Business Economics Exam Flashcards
Asset Definition
Something that can be used to create economic value. An asset can be tangible, such as a building or machinery or intangible, such as a patent or a brand name. Assets make up one side of a company’s balance-sheet; the other is liabilities.
Asymmetric Information
This occurs when one party to a transaction knows more than the other. Asymmetry can lead to market abuse, as when those with inside information of a coming takeover buy shares in the target company. It can also lead to inefficiencies. Since buyers of used cars know less than sellers, they will be inclined to regard all cars as potential “lemons”, leading to lower prices.
Austerity
A term used to describe efforts to reduce the share of public spending in GDP, particularly in the 2010s. When the economy is already weak, Keynesian economists view austerity programmes as a mistake, because they reduce demand. But free-market economists worry that, without austerity, the government’s role in the economy inexorably expands over time.
Balance of Payments
A term used to describe a country’s transactions with the rest of the world. The import and export of goods and services are captured in the current account, which also includes investment income and transfers (such as expatriate workers sending money home). The capital account captures financial transactions such as foreign direct investment or purchases of bonds and equities. These will balance in the sense that a current-account deficit (or surplus) must be offset by a capital-account surplus (or deficit).
Bank Rate
Term used in Britain to describe the official rate set by the Bank of England when it pays interest to commercial banks. By manipulating this rate, the Bank of England affects the level of rates that businesses and consumers pay to borrow money.
Behavioural Economics
School of thought that believes that the economic decisions of individuals are often driven by psychological biases rather than the rational analysis of expected returns. One example is the endowment effect. Individuals value the goods they own more highly than they would pay for the same item in an open market. For more, see this article.
Bounded Rationality
A theory which assumes that, while individuals try to act rationally, there is a limit to the amount of information they may have, or can absorb. This may make their decisions look irrational.
Budget
The annual process through which a government sets out its spending plans and tax measures. A balanced budget is when revenues are expected to match expenditure. More usually, spending outstrips revenues and the government runs a budget deficit. Creating or expanding a deficit can be a deliberate act to boost an economy.
Business Cycle
Another term to describe the way that economies tend to expand and contract over time. Various economists have tried to calculate the length of a typical cycle but these have varied widely over history. Booms tend to be much longer than busts, particularly in recent decades.
Capital
A word that serves a lot of purposes in economics. It is used to refer to the investment that an entrepreneur puts into a new project or business (hence capitalism); to any lump sum that has been saved; and more broadly to the people and institutions who invest in the world’s financial markets. It can also refer to a bank’s equity capital.
Capital Account
In international trade, the component of the balance of payments that comprises financial transactions, such as foreign direct investment. On a company’s balance-sheet, the capital account largely comprises the equity capital invested by the owners and retained profits.
Capital Controls
Regulations designed to prevent money from moving across borders. They are often used in regimes with a fixed exchange rate; by preventing money from flowing abroad, they protect the domestic currency from depreciation. Capital controls were a key component of the Bretton Woods system.
Capital Goods
Physical assets that companies use in the manufacturing process.
Capitalism
A term coined to describe the use of private capital to finance economic activity. Investors and entrepreneurs use their money to create businesses, hiring workers, renting property and buying equipment as needed. Any surplus, or profit, belongs to the entrepreneur or investors. Communism is seen as the obverse of capitalism, as all economic activity is controlled by the state.
Central Bank
The institution at the heart of a country’s financial system. It has many roles. Traditionally, it sets the level of short-term interest rates through its interactions with commercial banks. It uses rate changes to control inflation (often under an inflation targeting regime) and affect the level of economic output. More recently, central banks have attempted to affect long-term interest rates through quantitative easing. The central bank acts as a lender of last resort to protect the financial system from collapse; some central banks also act as regulators. Central banks also control foreign exchange reserves and can use these to intervene in the currency markets.
Classical Economics
The dominant school of thought in the late 18th and 19th centuries, as developed by Adam Smith and David Ricardo. It largely focused on the self-correcting nature of economies if left alone by governments and thus argued for a laissez faire approach and, thanks in part to the theory of comparative advantage, developed by Ricardo, a belief in free trade.
Coase’s Theory of the Firm
Ronald Coase, a British economist, tried to explain why companies exist in “The nature of the firm”, a paper published in 1937. His answer was that markets can be expensive and fiddly to use, especially for non-standard goods. Rather than arrange contracts for each and every transaction, entrepreneurs set up firms and employ workers to do a range of tasks. This allows them to shift employees from one area to another as they see fit. The paper, along with his work on externalities and property rights, helped to win Coase the Nobel prize for economics in 1991. For more detail, read our Schools Brief.
Commercial Banks
Banks that focus on taking in money in the form of deposits and lending it out to individuals and businesses. Such banks have a weakness in that most deposits can be withdrawn instantly whereas it can take time to recall loans. This can lead to a bank run.
Commodity
A raw material, such as oil or copper, that is usually traded in bulk. Changes in commodity prices can have significant economic effects by, for example, feeding through into consumer prices. A sharp rise in energy prices can adversely affect consumer demand; because consumers have to spend more on energy, they have less to spend elsewhere.
Comparative Advantage
This idea has been called one of the most profound insights in economics. If country A can make cars more cheaply than country B, and B can produce shirts more cheaply than A, it clearly makes sense to trade. Each has an absolute advantage in one area. But what if A is more efficient at producing everything than B? It still makes sense for them to trade, with B producing the goods where it is more competitive; if for example it is 90% as efficient as A in making shirts, and only 60% in car manufacturing, then it should specialise in making shirts and trade them for cars. Both countries will gain.
Competition
A concept at the heart of economics. Firms compete to sell the best goods and services to consumers, and to attract the best workers. The aim is to allocate resources in the most efficient manner.
Consumer Confidence
A measure, taken from a survey, of the public’s attitude towards the economic outlook. If people are worried about their jobs, or political unrest, or a pandemic, they will be less likely to spend money.
Consumption
The spending of money on goods and services by households. Consumers can either spend their income, or save it. When consumers are cautious, they spend less and save more. This can have adverse economic effects as consumption is usually the largest component of aggregate demand, ahead of public spending and investment.
Cost-benefit analysis
A process of assessing the feasibility and profitability of a public-sector project or business decision. As the name suggests, all the potential costs are compared with the potential revenues and other benefits. Although the idea is sound, the estimates are subject to a lot of uncertainty. Building projects are notorious for running over time and over budget. Quantifying non-monetary factors (eg, the value of life or the environment) is difficult—and controversial.
Curent Account
This measures all the non-financial transactions between a country and the rest of the world—chiefly its imports and exports of goods and services—and transfers such as remittances and financial aid. Since the balance of payments must balance, a current account deficit necessitates a capital account surplus (an inflow of money) to balance it.
Default
When a borrower fails to repay a debt. Widespread defaults are problematic since they can lead to a collapse in the banking system.
Deflation
Falling prices across an entire economy. Deflationary years were quite common under the gold standard when prices were stable over the long run, with some up and some down years. But deflation tends to be a problem in the modern era since it tends to be associated with falling nominal incomes. Since debt repayments are fixed in nominal terms, deflation often leads to a crisis as debtors struggle to repay their loans. Not to be confused with disinflation
Aggregate Demand
The flow of spending, across the economy, on goods and services. Demand can fall, even if people’s income and wealth are unchanged, if they decide to save, rather than spend.
Depression
A prolonged and sharp fall in economic output, associated with a high level of unemployment. The Great Depression of the 1930s is the most notable example.
Deregulation
It is a staple of conservative thought that there are too many regulations which hold back economic growth. So every few years, governments announce a policy of deregulation to cut back the red tape. It turns out, however, that public opinion often demands that governments act to ban things that are bad, or that are disliked. And so more regulations are introduced.
Derivatives
Financial assets whose value “derives” from something else, such as a stockmarket index or a commodity price. Examples include futures, options and swaps. Derivatives are often used to insure against a sudden change in the value of a key variable, such as a sharp rise in the oil price. But they can also be used to speculate on price movements which is why Warren Buffett, a veteran investor, described them as “financial weapons of mass destruction”.
Devaluation
A formal reduction in the value of a currency. This occurs when a country has a fixed exchange rate and decides to alter the rate; for example, sterling was devalued in 1949 and 1967. Depreciation, in contrast, is a day-to-day currency decline.
Developed Countries
A term used for nations where incomes per person are high, relative to the global average. These countries tended to industrialise early and are mainly based in Europe, and in former European settler colonies in North America and Australasia. Many Asian nations such as Japan and South Korea are also classified as developed.
Developing Countries
A term used to describe countries where income per person is lower than in “developed nations”. These countries will usually have industrialised later than those in Europe or America. There is no official designation of developing countries and the World Bank uses the terms “lower-middle” and “low-income”.
Diminishing Returns
Production involves certain inputs; labour, machinery, raw materials. At first, adding more inputs will improve productivity substantially; using fertilisers on crops for example or adding waiters in a restaurant to serve more diners. But eventually the marginal gains from adding more inputs will reduce; the waiters will have fewer people to serve. This is the law of diminishing returns.
Disinflation
A situation where prices across the economy are rising, but more slowly than before—eg, a fall in the annual inflation rate from 10% to 5%. Not to be confused with deflation.
Disintermediation
Cutting out the middleman, or connecting customers directly with producers. In theory, this should reduce costs. In practice, middlemen emerge in a new form; high-street travel agents may have declined in importance but many people use online versions such as Expedia or Booking.com
Dividend
A regular payment made by a company to its shareholders. The payment comes from a company’s profits. Normally companies try to increase dividends over time; when they cut the dividend, this is a sign of trouble.
Division of Labour
One of the fundamental principles of economics, described by Adam Smith in “The Wealth of Nations”. Work can be undertaken more efficiently if broken up into discrete tasks. It is also more efficient for individuals to focus on their own jobs and use their wages to purchase goods and services, rather than attempt to grow their own food or make their own electrical devices.
Duopoly
A situation where two producers control a market.
Economies of scale
The owner of a firm needs to buy machinery, rent property, and so on. Some of these costs are fixed. As the firm produces more, these costs are spread over more units; the average cost of production falls. These economies of scale mean that mass production tends to result in cheaper goods.
Efficient market hypothesis
The theory that market prices reflect all public information. Trading, or investing, on the basis of that information will thus not offer any advantage. The hypothesis explains why so many fund managers fail to beat the market, after costs, and has led to the popularity of low-cost index funds, which simply buy all the securities in the index.
Elasticity
A measure of the responsiveness of one variable to changes in another. For example, if a good rises in price by 10%, then demand could fall by less than 10% (price inelasticity) or more than 10% (price elasticity). Essential goods like food and fuel tend to be price inelastic.
Emerging Markets
A term, largely used in investment circles, for developing countries. Investors might put their capital into emerging markets because they believe the growth prospects for such countries (and thus the returns on equities) will be higher. But emerging markets tend to be risky, and can suffer from capital flight when investors become risk-averse.
Equilibrium
One of the commonest concepts in economics. At its simplest, equilibrium means a balance between the supply of and demand for a good at a market-clearing price. But economists also study equilibria across the entire economy (“general equilibrium”) or in which markets do not clear (see involuntary unemployment). Unhelpfully, equilibria need not be stable (see the commodity cycle) or socially optimal. See also Nash equilibrium. Some economists think too much attention has been given to equilibrium.
Exchange Rate
The rate at which one currency is exchanged for another. Generally, this is either a fixed exchange rate or a floating exchange rate although halfway houses (such as a crawling peg) have been attempted.
Externality
An externality is a cost or benefit to a third party as a result of someone else’s actions. Externalities lie outside the market system. Polluted air, caused by a chemical plant’s emissions, is a negative externality. A common textbook example of positive externalities involves beehives next door to an orchard: the nectar feeds the bees, which in turn pollinate the trees.
Factors of Production
The ingredients necessary for economic activity: land, labour, capital and entrepreneurship, which is needed to bring the other three elements together.
Financial Markets
The places where money is invested, in the form of short-term loans, bonds, equities and derivatives. Often anthropomorphised in the media (eg, “The markets were unhappy with the government’s budget plans”).
Fiscal Drag
A way in which inflation can boost tax revenues. In most tax systems, workers must earn a certain amount before they pay income tax, or pay it a higher rate. If those allowances are not uprated every year in line with inflation, workers end up paying more in tax in real terms when their wages rise.
Fiscal Policy
Decisions relating to the amount a government raises in taxes and spends on public services. Fiscal tightening means the government is raising taxes, or cutting spending (or both) and thus taking demand out of the economy. Fiscal easing means the government is lowering taxes, or raising spending (or both) and thus adding demand. A fiscally neutral budget would neither add nor subtract demand by, say, raising taxes and spending by the same amount.
Fixed Costs
Costs of production that do not change when output changes, for example the rent paid on a factory.
Foreign Direct Investment
When a foreign investor sets up a new operation in a country, or buys an existing business. FDI is distinct from portfolio investment, the purchase of a small stake in a business by a pension fund or sovereign wealth fund. FDI can boost productivity, by bringing new technology and upgrading the skills of domestic workers. It expanded rapidly at the end of the 20th century. But governments can be suspicious if a foreign company takes over an industry in an area (like technology or defence) which is perceived to be strategically important.
Framing
In behavioural economics, the idea that how a proposition is framed can affect the reaction of individuals. So expressing the cost of an annual subscription at $72 a year will attract fewer customers than describing it as $6 a month.
Free-market economists
Those who believe that the market is better at allocating resources than governments and that excessive regulation and high public spending tend to diminish growth in the long run. See also Austrian school, Chicago school, laissez-faire and neoliberalism.
Game Theory
A technique for analysing how people, firms and governments behave in situations they must take into account what others are likely to do and might respond to what they do. For instance, competition among firms can be analysed as a game in which they strive for long-term advantage; game theory has also been applied to nuclear deterrence (see this article).
Gig Economy
A term given to workers whose jobs are part-time or temporary, and who thus lack job security. Many work for the new wave of platform companies that have emerged in the 21st century such as Uber, a ride-sharing company, or Deliveroo, a food-delivery group. As contractors, gig-economy workers have few rights such as holiday pay or pensions, although courts have ruled that some must be treated as conventional employees.
Globalisation
The tendency for national economies to become integrated with each other, through the movement of goods and services, capital and people. The first modern wave of globalisation in the late 19th century was brought to an end by the first world war. A second stage emerged during the late 20th century as China, and the ex-communist countries of eastern Europe, joined the global trading system
Great Depression
The era in the 1930s when economic output and volumes of international trade collapsed. The depression was a challenge to classical economics which held that market forces would eventually bring the economy back to growth and eventually led to the adoption of Keynesian economics after the second world war.
Great Compression
A period from in the mid-20th century when income differentials narrowed in the face of the growth of the welfare state and high rates of marginal taxation.
Great Moderation
A period from the mid-1980s to 2007 when recessions in the developed world were rare, inflation was mostly low, interest rates steadily fell and asset markets soared. Came to a halt with the financial crisis of 2007, in what could be described as a Minsky moment.
GDP
The main measure of an economy’s size. GDP is calculated from the market value of all the finished goods and services within a country’s borders over a set period of time. It has its critics; if a vandal breaks a window, the cost of its repair is an addition to GDP even though human welfare has hardly improved. It is also hard to calculate and initial GDP figures are often revised later.
Gross National Product
GNP is the value of all goods and services produced by citizens of a country, both domestically and internationally. Income earned by foreign residents is deducted. The difference can sometimes be dramatic. Thanks to Ireland’s low corporate-tax rate, so many multinationals are based in the country that its GDP is much higher than its GNP.
Hot Money
Short-term capital that flows into a country in search of quick returns. Hot money tends to flow through the banks, leading to a lending spree that causes speculation in the property market. It also drives up the country’s currency, making life more difficult for its exports. When sentiment turns, hot money flows out, causing the currency to slump, bursting any speculative bubbles and leading to a banking crisis. Nations prefer to rely on foreign direct investment, which is more permanent.
Human Capital
The skills and brainpower of workers. Improving human capital through training and education is often seen as a way of improving productivity, although the effectiveness of such programmes can be hard to measure.
Hedging
This occurs when individuals, companies and institutions try to protect themselves against adverse market movements, such as changes in commodity prices, currencies or interest rates.
Hyperinflation
When inflation gets out of control—as happened, for example, in Germany in 1923. A loaf of bread cost 200bn marks in November 1923 and workers were paid twice a day because their wages fell in value during the day. Such high rates of inflation are fuelled by rapid expansion of the money supply.
Illiquid assets
Assets that cannot readily be tuned into cash or can only be sold quickly at a substantial discount. Illiquid assets are often the cause of financial crises when entities like banks have a mismatch between their liabilities (customers’ deposits, which can be instantly withdrawn) and their assets (long-term loans, which are illiquid). Illiquid assets will often offer a higher return because of their greater risk.
Indirect Taxation
Tax collected by an entity other than the government. Examples include sales tax (collected by retailers), levies on alcohol and tobacco, and taxes on tourism (collected by hotels and airlines). Governments can favour these as a way of increasing revenues without changing the headline rate of direct taxes like income tax.
Inequality
A subject of perennial debate among economists is how much inequality is “normal” and which changes in economic policy are likely to decrease or increase it? Inequality is often measured by the Gini coefficient but other gauges include the share of income and wealth taken by the top 1% or 10% of the population. One hypothesis, the Kuznets curve, suggested that industrialisation initially increases inequality, then decreases it. This seemed plausible during the Great Compression from 1940 to 1980 but inequality in the developed world has increased since then. This Briefing explores a debate among economists about whether inequality is increasing and this Explainer examines the relationship between inequality and economic growth.
Inflation
A general rise in the price level. This is normally calculated by comparing the price of a basket of goods (measured by a consumer price index) at different times, and can be used as a measure of the cost of living. But consumers can substitute cheaper products for more expensive ones (eg, chicken for beef) and a hedonic adjustment needs to be made to reflect the improved quality of goods. Central banks often have a mandate to control inflation and may look at a wide range of gauges to understand the underlying trend; for example, measures of “core” inflation that exclude volatile items such as food and energy.
Informal Economy
Activities that have economic value but are not registered with the country’s authorities; this may include teenagers who babysit for neighbours, hawkers who sell tourist souvenirs in big cities and ticket touts. The International Labour Organisation has estimated that 2bn people may have occasional involvement in the informal economy.
Insider Trading
The use of non-public information to gain an advantage in financial markets. It is illegal in many countries because it discriminates against other investors and can cause confidence in the probity of financial markets to fall.
Insurance
The act of protecting yourself against the financial impact of risk. Traditionally, insurance was developed to cover fire, the sinking or seizure of a ship, or the death of the family breadwinner. Insurance companies attempted to calculate the likelihood of such risks occurring and protected themselves by diversification. In the modern era, insurance is also widely used to protect, or hedge, against risks such as changes in market prices or interest rates. Sometimes the other side of the risk is assumed by speculators hoping to make a profit.
Intangible Asset
Something without physical form that can create value. Examples include patents and brand names.
Interest Rates
The return for lending money, and the cost of borrowing it. The level of interest rates depends on the time value of money, the credit risk of the borrower, the level of inflation and other factors. Short-term rates are generally set by, or are closely linked to, the decisions of the country’s central bank. Long-term interest rates, including long-term bond yields, are affected by the balance between the supply of savings and the demand for credit.
Investment
This term is used in two linked ways, both referring to putting money to work, usually for the long term. Business investment occurs when companies buy new machines, or build new factories, or conduct research and development, with the aim of increasing profits. Portfolio investment occurs when individuals or institutions put money into long-term assets such as bonds, equities and property.
Invisible Hand
A metaphor used by Adam Smith to describe how an individual may be “led by an invisible hand to promote an end which was no part of his intention”. This has been interpreted in the modern era to suggest that individuals who act in their own self-interest may end up promoting the good of society as a whole.
Involuntary unemployment
The unemployment that results when not everyone who is willing to work at the prevailing wage can find a job. Causes can include a shortfall in aggregate demand or some rigidity in the labour market. A central idea in Keynesian economics.
J-Curve
This describes the normal pattern of a country’s balance of payments after the devaluation or sharp depreciation of its currency. Initially imports are more expensive and exports are cheaper, so the balance deteriorates (the deficit widens). Eventually, foreigners buy more of the country’s exports while domestic consumers buy fewer imports and the balance improves.
Joint Supply
When the process of producing one product leads to the production of another. For example, the distillation of crude oil yields gasoline, kerosene, asphalt and more.
Keynesian Economics
John Maynard Keynes, a British academic and government official, changed the field of economics. Under classical economics, governments did little to manage the economic cycle, which they believed would right itself. But Keynes argued, in the face of the Great Depression, that a recession could dent the “animal spirits” of businesspeople and discourage consumers from spending. Governments, rather than balance their budgets, could borrow to spend money and this spending would revive demand. After 1945, many governments adopted a Keynesian approach and used fiscal policy to manage the economic cycle.
Labour
John Maynard Keynes, a British academic and government official, changed the field of economics. Under classical economics, governments did little to manage the economic cycle, which they believed would right itself. But Keynes argued, in the face of the Great Depression, that a recession could dent the “animal spirits” of businesspeople and discourage consumers from spending. Governments, rather than balance their budgets, could borrow to spend money and this spending would revive demand. After 1945, many governments adopted a Keynesian approach and used fiscal policy to manage the economic cycle.
Labour Theory of Value
The idea, mentioned by Adam Smith and championed by Karl Marx, that the value of a good depends on the labour put into it. The problem is that the value of a good is also dependent on demand; someone might put an enormous amount of effort into assembling a model of the Eiffel Tower from old pencils, but it will have little market value if no one wants to buy it.
Laissez-faire
This French term refers to the idea that governments should leave the economy alone as much as possible, and should allow free trade. Associated with the classical school of economics.
Loss Aversion
A psychological trait, discussed in behavioural economics, that dislikes the acceptance of losses. Investors may hold on to losing positions, rather than sell them, because they are unwilling to recognise their mistake. Depending on how a proposition is framed, people may act differently; a discount for paying taxes early will be less effective as an inducement for early payment than a penalty for paying late. See also framing and sunk cost syndrome.
