made." Shubik's two rules swiftly lead to madness. "Do I hear 10 cents?" asks the auctioneer "5 cents?" Well, it's a dollar bill, and anyone can have it for a penny. So someone says 1 cent. The auctioneer accepts the bid. Now anyone can have the dollar bill for 2 cents. That's still better than the rate Chase Manhattan gives you, so someone says 2 cents. It would be crazy not to. The second bid puts the first bidder in the uncomfortable position of being the second-highest bidder. Should the bidding stop now, he would be charged 1 cent for nothing. So this person has particular reason to make a new bid "3 cents." And so on Maybe you're way ahead of me. You might think that the bill will finally go for the full price of $1.00 a sad comment on greed, that no one got a bargain. If so, you'd be way too optimistic. Eventually someone does bid $1.00. That leaves someone else with a second-highest bid of 99 cents or less. If the bidding stops at $1.00, the under bidder is in the hole for as much as 99 cents. So this person has incentive to bid $1.01 for the dollar bill. Provided he wins, he would be out only a penny (for paying $1.01 for a dollar bill). That's better than losing 99 cents. That leads the $1.00 bidder to top that bid. Shubik wrote, "There is a pause and hesitation in the group as the bid goes through the one dollar barrier. From then on, there is a duel with bursts of speed until tension builds, bidding then slows and finally peters out." No matter what the stage of the bidding, the second-highestDepartment of Economics | FUUAST, Islamabad

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bidder can improve his position by almost a dollar by barely topping the current high bid. Yet the predicament of the secondhighest bidder gets worse and worse! This peculiar game leads to a bad case of buyer's remorse. The highest bidder pays far more than a dollar for a dollar, and the second-highest bidder pays far more than a dollar for nothing. Computer scientist Marvin Minsky learned of the game and popularized it at MIT. Shubik reported: "Experience with the game has shown that it is possible to 'sell' a dollar bill for considerably more than a dollar. A total of payments between three and five dollars is not uncommon." Possibly W. C. Fields said it best: "If at first you don't succeed, try, try again. Then quit. No use being a damn fool about it." Shubik's dollar auction demonstrates the difficulty of using von Neumann and Morgenstern's game theory in certain situations. The dollar auction game is conceptually simple and contains no surprise features or hidden information. It ought to be a "textbook case" of game theory. It ought to be a profitable game, too. The game dangles a potential profit of up to a dollar in front of the bidders, and that profit is no illusion. Besides, no one is forced to make a bid. Surely a rational player can't lose. The players who bid up a dollar to many times its value must be acting "irrationally." It is more difficult to decide where they go wrong. Maybe the problem is that there is no obvious place draw the line between a rational bid and an irrational one. Shubik wrote of the dollar auction that "a game theory analysis alone will probably never be adequate to explain such a process." Also we can define the Dollar auction as This article sets the stage to learn about conflict escalation by playing a game. The game is called The Dollar Auction, and the rules are as follows. You are the auctioneer. In any group, either social or at work, propose the following. You will auction a $1 bill to the highest bidder. The highest bidder will win $1 less the amount of the bid. If the high bid is 15 cents, you will pay out 85 cents ($1 minus the bid). The catch is that the second highest bidder must pay you his or her bid as well. So if the second bidder was 12 cents, the bidder pays you 12 cents. People typically start this game by calling out a small amount of money because they figure they have little to lose. They think toDepartment of Economics | FUUAST, Islamabad

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themselves, "If I can win a buck for 10 or 15 cents, I'm pretty smart." The problem is that everyone else in the game has the same logic. Consequently, several people start to bid. Eventually, the bids will approach $1 and two things happen. First, the number of players typically decreases until there are two bidders. Second, the motivation of the remaining two bidders changes from a desire to maximize returns to one of minimizing losses. Thus, the question transforms from "How much can I win?" to "How do I keep from losing?" Guess what? At this point, the auction often goes above $1. Why doesn't someone quit when the expected reward is less than the known expense of continuing the game? First, the players have expended time and effort in an expectation of an easy gain. They have made an "investment" that they are loathe to relinquish. Second, each party secretly hopes the other bidder will quit, leaving victory to the remaining player. Of course, both parties reason this way, and neither one quits. As the bidding exceeds $1, another transformation occurs. Now, a certain fatalistic attitude typically sets in so that each party makes certain the other will lose just as much. "I may go down in flames, but I'm taking you with me." This reaction seems to stem from a fear of looking weak or foolish for quitting and letting the other guy win. The bidders are now concerned with threats to their personal image. The auction has changed from an "investment" to "a matter of principle." If you play this game, I would be interested in knowing how much the dollar ultimately was sold for. I have heard of auctions going as high as $5 or $6, and in one case where the auction was for $100, the final bid was $3,000. Perhaps your players will show some restraint, but perhaps not. The Dollar Auction game is a great example of conflict escalation processes. Notice how the goals change as the game, which is a metaphor for conflict, progresses. Very often conflicts start with one set of goals. At an intermediate stage, the goals shift to something quite different. If the genesis of the conflict was to gain something, the first transformation will be to minimize loss. Thus, the conflict will escalate as this new goal takes hold. Since the transformation is unconscious, logic provides a rationalization rather than a reasoned before-the-fact decision. As parties become aware of the destructive nature of the escalation, a second transformation occurs. Now the conflict isDepartment of Economics | FUUAST, Islamabad

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centered on identity-preserving one's own face and, if possible, destroying the other's face. One can only back down now by admitting defeat. There seems to be an implicit message that the winner is stronger, better, and more capable. We react against this, again unconsciously, because succumbing to another in this way constitutes a primal threat to our ability to survive in the group. When I was trying business cases, I saw this phenomenon time after time but did not understand it. I suppose I became entrapped in it as well. As a peacemaker, I now recognize the symptoms and understand the causes. Once in this cycle, people have an extraordinarily difficult time breaking out. That is when mediation and peacemaking can be very effective. How do you know if you or your colleagues are caught in the cycle? Listen for expressions like "I don't care about the money. It's the principle of the thing;" "We've got a lot invested in this, but it should be over in a few more months." "I don't care what it costs; XYZ is not going to win this one!" These phrases and others like them reveal how conflict goals have changed to escalation. This phenomenon is not limited to litigation. For those of you engaged in bidding wars for companies, think about whether your original business objectives became transformed to preventing loss and then to preserving yourself or corporate image. The competition in a contested merger or acquisition has led many acquiring companies into a deal that made no sense whatsoever. How often have you heard of an intense, competitive auction for a company, only to hear of the quiet divestment two or three years later? The point I make is that conflict escalation is often caused by unconscious transformations triggered by the deepening conflict. Being aware of this propensity can help you avoid bad decisions and help you get out before the cost becomes excessive.

Easterlin ParadoxThe Easterlin Paradox is a key concept in happiness economics. It is named for economist Richard Easterlin who discussed the factors contributing to happiness in the 1974 paper "Does Economic Growth Improve the Human Lot? Some Empirical Evidence."[1] Easterlin found that within a given country people with higher incomes are more likely to report being happy. However, in international comparisons the average reported levelDepartment of Economics | FUUAST, Islamabad

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of happiness does not vary much with national income per person, at least for countries with income sufficient to meet basic needs. Similarly, although income per person rose steadily in the United States between 1946 and 1970, average reported happiness showed no long-term trend and declined between 1960 and 1970. This concept has recently [when?] been revived by Andrew Oswald of the University of Warwick, driving media interest in the topic. Recent research has utilized many different forms of measuring happiness, including biological measures, showing similar patterns of results. This goes some way to answering the problems of self-rated happiness. The implication for government policy is that once basic needs are met, policy should focus not on economic growth or GDP, but rather on increasing life satisfaction or GNH. In 2003 Rut Veenhoven and Michael Hagerty published a new analysis based on including various sources of data, and their conclusion was that there is no paradox and countries get indeed happier with increasing income. In his reply Easterlin maintained his position, pointing that the critics were using inadequate data. In 2008, economists Justin Wolfers and Betsey Stevenson, both of the University of Pennsylvania, published a paper where they reassessed the Easterlin paradox using new time-series data. They conclude like Veenhoven et al. that, contrary to Easterlin's claim, increases in absolute income are clearly linked to increased self-reported happiness, for both individual people and whole countries. The statistical relationship demonstrated is between happiness and the logarithm of absolute income, suggesting that above a certain point, happiness increases more slowly than income, but no "saturation point" is ever reached. The study provides evidence that happiness is determined not only by relative income, but also by absolute income. That is in contrast to an extreme understanding of the hedonic treadmill theory where "keeping up with the Joneses" is the only determinant of behavior.

Gibson's ParadoxDepartment of Economics | FUUAST, Islamabad

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Due in no small measure to articles he wrote as a young economist, especially his 1966 essay "Gold and Economic Freedom" (reprinted in A. Rand, Capitalism: The Unknown Ideal, available online at www.gold-eagle.com/greenspan041998.html), Fed chairman Alan Greenspan is widely recognized as quite an authority on gold. Far less widely known are professional articles on gold by another young economist who also went on to serve until quite recently in some of the nation's top economic policy positions. Not long before joining the new Clinton administration as undersecretary of the treasury for international affairs, Harvard president and former treasury secretary Lawrence H. Summers, then Nathaniel Ropes professor of political economy at Harvard, co-authored with Robert B. Barsky an article entitled "Gibson's Paradox and the Gold Standard" published in the Journal of Political Economy. The article, which appears to draw heavily on a 1985 working paper of the same title by the same authors, is an excellent technical piece, revealing a high level of expertise regarding gold, gold mining, and the interconnections among gold prices, interest rates, and inflation. Indeed, for any administration concerned that the bond vigilantes on Wall Street might thwart its economic policies by pushing up long-term rates at inopportune times, the article is must reading and qualifies its authors as attractive candidates for government service. Of even more interest looking at the Clinton administration retrospectively, the article provides strong theoretical evidence that since 1995 gold prices have not acted as would normally be expected in a genuine free market, but instead have behaved as if subject to what the authors describe as "government pegging operations." Lord Keynes gave the name "Gibson's paradox" to the correlation between interest rates and the general price level observed during the period of the classical gold standard. It was, he said, "one of the most completely established empirical facts in the whole field of quantitative economics." J.M. Keynes, A Treatise on Money (Macmillan, 1930), vol. 2, p.198. And it was a paradox because contemporary monetary theory, largely associated with Irving Fisher, suggested that interest rates should move with the rate of change in prices, i.e., the inflation rate or expected inflation rate, rather than the price level itself. Yet when Keynes wrote, data for the prior twoDepartment of Economics | FUUAST, Islamabad

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centuries showed that the yield on British consoles (government securities issued at a fixed rate of interest but with no redemption date) had moved in close correlation with wholesale prices but almost no correlation to the inflation rate. Economists have long tried to find a theoretical explanation for Gibson's paradox. Professors Summers and Barsky provide the following executive summary of their contribution to this debate (at 528): A shock that raises the underlying real rate of return in the economy reduces the equilibrium relative price of gold and, with the nominal price of gold pegged by the authorities, must raise the price level. The mechanism involves the allocation of gold between monetary and nonmonetary uses. Our explanation helps to resolve some important anomalies in previous work and is supported by empirical evidence along a number of dimensions. They begin their article with an examination (at 530-539) of the data supporting the existence of Gibson's paradox, concluding that it was "primarily a gold standard phenomenon" (at 530) that applies to real rates of return. Regression analysis of the classical gold standard period, 1821-1913, shows a close correlation between long-term interest rates and the general price level. The correlation is not as strong for the pre-Napoleonic era, 1730-1796, when Britain effectively adhered to the gold standard but many other nations did not, and "completely breaks down during the Napoleonic war period of 1797-1820, when the gold standard was abandoned" (at 534). Nor is the evidence of Gibson's paradox as strong for the period of the interwar gold exchange standard, 1921-1938, which was marked by active central bank management and restrictions on gold convertibility. Following World War II, the correlation weakened substantially under the Bretton Woods system, and "[t]he complete disappearance of Gibson's paradox by the early 1970s coincides with the final break with gold at that time" (at 535). With the nominal price of gold fixed, Barsky and summers note (at 529) that "the general price level is the reciprocal of the price of gold in terms of goods. Determination of the general price level then amounts to the microeconomic problem of determining the relative price of gold." For this, they develop a simple model (at 539-543) that assumes full convertibility between gold and dollars at a fixed parity, fully flexible prices for goods and services, and fixed exchange rates.Department of Economics | FUUAST, Islamabad

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Next, they examine the response of the model to changes in the available real rate of return. In this connection, they observe (at 539): "Gold is a highly durable asset, and thus ... it is the demand for the existing stock, as opposed to the new flow, that must be modeled. The willingness to hold the stock of gold depends on the rate of return available on alternative assets." With respect to the gold stock, the model distinguishes between bank reserves (monetary gold under the gold standard) and nonmonetary gold, principally jewelry. Summarizing the mathematical formulas of the model, Barsky and summers make two key points. The first (at 540): The price level may rise or fall over time depending on how the stock of gold, the dividend function [formulaic abbreviation omitted] and the demand for money [formulaic abbreviation omitted] evolve over time. Secular increases in the demand for monetary and nonmonetary gold caused by rising income levels tend to create an upward drift in the real price of gold, which is secular deflation. Tending to offset this effect would be gold discoveries and technological innovations in mining such as the cyanide process. And the second (at 542): The economic mechanism is clear. Increases in real interest rates raise the carrying cost of nonmonetary gold, reducing the demand for it. They also reduce the demand for monetary gold as long as money demand is interest elastic. The resulting reduction in the real price of gold is equivalent to an increase in the general price level. Because the model is "essentially a theory of the relative price of gold," Barsky and summers postulate (at 543) that "an important test of the model is to see how well it accounts for movements in the relative price of gold (and other metals) outside the context of the gold standard." They continue (id.): The properties of the inverse relative prices of metals today ought to be similar to the properties of the general price level during the gold standard years. We focus on the period from 1973 to the present, after the gold market was sufficiently free from government pegging operations and from limitations on private trading for there to be a genuine "market" price of gold. And they conclude (at 548):


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The price level under the gold standard behaved in a fashion very similar to the way the reciprocal of the relative price of gold evolves today. Data from recent years indicate that changes in long-term real interest rates are indeed associated with movements in the relative price of gold in the opposite direction and that this effect is a dominant feature of gold price fluctuations. In other words, the bottom line of their analysis is that gold prices in a free market should move inversely to real interest rates. Under the gold standard, higher prices meant that an ounce of gold purchased fewer goods, i.e., the relative price of gold fell. Since under the Gibson paradox long-term interest rates moved with the general price level, the relative price of gold moved inversely to long-term rates. Assuming, as Barsky and Summers assert, that the Gibson paradox operates in a truly free gold market as it did under the gold standard, gold prices will move inversely to real long-term rates, falling when rates rise and rising when they fall. To test this proposition, particularly for the period after 1984 not covered by Barsky and Summers in their 1988 article, Nick Laird has constructed the following chart at my request. Nick is the proprietor of www.sharelynx.net, which offers an excellent collection of charts relating to gold and financial matters, and I am most grateful for his assistance. The chart plots average monthly gold prices on the inverted right scale, i.e., higher prices at the bottom. Real long-term rates are plotted on the left scale. They are defined as the 30-year U.S. Treasury bond yield minus the annualized increase in the Consumer Price Index (calculated as the sum of the monthly CPI increases for the preceding twelve months).


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As the chart shows, Gibson's paradox continued to operate for another decade after the period covered by Barsky and Summers. But sometime around 1995, real long-term interest rates and inverted gold prices began a period of sharp and increasing divergence that has continued to the present time. During this period, as real rates have declined from the 4% level to near 2%, gold prices have fallen from $400/oz. to around $270 rather than rising toward the $500 level as Gibson's paradox and the model of it constructed by Barsky and Summers indicates they should have. The historical evidence adduced by Barsky and Summers leaves but one explanation for this breakdown in the operation of Gibson's paradox: what they call "government pegging operations" working on the price of gold. What is more, this same evidence also demonstrates that absent this governmental interference in the free market for gold, falling real rates would have led to rising gold prices which, in today's world of unlimited fiat money, would have been taken as a warning of future inflation and likely triggered an early reversal of the decline inDepartment of Economics | FUUAST, Islamabad

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real long-term rates. Other analysts have noted the inverse relationship between real rates and gold prices. An interesting and informative recent article along these lines is Adam Hamilton's Real Rates and Gold, which makes reference to a 1993 Federal Reserve study containing the following statement: "The Fed's attempts to stimulate the economy during the 1970s through what amounted to a policy of extremely low real interest rates led to steadily rising inflation that was finally checked at great cost during the 1980s." The low real long-term interest rates of the past few years may have been engineered with far more sophistication than those of a generation ago, including the coordinated and heavy use of both gold and interest rate derivatives. By demonstrating that falling real long-term rates will lead to rising gold prices absent government interference in the gold market, Barsky and Summers underscore the futility of trying to control the former without also controlling the latter. But they do not provide a model for successful long-term suppression of gold prices in the face of continued low real rates. What they do indicate (at 548), however, is that their model of Gibson's paradox accords only a "minimal role [to] new gold discoveries" and fails to account fully for shifts between monetary and nonmonetary gold. As they note (at 546-548), the fraction of the total gold stock held in nonmonetary form during the gold standard era was substantial, perhaps exceeding one-half, and the fraction varied over time. Also (at 548), "the post-1896 rise in prices, after more than two decades of deflation, is usually attributed to gold discoveries in combination with the development of the cyanide process for extraction." Accordingly, they conclude (at 548-549) that their "proposed resolution of the Gibson paradox cannot be the whole answer" and that determination of "the quantitative importance of the mechanism in this paper would require better methods for proxying movements in the stocks of monetary and nonmonetary gold, and this might be an appropriate topic for further research." The unusual and sharp divergence of real long-term interest rates from inverted gold prices that began in 1995 suggests that Mr. Summers found an opportunity to do some further applied research on these matters during his tenure at the Treasury.Department of Economics | FUUAST, Islamabad

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Both the heavy use of forward selling by mining companies and the World Gold Council's obsession with promoting gold as jewelry to the near exclusion of its historic monetary role appear designed to exploit the conceded points of vulnerability in the operation of the model. Viewed in this light, these two novel and distinguishing features of the post-1995 gold market appear less accidental and more as the handmaidens of the government price-fixing operations that the model reveals. At the time of his appointment, Professor Summers was the youngest tenured professor in Harvard's modern history. On Friday, October 12, 2001, in outdoor ceremonies in Tercentenary Theatre, he will be formally installed as its 27th president, entrusted with the job of leading the nation's oldest university -where "Veritas" is the motto -- into the new millennium. Three days earlier, in Courtroom No. 11 of the new U.S. Courthouse on Boston Harbor, the search for the truth about his interim service in the highest positions at the U.S. Treasury will resume. Judge Lindsay has scheduled a hearing on the defendants' motions to dismiss for Tuesday, October 9, at 3:30 p.m. The underlying issue in that proceeding is whether the Constitution and laws of the United States may be enforced in a federal court action challenging the authority of Mr. Summers and other American officials, working at least in part through the Bank for International Settlements, to conduct the surreptitious and illegal gold price-fixing operations exposed even by his own academic research.

Giffen paradox:For most products, price elasticity of demand is negative. In other words, price and demand pull in opposite directions; price goes up and quantity demanded goes down, or vice versa. Giffen goods are an exception to this. Their price elasticity of demand is positive. When price goes up the quantity demanded also goes up, and vice versa. In order to be a true Giffen good, price must be the only thing that changes to get a change in demand. Giffen goods are named after Sir Robert Giffen, who was attributed asDepartment of Economics | FUUAST, Islamabad

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the author of this idea by Alfred Marshall in his book Principles of Economics. The classic example given by Marshall is of inferior quality staple foods whose demand is driven by poverty, which makes their purchasers unable to afford superior foodstuffs. As the price of the cheap staple rises, they can no longer afford to supplement their diet with better foods, and must consume more of the staple food. Marshall wrote in the 1895 edition of Principles of Economics: As Mr. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it.

Analysis of Giffen goodsThere are three necessary preconditions for this situation to arise. They are:1.

The good in question must be an inferior good,

2. There must be a lack of close substitutes, 3. And the good must comprise a substantial percentage of the buyers income. If precondition #1 is changed to "The good in question must be so inferior that the income effect is greater than the substitution effect" then this list defines necessary and sufficient conditions.


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The Giffen ParadoxThis can be illustrated with a diagram. Initially the consumer has the choice between spending their income on either commodity Y or commodity X as defined by line segment MN (where M= total available income divided by the price of commodity Y, and N= total available income divided by the price of commodity X). Given the consumers preferences toward the two products, as expressed in indifference curve Io, the optimum mix of purchases for this individual is point A. Now if there is a drop in the price of commodity X, there will be two effects. The reduced price will alter relative prices in favour of commodity X, known as the substitution effect. This is illustrated by a movement down the indifference curve from point A to point B. At the same time the price reduction causes the consumers purchasing power to increase, known as the income effect. This is illustrated by the budget line that pivots out from MN to MP (where P=is the total available income divided by the new price of commodity X). TheDepartment of Economics | FUUAST, Islamabad

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substitution effect (point A to point B) raises the quantity demanded of commodity X from Xa to Xb while the income effect lowers the quantity demanded from Xb to Xc. The net effect is a reduction in quantity demanded from Xa to Xc making commodity X a Giffen good by definition. Any good where the income effect more than compensates for the substitution effect is a Giffen good.

Empirical evidence for Giffen goodsDespite years of searching, no generally agreed upon example has been found. A 2002 preliminary working paper by Robert Jensen and Nolan Miller made the claim that rice and noodles are Giffen goods in parts of China. It is easier to find Giffen effects where the number of goods available is limited, as in an experimental economy: DeGrandpre et al (1993) provide such an experimental demonstration. One reason for the difficulty in finding Giffen goods is Giffen originally envisioned a specific situation faced by individuals in a state of poverty. Modern consumer behaviour research methods often deal in aggregates that average out income levels and are too blunt an instrument to capture these specific situations. It is for this reason that many text books use the term Giffen Paradox rather than Giffen Good. Some types of premium goods (such as expensive French wines, or celebrity endorsed perfumes) are sometimes claimed to be Giffen goods. It is claimed that lowering the price of these high status goods can decrease demand because they are no longer perceived as exclusive or high status products. However, the perceived nature of such high status goods changes significantly with a substantial price drop. This disqualifies them from being considered as Giffen goods, because the Giffen goods analysis assumes that only the consumer's income or the relative price level changes, not the nature of the good itself. If a price change modifies consumers' perception of the good, they should be analyzed as Veblen goods. Some economists question the empirical validity of the distinction between Giffen and Veblen goods, arguing that whenever there is a substantial change in the price of a good its perceived nature also changes, since price is a large part of what constitutes a product. However the theoretical distinction between the two types of analysis remains clear; whichDepartment of Economics | FUUAST, Islamabad

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one of them should be applied to any actual case is an empirical matter.

Icarus paradox:The fabled Icarus of Greek mythology is said to have flown so high, so close to the sun, that his artificial wax wings melted and he plunged to his death in the Aegean Sea. The power of Icarus's wings gave rise to the abandon that so doomed him. The paradox, of course, is that his greatest asset led to his demise. And that same paradox applies to many outstanding companies: their victories and their strengths so often seduce them into the excesses that cause their downfall. Success leads to specialization and exaggeration, to confidence and complacency, to dogma and ritual. This general tendency, its causes, and how to manage it are what this article is all about. It is ironic that many of the most dramatically successful organizations are so prone to failure. The histories of outstanding companies demonstrate this time and again. In fact, it appears that when taken to excess the same things that drive success-focused, tried-and-true strategies, confident leadership, galvanized corporate cultures, and especially the interplay of all these elements--also cause decline. Robust, superior organizations evolve into flawed purebreds; they move from rich character to exaggerated caricature as all subtlety, all nuance, is gradually lost. Many outstanding organizations follow such paths of deadly momentum--time-bomb trajectories of attitudes, policies, and events that lead to falling sales, plummeting profits, even bankruptcy. These companies extend and amplify the strategies to which they credit their success. Productive attention to detail, for instance, turns into an obsession with minutiae; rewarding innovation escalates into gratuitous invention; and measured growth becomes unbridled expansion. In contrast, activities that were merely de-emphasized-not viewed as integral to the recipe for success--are virtually extinguished. Modest marketing deteriorates into lackluster promotion and inadequateDepartment of Economics | FUUAST, Islamabad

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distribution; tolerable engineering becomes shoddy design. The result: strategies become less balanced. They center more and more around a single core strength that is amplified unduly while other aspects are forgotten almost entirely.

Jevons ParadoxJevons Paradox tells us that when we increase the efficiency of the use of a resource, we initially decrease the demand for that resource, but that ultimately this lower demand reduces price, which causes a rebound of increasing demand. When applied specifically to energy efficiency, this is commonly referred to as the Rebound Effect. Heres a real-world example. Lets magically double the average fuel economy of Americas cars and trucks. Gasoline demand would drop immediately by 50%. This would affect the supplydemand equilibrium of gasoline, reducing its price significantly. However, with dramatically lower gas prices, many people would choose to drive more than they had in the pastthis is the rebound, where some of the energy savings provided by gains in efficiency are negated by the corresponding effect on energy prices. Clearly, a 50% drop in gas prices wont result in the average American doubling their driving, as would be required to completely negate the efficiency gains in this scenario. Even if gas was free, there would be some limit to how much we would drive. So this rebound effect doesnt negate the entirety of energy savings due to efficiency. Studies suggest that it erases perhaps 10%-30% of the gains. If Jevons Paradox, via the rebound effect, only negates 10%30% of gains from improved efficiency, then efficiency appears to be a very viable policy option to reduce energy consumption, right? Not so fast. Jevons Paradox and the Rebound Effect are models that create snapshots in time of the operation of a highly complex systemit is important that we approach this problem with the entire system in mind. Consider the cascading effects in the energy-consumer system: when you save energy because of improved efficiency, you also save money. What do you do with that money? Chances are that most or all of it is spent on goodsDepartment of Economics | FUUAST, Islamabad

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and services, and that these reflect energy consumption in some form. Whether you spend your savings on a trip to Hawaii, a new coffee table, or merely a plastic bauble, that expenditure reflects energy consumption. The exact form of energy consumed, as well as the relative quantity of energy consumed compared to energy initially saved via an improvement in efficiency is difficult to quantify, but in aggregate these two may be roughly equal. This is the shadow rebound effect. The direct rebound effectthat is, the increase in consumption of the same energy resource through the same process that experiences an improvement in efficiencymay be only 10%-30%, but it is possible that the true rebound effect approaches 100% when this shadow is accounted for. Does this mean that efficiency is an invalid policy choice? No: true conservation, the goal of efficiency policy, can be achieved, but this represents a far more challenging policy dilemma. It is relatively simple, for example, to legislate higher CAFE standards. But what happens with the money saved on gasoline? It is quite a policy challenge to ensure that the energy saved by CAFE changes doesnt simply go to another use of energy. One solution the one that I am proposingis that monetary savings from efficiency legislation is offset by an energy tax that is then invested in a manner that minimizes its energy consumption. Options for this offset fund reducing existing spending deficits, encouraging social pressure for absolute conservation, or my personal choice, funding efforts to design for quality of life using less energywhat I have called the Design Imperative. But selling this policy combinationCAFE increases paired with gas tax increases, for exampleis a much more difficult task. My intent is not to discourage the push for energy efficiency quite the opposite: energy efficiency is a key part of addressing the challenges posed by Peak Oil, but ONLY if it is paired with measures to address both the direct and shadow rebound effects. There are valid arguments to focus on efficiency first, because it takes time to develop the technologies that create efficient energy use. However, we must be careful not to present efficiency as a standalone panacea, but rather to spur debate of systemic solutions of which efficiency is a key part.Department of Economics | FUUAST, Islamabad

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Rebound effect (conservation)In conservation, energy economics and green marketing, the rebound effect (or take-back effect) refers to the behavioral or other systemic responses to the introduction of new technologies, or other measures taken to reduce resource use. These responses tend to offset the beneficial effects of the new technology or other measures taken. While the literature on the rebound effect generally focuses on the effect of technological improvements on energy consumption, the theory can also be applied to the use of any natural resource. The rebound effect is generally expressed as a ratio of the lost benefit compared to the expected environmental benefit when holding consumption constant.[1] For instance, if a 5% improvement in vehicle fuel efficiency results in only a 2% drop in fuel use, there is a 60% rebound effect. The 'missing' 3% might have been consumed by driving faster or further than before. The existence of the rebound effect is uncontroversial. However, debate continues as to the size and importance of the effect in real world situations. There are three possible outcomes regarding the size of the rebound effect: The actual resource savings are higher than expected the rebound effect is negative. This is unusual, and can only occur in certain specific situations (e.g. if the government mandates the use of more resource efficient technologies that are also more costly to use). The actual savings are less than expected savings the rebound effect is between 0% and 100%. This is sometimes known as 'take-back', and is the most common result of empirical studies on individual markets. The actual resource savings are negative the rebound effect is higher than 100%. This situation is commonly known as the Jevons paradox, and is sometimes referred to as 'back-fire'. Governments and environmental groups often advocate research into higher fuel efficiency as the primary means of energy conservation. Economists tend to believe that, for the economy as a whole, the long term rebound effect for more fuel-efficient technologies is higher than 100%; if this is the case, the invention of technologies that improve fuel efficiency may paradoxically increase energy use. Within conservation and energy circles of discussion, the rebound effect has a very specific definition. It refers to what happensDepartment of Economics | FUUAST, Islamabad

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when users of energy acquire a real savings through increased efficiency that they increase usage as a result. Thus, their energy consumption rebounds to a higher level than before the efficiency increase. A simple example of the rebound effect would be demonstrated by a person trading his car for one that delivered twice the mileage. If he drove the same number of miles in his new car, he would require 50% as much fuel. However, he might decide to drive twice what he had been because of lower fuel costs, resulting in a 0% advantage over prior fuel use. In other words, his use rebounded to much higher levels. The significance of trying to define the rebound effect in energy areas is the important role that it plays in planning for national, and even global energy needs in the future. Until such time when an infinite amount of energy is available, careful planning with current finite resources is required. As individuals who share both the bounty and the limitations of present energy resources, we should be concerned about falling prey to the rebound effect as it applies to each of us. Mankind's history to date has shown little inclination by man to avoid excesses in practically everything. While Vice President Gore was campaigning for more concern by everyone to global warming problems, he asked everyone to limit their needless use of energy. However, he also continued to live in and air condition a virtual mansion for his own personal residence. However wellintentioned he was with his environmental concerns, his personal excesses defined the reality that most people will indulge themselves to the extent of their possibilities. This attitude plays into the question of the rebound effect. There are very real dangers lurking for those who ignore what finite resources actually exist today. Invention and technology will undoubtedly affect future energy sources. In the meantime, education will have to help scientists by creating a culture of energy awareness for everyone's good. It will be impossible to justify the day when wealth buys energy while the masses of poor people have to do without. Understanding the rebound effect as it relates to energy is the first step in educating the public. From a perspective of understanding, the majority of people will hopefully modify theDepartment of Economics | FUUAST, Islamabad

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areas of their indulgences that are detrimental to a future that lives up to the promise that we hope for.

HistoryThe rebound effect was first described by William Stanley Jevons in his 1865 book The Coal Question, where he observed that the invention in Britain of a more efficient steam engine meant that the use of coal became economically viable for many new uses. This ultimately led to increased coal demand and much increased coal consumption, even as the amount of coal required for any particular use fell. According to Jevons, "It is a confusion of ideas to suppose that the economical use of fuel is equivalent to diminished consumption. The very contrary is the truth." However, most contemporary authors credit Daniel Khazzoom for the re-emergence of the rebound effect in the research literature. Although Khazzoom did not use the term, he raised the idea that there is a less than one-to-one correlation between gains in energy efficiency and reductions in energy use, because of a change in the 'price content' of energy in the provision of the final consumer product.[4] His study was based on energy efficiency gains in home appliances, but the principle applies throughout the economy. A commonly studied example is that of a more fuelefficient car. Since each kilometer of travel becomes cheaper, there will be an increase in driving speed and/or kilometers driven, as long as the price elasticity of demand for car travel is not zero. Other examples might include the growth in garden lighting after the introduction of energy-saving compact fluorescent lamps or the increasing size of houses driven partly by higher fuel efficiency in home heating technologies. If the rebound effect is larger than 100%, all gains from the increased fuel efficiency would be wiped out by increases in demand (the Jevons paradox). Khazzoom's thesis was criticized heavily by Michael Grubb and Amory Lovins who dismissed any disconnection between energy efficiency improvements in an individual market, and anDepartment of Economics | FUUAST, Islamabad

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economy-wide reduction in energy consumption. Developing Khazzoom's idea further and prompting heated debate in the Energy Policy journal at that time, Len Brookes wrote of the fallacies in the energy-efficiency solution to greenhouse gas emissions. His analysis showed that any economically justified improvements in energy efficiency would in fact stimulate economic growth and increase total energy use. For improvements in energy efficiency to contribute to a reduction in economy-wide energy consumption, the improvement must come at a greater economic cost. Commenting in regard to energy efficiency advocates, he concludes that, "the present high profile of the topic seems to owe more to the current tide of green fervor than to sober consideration of the facts, and the validity and cost of solutions.

Saint Petersburg ParadoxIntroduction:In economics, the St. Petersburg paradox is a paradox related to probability theory and decision theory. It is based on a particular (theoretical) lottery game (sometimes called St. Petersburg Lottery) that leads to a random variable with infinite expected value, i.e., infinite expected payoff, but would nevertheless be considered to be worth only a very small amount of money. The St. Petersburg paradox is a classical situation where a nave decision criterion (which takes only the expected value into account) would recommend a course of action that no (real) rational person would be willing to take. The paradox can be resolved when the decision model is refined via the notion of marginal utility (and it is one origin of notions of utility functions and of marginal utility), by taking into account the finite resources of the participants, or by noting that one simply cannot buy that which is not sold (and that sellers would not produce a lottery whose expected loss to them were unacceptable). The paradox is named from Daniel Bernoulli's presentation of the problem and his solution, published in 1738 in the Commentaries of the Imperial Academy of Science of Saint Petersburg (Bernoulli 1738). However, the problem was invented by Daniel's cousin Nicolas Bernoulli who first stated it in a letter to Pierre RaymondDepartment of Economics | FUUAST, Islamabad

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de Montmort of 9 September 1713. Consider a game, first proposed by Nicolaus Bernoulli, in which a player bets on how many tosses of a coin will be needed before it first turns up heads. The player pays a fixed amount initially, and then receives dollars if the coin comes up heads on the expectation value of the gain is then th toss. The ( 1 ) dollars, so any finite amount of money can be wagered and the player will still come out ahead on average. Feller (1968) discusses a modified version of the game in which the player receives nothing if a trial takes more than a fixed number of tosses. The classical theory of this modified game concluded that is a fair entrance fee, but Feller notes that "the modern student will hardly understand the mysterious discussions of this 'paradox.' " In another modified version of the game, the player bets $2 that heads will turn up on the first throw, $4 that heads will turn up on the second throw (if it did not turn up on the first), $8 that heads will turn up on the third throw, etc. Then the expected payoff is ( 2 ) so the player can apparently be in the hole by any amount of money and still come out ahead in the end. This paradox can clearly be resolved by making the distinction between the amount of the final payoff and the net amount won in the game. It is misleading to consider the payoff without taking into account the amount lost on previous bets, as can be shown as follows. At the time the player first wins (say, on the th toss), he will have lost ( 3 )Department of Economics | FUUAST, Islamabad

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dollars. In this toss, however, he wins dollars. This means that the net gain for the player is a whopping $2, no matter how many tosses it takes to finally win. As expected, the large payoff after a long run of tails is exactly balanced by the large amount that the player has to invest. In fact, by noting that the probability of winning on the the toss is , it can be seen that the probability distribution for the number of tosses needed to win is simply a geometric distribution with .


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The paradox of thriftThe Paradox of Thrift used to say that if consumers dont save more, it will wreck the economy, but if the consumers do save more, it will wreck the economy. For the record, I am certainly among those who had been suggesting that America's low saving rate was a significant problem. Let me begin by reviewing why I said that. Recall that we can separate the various components of GDP (Y) in terms of goods and services purchased by consumers (C), government purchases (G), investment spending (I), and net exports (X): Y=C+I+G+X Subtracting C and G from both sides of the equation, Y-C-G=I+X The two terms on the right-hand side are the critical determinants of what kind of economic future we'll have. Investment in plant and equipment is the single most important variable that will determine our future productivity and standard of living. And negative net exports, such as the U.S. has increasingly opted for over my lifetime, necessarily involves selling off our national assets and going further into debt to foreigners. The size of our current account deficit is large enough relative to GDP that, if this were any country other than the United States, I would worry that a currency crisis (a sudden flight from dollars) is a very real possibility. And even for the United States, it is something I for one do worry about.


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U.S. net exports as a percentage of GDP. Data source: BEA Table 1.1.5.

From the equation above, if we want I + X to be bigger, we must want Y - C - G to be bigger as well. We can define private sector saving to be gross domestic income less consumption spending and net taxes paid: private saving = Y - C - T. Notice I'm using the same symbol Y for both GDP and GDI, since the two are conceptually the same-- every dollar of production necessarily generates a dollar of income. There is a statistical discrepancy between the actual measures available for GDP and GDI, though these are not relevant for the longer run issues I'm discussing here. We likewise can define "public saving" to be the excess of the government's receipts over its expenditures, public saving = T - G, and national saving to be the sum of private and public saving: national saving = Y - C - T + T - G = Y - C - G. In other words, national saving = I + XDepartment of Economics | FUUAST, Islamabad

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This equation is an accounting identity, as well as a condition that has to characterize equilibrium in any coherent macroeconomic model. Hence my longstanding advocacy of measures to raise the private saving rate or lower the federal deficit. So then, aren't I delighted that consumers are now, finally, saving more?

Personal saving as a percentage of disposable personal income. Data source: BEA Table 2.1.

Well, no. It is one thing to identify a higher national saving rate as the long-term goal, and quite another thing to try to get there overnight in the form of a sudden drop in consumption spending. Here I am very much taking the side of Brad DeLong and Arnold Kling and against Eugene Fama and John Cochrane. The relevant question is whether, in response to an abrupt decrease in consumption spending such as we're now experiencing, some of the other variables (most importantly, Y) might adjust in response as well. It is certainly true that in a very simple economic setting-for example, an economy that consists of a single farm producingDepartment of Economics | FUUAST, Islamabad

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only one good-- the decision to save more of your income (leave some of your wheat unconsumed) is necessarily identical to the decision to invest more (save the wheat for later). And one can write down more complicated models in which economic actors and markets adjust in a way to see through the veil of production and exchange and make sure it is I + X that adjusts in response to a higher saving rate, and not Y. But it's also possible to write down models in which there are significant frictions that cause the adjusting to come in the form of lower Y in response to lower demand. The traditional such friction is the textbook Keynesian notion that wages and prices fail to adjust. In such models, responding to the lower C by increasing G may succeed in mitigating the loss in Y. Though here I must agree with Cochrane that those same models imply that if monetary policy could stimulate aggregate demand, that would achieve the same objective. I am definitely of the view that it is within the current power of the Federal Reserve to stimulate demand, and have urged the Fed to try to aim for a 3% inflation rate over the next several years. But where I may disagree with some of my colleagues is in their presumption that wage or price rigidities are the core frictions that are responsible for producing the present situation. I have in my research instead stressed technological frictions. For example, when spending on cars abruptly falls, there is a physical, technological challenge with getting the specialized labor and capital formerly employed in manufacturing cars into some alternative activity. In my mind, it is a mistake to pretend that any federal program is capable of immediately re-employing those resources into an alternative, equally productive enterprise. More fundamentally, I have suggested that our present situation is as if someone had quite successfully sabotaged the basic functionality of our financial system. Until we once again have a financial sector that can successfully allocate credit to worthy projects, we're not possibly going to be able to produce as much in the way or real goods and services, no matter what the level of aggregate demand or stimulus package might be. In terms of the textbook Keynesian models that people play with, I'm suggesting that "potential" GDP growth for 2009:Q1-- that growth rate which, if we try to exceed it by stimulating aggregate demand, weDepartment of Economics | FUUAST, Islamabad

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primarily just get more inflation-- is in fact a negative number. I do not accept the proposition that there is a level of government spending-- however large a number you choose to suggest-- that will prevent the unemployment rate from rising above 8%. But I do believe that if the government borrows a sufficiently large amount, we will have to worry in a very concrete way about what will sustain the foreign demand for U.S. assets.

The Paradox of Value:Why is it that some items that have relatively little use to society, such as diamonds, are extremely expensive, whereas others that are vital, such as water, are inexpensive. Adam Smith and other economists for a century after him struggled unsuccessfully to explain this Paradox of Value. Though Smith never unraveled the paradox of value, you can do it easily with a little help from the concept of consumers' surplus. To see how this paradox is resolved, consider again the downward-sloping demand curve discussed in the last section. As an item grows more abundant, its total use value to consumers, which is the entire area under the demand curve, rises; but its price, or its marginal value to consumers, declines. Thus, if two items in the table below are available, the total value to consumers is $9.00 (or $5.00 for the first and $4.00 for the second), but the price or value in exchange is only $4.00. If six are available, total use value rises to $15.00, but exchange value (price) drops to $.50. Smith and his early followers missed this distinction between marginal and total. Thus, diamonds are scarce and have a high marginal value but a low total value. Another pound of diamonds has valuable uses that are not currently being met. Water is tremendously abundant and thus has a high total value and a low marginal value. Another gallon of water is not particularly important. A Demand Curve Price $5.00 $4.00 $3.00 Amount People Are Willing to Buy 1 2 3


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If there is a consumers' surplus, should there not also be a producers' surplus?

The Productivity Paradox:Nobel Prize-winning economist Robert Solow has said that we see computers everywhere except in the productivity statistics. That productivity measures do not seem to show any impact from new computer and information technologies has been labeled the "productivity paradox." Productivity growth has slowed every decade since the 1960s while investments in information technology have grown dramatically. Some take this as proof that information technology doesn't affect productivity. Yet the real reason for the productivity paradox may lie in the fact that the U.S. economy is neither fully in the old mechanized economy nor yet in the new digital economy. The animating force in the old economy was the desire to mechanize goods production and handling-to automate the assembly line and the farm. And this effort has paid off handsomely, with 3 percent to 4 percent productivity growth per year in manufacturing and agriculture for the last 100 years. But now, with over 80 percent of jobs in the service sector, where productivity is growing at less than 1 percent per year, mechanization has run its course as the predominant driver of productivity. Until recently, it has proven difficult to introduce the kinds of productivity-enhancing technologies in many service industries that are used in manufacturing. But the next big motor force of productivity improvement, digitization, is only in its early stages and hasn't yet reached the critical mass necessary to significantly affect macro-economic productivity statistics. Make no mistake, application of information technology does improve productivity. Since the 1970s, productivity has grown about 1.1 percent per year for sectors that have invested heavily in computers and approximately 0.35 percent for sectors that have invested less heavily. Research by MIT economists shows that in the 1990s computers contribute significantly to firm-levelDepartment of Economics | FUUAST, Islamabad

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output and productivity. But the effects have been concentrated in a limited number of firms and industries. As we make the transition to a more digital economy, the effects are likely to be felt economy-wide. It wasn't until the early 1990s that microprocessors were fast and cheap enough to really work well in a wide range of applications. Pentium computer chips weren't introduced until 1993. The Internet didn't begin to become a mass medium until 1994. Emerging new technologies such as smart cards, voice-based computing, video telephony, "expert system" software, and the "Next Generation Internet" are just now beginning to arrive. When these and others are widely used, and when a majority of the economy and society are linked through digital networks, it will be possible to speak of a nearly complete digitization of the economy. When this happens, a large share of economic functions will be conducted through digital information technology, while paper (e.g., cash, forms, files) and routine face-to-face (e.g, clerks, order takers) transactions will become less important, leading to significantly increased efficiencies. For example, while the cost of a teller transaction at a bank is $1.07, the cost of a similar online banking transaction is one cent. As a result, the animating force for productivity and wage growth in the New Economy will be the pervasive use of digital electronic technologies to increase efficiency and productivity, particularly in the heretofore low-technology service sector. The digitization of the economy in the 21st century promises to bring the kinds of economic benefits to Americans that mechanization brought in the 20th. And this will be spurred by the "network effect"-the more Americans use these technologies (e.g., Internet, smart cards, broadband telecommunications), the more applications will be developed, and the more value they will provide for users. Once this occurs, the productivity paradox could very likely give way to a productivity and wage boom. Government can play an important role in facilitating the transition to a digital economy by adopting laws and regulations that explicitly support and advance electronic commerce.


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