Paradoxes of Economics

1 Economic Paradoxes
Economic
Paradoxes
Discuss some major paradoxes in Economics
Submitted To :: Mam Zubaria Andalib
Submitted By :: Najeebullah Khan
Dated :: 23 March 2010
Semester :: 2nd
Department of Economics | FUUAST, Islamabad

Table of Contents
Topics
Page
:: Arrow’s Impossibility Theorem

……………………………………. 02
:: Bertrand Paradox
……………………………………. 03
:: Dollar Auction
……………………………………. 04
:: Easterlin Paradox
……………………………………. 09
:: Gibson's Paradox
……………………………………. 10
:: Giffen paradox
……………………………………. 16
:: Icarus paradox
……………………………………. 19
:: Jevon’s Paradox
……………………………………. 20
:: Rebound Effect (conversation)
……………………………………. 22

:: Saint Petersburg Paradox

…………………………………………. 25
:: The Paradox of Thrift

…………………………………………. 26
:: The Paradox of Value

…………………………………………. 31
:: The Productivity Paradox

…………………………………………. 32

Arrow’s 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 Vanilla Chocolate Strawberry

X 1 2 3
Y 2 3 1
Z 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 Y

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 Arrow’s Impossibility Theorem

Kenneth 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.

➢ 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 individual’s
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 Nash

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 constraints–Sometimes firms have not enough

capacity to satisfy all demand.
➢ Product differentiation–If products of different firms are
differentiated, then consumers may not switch completely to
the product with lower price.

➢ Dynamic competition–Repeated interaction or repeated price

competition can lead to the price above MC in equilibrium.
➢ Money for higher price–It 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 "extremely

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-highest

bidder can improve his position by almost a dollar by barely

topping the current high bid. Yet the predicament of the second-
highest 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 to
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 is

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 Paradox
The 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 level
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 Paradox

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 two
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.
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):

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).

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 in

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.

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 as

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 goods
There 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.

The Giffen Paradox

This 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). The
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 goods
Despite 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; which

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 inadequate

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.
Jevon’s Paradox
Jevon’s 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.”
Here’s a real-world example. Let’s magically double the average
fuel economy of America’s cars and trucks. Gasoline demand
would drop immediately by 50%. This would affect the supply-
demand 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 past—this 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 won’t 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” doesn’t negate the entirety of
energy savings due to efficiency. Studies suggest that it erases
perhaps 10%-30% of the gains.
If Jevon’s 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. Jevon’s Paradox and the Rebound Effect are
models that create snapshots in time of the operation of a highly
complex system—it 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 goods

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 effect—that
is, the increase in consumption of the same energy resource
through the same process that experiences an improvement in
efficiency—may 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 doesn’t simply go to another use of energy. One solution
—the one that I am proposing—is 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 energy—what I have called the Design Imperative. But selling
this policy combination—CAFE increases paired with gas tax
increases, for example—is 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.

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 happens

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 well-
intentioned 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 the

areas of their indulgences that are detrimental to a future that

lives up to the promise that we hope for.
History
The 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 fuel-
efficient car. Since each kilometer of travel becomes cheaper,
there will be an increase in driving speed and/or kilometer’s
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 an
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 Paradox
Introduction:
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 naïve
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 Raymond

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 th toss. The
expectation value of the gain is then
(
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
)

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 .

The paradox of thrift

The Paradox of Thrift used to say that if consumers don’t 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.

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 + X
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 producing

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, we
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
Amount People Are
Price
Willing to Buy
$5.00 1
$4.00 2
$3.00 3

$2.00 4
$1.00 5
$0.50 6
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-level
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.

Paradoxes of Economics

Hochgeladen von

Dokumentinformationen

Originalbeschreibung:

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Paradoxes of Economics

Hochgeladen von

Copyright:

Verfügbare Formate

1 Economic Paradoxes

Submitted By :: Najeebullah Khan

Dated :: 23 March 2010

Department of Economics | FUUAST, Islamabad

:: Arrow’s Impossibility Theorem

Department of Economics | FUUAST, Islamabad

:: Saint Petersburg Paradox

:: The Paradox of Thrift

:: The Paradox of Value

:: The Productivity Paradox

Department of Economics | FUUAST, Islamabad

Arrow’s Impossibility Theorem:

Ice Cream Flavour Preference

Group Vanilla Chocolate Strawberry

Department of Economics | FUUAST, Islamabad

Kenneth Arrow’s Impossibility Theorem

➢ Social preferences should be complete in that given a choice

Department of Economics | FUUAST, Islamabad

➢ Social Preferences should be independent of irrelevant

What Kenneth Arrow was able to prove mathematically is that

Department of Economics | FUUAST, Islamabad

equilibrium with positive economic profits. In game theory, the

Bertrand's result is paradoxical because if the number of firms

Some reasons the Bertrand paradox does not strictly

➢ Capacity constraints–Sometimes firms have not enough

Department of Economics | FUUAST, Islamabad

➢ Dynamic competition–Repeated interaction or repeated price

Oligopoly If the two companies can agree on a price, it is in their

SHUBIK'S DOLLAR AUCTION:

In 1950, Shubik, John Nash, Lloyd Shapley, and Melvin Hausner

Department of Economics | FUUAST, Islamabad

simple, highly amusing and instructive parlor game." A dollar bill

Department of Economics | FUUAST, Islamabad

bidder can improve his position by almost a dollar by barely

“This article sets the stage to learn about conflict escalation by

themselves, "If I can win a buck for 10 or 15 cents, I'm pretty

Department of Economics | FUUAST, Islamabad

centered on identity-preserving one's own face and, if possible,

of happiness does not vary much with national income per

Department of Economics | FUUAST, Islamabad

Due in no small measure to articles he wrote as a young

centuries showed that the yield on British consoles (government

Next, they examine the response of the model to changes in the

Department of Economics | FUUAST, Islamabad

Department of Economics | FUUAST, Islamabad

As the chart shows, Gibson's paradox continued to operate for

Department of Economics | FUUAST, Islamabad

real long-term rates. Other analysts have noted the inverse

Department of Economics | FUUAST, Islamabad

Both the heavy use of forward selling by mining companies and

Department of Economics | FUUAST, Islamabad

the author of this idea by Alfred Marshall in his book Principles of

Department of Economics | FUUAST, Islamabad

The Giffen Paradox

substitution effect (point A to point B) raises the quantity

Department of Economics | FUUAST, Islamabad

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

Department of Economics | FUUAST, Islamabad

distribution; tolerable engineering becomes shoddy design. The

Department of Economics | FUUAST, Islamabad

and services, and that these reflect energy consumption in some

Department of Economics | FUUAST, Islamabad

Rebound effect (conservation)