Edward Prescott shared the 2004 Nobel Prize in economic science with finn kydland “for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles.” Because Prescott and Kydland worked together so closely, this biography deals with their work on business cycles. Kydland’s biography deals with their work on time consistency. In 1982 Prescott and Kydland wrote a paper that fundamentally challenged the Keynesian view that changes in aggregate demand for goods and services drive the business cycle. Prescott’s and Kydland’s article was squarely in the rational-expectations tradition of robert lucas, who had demonstrated that a fundamental problem of standard Keynesian and monetarist models was that their posited relations between aggregate variables (say, consumption and income) were assumed to hold regardless of government policy. Prescott and Kydland speculated that changes in technology could generate many of the fluctuations in employment and output that had been noted in the past, and that changes in aggregate demand were not necessary to explain such fluctuations. In particular, they showed that if the elasticity of supply of labor is three, and if various “shocks” (i.e., unanticipated changes) in total factor productivity (TFP) are persistent and of the right magnitude, their model could account for 70 percent of the fluctuation in output in the postwar United States. The next step was to see if their key assumptions were reasonable. In 1986, Prescott did find that “shocks” in TFP productivity were persistent and of the right magnitude. But the posited labor supply elasticity of three seemed high. Prescott pointed out in his Nobel prize lecture, though, that this seemed implausible only because most people picture everyone working more in response to higher wages, when what really happens is that a small percentage of the population that was not working begins to work.1 In the early 2000s, to check whether such a high responsiveness of work hours to wages was reasonable, Prescott studied work hours in various countries. His reasoning was that because workers would respond to wages net of marginal tax rates, he could see how responsive hours were by studying countries with large differences in marginal tax rates. Canada, the United States, and Japan, he noted, have marginal tax rates of about 40 percent, whereas France, Germany, and Italy have marginal tax rates of about 60 percent. He showed that a labor supply elasticity of three would predict that Western Europeans would work about one-third less than North Americans and Japanese. The evidence confirmed his prediction. Moreover, his posited labor supply elasticity is consistent with the fact that hours worked per person were much higher in France and Germany in the early 1970s when marginal tax rates were substantially lower. It should be noted, though, that many economists still find an elasticity of three to be too high. In his Nobel lecture, Prescott noted some important conclusions that follow from his and Kydland’s research on business cycles: We learned that business cycle fluctuations are the optimal response to real shocks. The cost of a bad shock cannot be avoided, and policies that attempt to do so will be counterproductive, particularly if they reduce production efficiency. During the 1981 and current oil crises, I was pleased that policies were not instituted that adversely affected the economy by reducing production efficiency. This is in sharp contrast to the oil crisis in 1974 when, rather than letting the economy respond optimally to a bad shock so as to minimize its cost, policies were instituted that adversely affected production efficiency and depressed the economy much more than it would otherwise have been. Prescott concluded that the gains in well-being from eliminating business cycles are small or negative, while the gains from eliminating depressions such as the Great Depression and from creating growth “miracles” are large. He noted work by Harold Cole and Lee Ohanian that is also consistent with this encyclopedia’s article on the great depression, suggesting that Franklin Roosevelt’s cartelization of U.S. industries in the early 1930s could have been the reason for the stunning reduction in hours worked per adult over that time.2 Prescott was born in the United States and earned his B.A. in mathematics from Swarthmore College in 1962, his M.S. in operations research from Case-Western Reserve University in 1963, and his Ph.D. from Carnegie Mellon University in 1967. His main academic positions have been at the University of Pennsylvania from 1967 to 1971, Carnegie Mellon University from 1971 to 1980, the University of Minnesota from 1980 to 1998 and again from 1999 to 2003, and at Arizona State University since 2003. Selected Works   1977. (with Finn Kydland). “Rules Rather Than Discretion: The Inconsistency of Optimal Plans.” Journal of Political Economy 85: 473–490. 1982. (with Finn Kydland). “Time to Build and Aggregate Fluctuations.” Econometrica 50: 1345–1371. 1986. “Theory Ahead of Business Cycle Measurement.” Federal Reserve Bank of Minneapolis Quarterly Review 10 (Fall): 9–22. 1999. (with S. L. Parente). “Monopoly Rights: A Barrier to Riches.” American Economic Review 89, no. 5: 1216–1233. 2002. “Prosperity and Depressions.” American Economic Review 92, no. 2: 1–15. 2004. “Why Do Americans Work So Much More than Europeans.” Federal Reserve Bank of Minneapolis Quarterly Review 28, no. 1: 2–15.   Footnotes 1. See http://nobelprize.org/economics/laureates/2004/prescott-lecture.pdf.   2. Ibid.; Harold L. Cole and Lee E. Ohanian, “New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis,” Journal of Political Economy 112 (August 2004): 779–816.   (0 COMMENTS)

  The eldest son of economist James Mill, John Stuart Mill was educated according to the rigorous expectations of his Benthamite father. He was taught Greek at age three and Latin at age eight. By the time he reached young adulthood John Stuart Mill was a formidable intellectual, albeit an emotionally depressed one. After recovering from a nervous breakdown, he departed from his Benthamite teachings to shape his own view of political economy. In Principles of Political Economy, which became the leading economics textbook for forty years after it was written, Mill elaborated on the ideas of David Ricardo and Adam Smith. He helped develop the ideas of economies of scale, opportunity cost, and comparative advantage in trade. Mill was a strong believer in freedom, especially of speech and of thought. He defended freedom on two grounds. First, he argued, society’s utility would be maximized if each person was free to make his or her own choices.1 Second, Mill believed that freedom was required for each person’s development as a whole person. In his famous essay On Liberty, Mill enunciated the principle that “the sole end for which mankind are warranted, individually or collectively, in interfering with the liberty of action of any of their number, is self-protection.” He wrote that we should be “without impediment from our fellow-creatures, so long as what we do does not harm them, even though they should think our conduct foolish, perverse, or wrong.” Surprisingly, though, Mill was not a consistent advocate of laissez-faire. His biographer, Alan Ryan, conjectures that Mill did not think of contract and property rights as being part of freedom. Mill favored inheritance taxation, trade protectionism, and regulation of employees’ hours of work. Interestingly, although Mill favored mandatory education, he did not advocate mandatory schooling. Instead, he advocated a voucher system for schools and a state system of exams to ensure that people had reached a minimum level of learning. Although Mill advocated universal suffrage, he suggested that the better-educated voters be given more votes. He emphatically defended this proposal from the charge that it was intended to let the middle class dominate. He argued that it would protect against class legislation and that anyone who was educated, including poor people, would have more votes. Mill spent most of his working life with the East India Company. He joined it at age sixteen and worked there for thirty-eight years. He had little effect on policy, but his experience did affect his views on self-government. Selected Works   1844. Essays on Some Unsettled Questions of Political Economy. 2d ed., 1874. Available online at: http://www.econlib.org/library/Mill/mlUQP.html 1848. Principles of Political Economy, with Some of Their Applications to Social Philosophy. 2 vols. London: John W. Parker. Available online at: http://www.econlib.org/library/Mill/mlP.html 1859. On Liberty. London: J. W. Parker. 4th ed., 1869. Available online at: http://www.econlib.org/library/Mill/mlLbty.html 1861. Considerations on Representative Government. London: Parker, Son, and Bourn. 1869. The Subjection of Women. London: Longmans, Green, Reader and Dyer, available online at: http://etext.library.adelaide.edu.au/m/mill/john_stuart/m645s/.   Footnotes 1. The “her” is particularly appropriate. Mill strongly believed, possibly due to the influence of his wife, Harriet Taylor, whom he idolized, that women were the equals of men. His book The Subjection of Women attacked the contemporary view of women’s inherent inferiority.   (0 COMMENTS)

  Pareto is best known for two concepts that are named after him. The first and most familiar is the concept of Pareto optimality. A Pareto-optimal allocation of resources is achieved when it is not possible to make anyone better off without making someone else worse off. The second is Pareto’s law of income distribution. This law, which Pareto derived from British data on income, showed a linear relationship between each income level and the number of people who received more than that income. Pareto found similar results for Prussia, Saxony, Paris, and some Italian cities. Although Pareto thought his law should be “provisionally accepted as universal,” he realized that exceptions were possible; as it turns out, many have been found. Pareto is also known for showing that the assumption that the utility of goods can actually be measured is not necessary to derive any of the standard results in consumer theory. Simply by being able to rank bundles of goods, consumers would act as economists had said they would. In his later years Pareto shifted from economics to sociology in response to his own change in beliefs about how humans act. He came to believe that men act nonlogically, “but they make believe they are acting logically.” Born in Paris to Italian exiles, Pareto moved to Italy to complete his education in mathematics and literature. After graduating from the Polytechnic Institute in Turin in 1869, he applied his prodigious mathematical abilities as an engineer for the railroads. Throughout his life Pareto was an active critic of the Italian government’s economic policies. He published pamphlets and articles denouncing protectionism and militarism, which he viewed as the two greatest enemies of liberty. Although he was keenly informed on economic policy and frequently debated it, Pareto did not study economics seriously until he was forty-two. In 1893 he succeeded his mentor, Leon Walras, as chair of economics at the University of Lausanne. His principal publications are Cours d’économie politique (1896–1897), Pareto’s first book, which he wrote at age forty-nine; and Manual of Political Economy (1906). A self-described pacifist who disdained honors, Pareto was nominated in 1923 to a senate seat in Mussolini’s fledgling government but refused to become a ratified member. He died that year and was buried without fanfare in a small cemetery in Celigny. Selected Works   1897. “The New Theories of Economics.” Journal of Political Economy 5: 485–502.   (0 COMMENTS)

  Robert Merton, along with Myron Scholes, received the 1997 Nobel Prize in economics “for a new method to determine the value of derivatives” (see the biography for myron scholes for a discussion of the significance of this contribution to knowledge). In 1969, as one of his steps toward developing a formula for valuing options, Merton had written a paper with Paul Samuelson on the value of warrants. Merton, who was himself working on the options pricing issue in competition with his friend Myron Scholes, had planned to attend Fischer Black’s and Scholes’s presentation on option pricing at a July 1970 conference on capital markets sponsored by Wells Fargo Bank. But he overslept and missed the session. Maybe that was just as well, because he proceeded on his own and developed an alternate proof, published in 1973, of the option-pricing model. In his 1973 article, Merton generalized the Black-Scholes result by changing various assumptions on interest rates, dividend payments, and other variables. In his Nobel lecture, Merton pointed out the wide applicability of the options-pricing framework. It can be, and has been, used to estimate the value of many things that can be seen as options—deposit insurance (see Financial Regulation), pension insurance, guarantees of student loans, rights to drill offshore oil, development of pharmaceutical products, and others. Merton also extended william sharpe’s early work on the capital asset pricing model by developing an intertemporal capital asset pricing model. Merton’s academic interests were fueled strongly by his other interests. While a master’s student at Cal Tech, he actively traded stocks, convertible bonds, warrants, and over-the-counter options at a local brokerage house before going off to his morning classes. These activities led him to a discovery that put him ahead of his later, more academic colleagues: the “institutional rigidities” that economists often claim are inviolate are more flexible in a free market. (Specifically, he found banks that would lend him up to 85 percent of the value of some of his convertible bonds rather than the usual 50 percent.) Also, his trading in warrants led him to work on warrant pricing with Samuelson. And, finally, a section of his 1973 paper that helped win him the Nobel Prize was on pricing of a particular kind of call option that he had become aware of on a consulting job in Asia. Merton’s academic interests also fueled his other interests. In response to the large stock-market decline of 1973–1974, Merton and Myron Scholes started a mutual fund that used options to protect investors from losses. In 1993, he helped start Long Term Capital Management. Merton earned his B.S. in engineering mathematics at Columbia University, his M.S. in applied mathematics at the California Institute of Technology, and his Ph.D. in economics at MIT. From 1970 to 1988, he was a professor at MIT, and from 1988 to the present he has been a professor at Harvard Business School. He is the son of sociologist Robert Merton (see unintended consequences). Selected Works   1969 (with Paul A. Samuelson). “A Complete Model of Warrant Pricing That Maximizes Utility.” Industrial Management Review 10 (1969) pp. 17–46. (Chapter 7 in Continuous-Time Finance.) 1973. “Theory of Rational Option Pricing.” Bell Journal of Economics and Management Science 4 (Spring 1973): pp. 141–183. (Chapter 8 in Continuous-Time Finance.) 1977. “An Analytic Derivation of the Cost of Loan Guarantees and Deposit Insurance: An Application of Modern Option Pricing Theory.” Journal of Banking and Finance 1: pp. 3–11. 1985. “Implicit Labor Contracts Viewed as Options: A Discussion of ‘Insurance Aspects of Pensions.’” In D. A. Wise, ed., Pensions, Labor, and Individual Choice. Chicago: University of Chicago Press. 1992. Continuous-Time Finance. Rev. ed. London: Basil Blackwell. 1993 (with Zvi Bodie). “Pension Benefit Guarantees in the United States: A Functional Analysis.” In R. Schmitt, ed., The Future of Pensions in the United States. Pension Research Council. Philadelphia: University of Pennsylvania Press.   (0 COMMENTS)

  Swedish economist Bertil Ohlin received the Nobel Prize in 1977, along with James Meade, for his “pathbreaking contribution to the theory of international trade and international capital movements.” Ohlin’s prize was based on his book Interregional and International Trade, published in 1933. With a 1919 article by his former teacher Eli Heckscher as his starting point, Ohlin showed that both interregional and international trade occur because goods can move more easily than the labor, capital, and land that produce them. Therefore, a country with a relatively abundant factor of production should export goods that intensively use that abundant factor, and should import those that intensively use the factor that is relatively scarce. Much later, economists showed that this would be true only for a world with just two goods. (See wassily leontief.) In publications beginning in 1927 and ending in 1934, Ohlin also laid out theoretical reasoning and policy conclusions very similar to those in John Maynard Keynes’s 1936 classic, The General Theory of Employment, Interest and Money. Unfortunately, Ohlin’s contributions were published in Swedish and were never translated, and when he tried to get credit for them in a 1937 article in a British journal, the Keynesians did not believe him. Much later, though, his originality in this area was recognized. Ohlin earned his Ph.D. at Stockholm University in 1924. He taught at the University of Copenhagen from 1925 to 1930 and at the Stockholm School of Business Administration from 1930 to 1965. Ohlin was also a member of the Swedish Parliament from 1938 to 1970 and the leader of the Liberal Party from 1944 to 1967. Selected Works   1929. “Transfer Difficulties, Real and Imagined.” Economic Journal 37 (March). Reprinted in H. S. Ellis and L. Metzler, eds., Readings in the Theory of International Trade. Philadelphia: Blakiston, 1949. 1933. Interregional and International Trade. Cambridge: Harvard University Press. 1937. “Some Notes on the Stockholm Theory of Saving and Investment.” 2 parts. Economic Journal 47 (March): 53–69; (June): 221–240. Reprinted in G. Haberler, ed., Readings in Business Cycle Theory. Philadelphia: Blakiston, 1951.   (0 COMMENTS)

  Gunnar Myrdal, a Swedish economist, made an international reputation with his 1944 book, An American Dilemma, today considered a classic in sociology. The book was the end product of a study that the Carnegie Corporation had commissioned about what was then called the “Negro question.” Myrdal’s damning critique of the “separate but equal” doctrine played a large role in the Supreme Court’s 1954 ruling on Brown v. Board of Education of Topeka, which outlawed racial segregation in public schools. The book also contains solid economic reasoning. Myrdal, an egalitarian sympathetic to socialism, showed that Franklin Roosevelt’s economic policies had badly hurt blacks. Myrdal singled out two New Deal policies in particular: restrictions on agricultural output and the minimum wage. Myrdal opened a chapter titled “New Blows to Southern Agriculture During the Thirties: Trends and Policies” with the following: Of all the calamities that have struck the rural Negro people in the South in recent decades—soil erosion, the infiltration of white tenants into plantation areas, the ravages of the boll weevil, the southwestern shift in cotton cultivation—none has had such grave consequences, or threatens to have such lasting effect, as the combination of world agricultural trends and federal agricultural policies initiated during the thirties. (p. 254) In an attempt to stabilize farm income, wrote Myrdal, the U.S. government restricted the production of cotton, putting hundreds of thousands of mostly black sharecroppers out of work: It seems, therefore, that the agricultural policies, and particularly the Agricultural Adjustment program (A.A.A.), which was instituted in May, 1933, was the factor directly responsible for the drastic curtailment in number of Negro and white sharecroppers and Negro cash and share tenants. (Ibid.; italics in original) Myrdal also described how minimum wage legislation, ostensibly to improve working conditions, actually worsened blacks’ economic standing: During the ’thirties the danger of being a marginal worker became increased by social legislation intended to improve conditions on the labor market. The dilemma, as viewed from the Negro angle is this: on the one hand, Negroes constitute a disproportionately large number of the workers in the nation who work under imperfect safety rules, in unclean and unhealthy shops, for long hours, and for sweatshop wages; on the other hand, it has largely been the availability of such jobs which has given Negroes any employment at all. As exploitative working conditions are gradually being abolished, this, of course, must benefit Negro workers most, as they have been exploited most—but only if they are allowed to keep their employment. But it has mainly been their willingness to accept low labor standards which has been their protection. When government steps in to regulate labor conditions and to enforce minimum standards, it takes away nearly all that is left of the old labor monopoly in the “Negro jobs.” As low wages and sub-standard labor conditions are most prevalent in the South, this danger is mainly restricted to Negro labor in that region. When the jobs are made better, the employer becomes less eager to hire Negroes, and white workers become more eager to take the jobs from the Negroes. (p. 397) Myrdal’s analysis predated george stigler’s classic 1946 article detailing the harmful effects of the minimum wage law. It supports the view that there truly is consensus among economists of various political persuasions when ideological loyalties are laid aside and clear economic analysis is undertaken. Myrdal’s other major classic is Asian Drama: An Inquiry into the Poverty of Nations. Its major message is that the only way to bring about rapid development in Southeast Asia is to control population, have a wider distribution of agricultural land, and invest in health care and Education. In 1974 Myrdal and Friedrich Hayek shared the Nobel Prize in economics “for their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the interdependence of economic, social, and institutional phenomena.” Besides being an economist and a sociologist, Myrdal was also a politician. He was twice elected to Sweden’s Parliament as a senator (1934–1936, 1942–1946), was minister for trade and commerce (1945–1947), and served as the executive secretary for the United Nations Economic Commission for Europe (1947–1957). Selected Works   1944. An American Dilemma: The Negro Problem and Modern Democracy. Reprint. New York: McGraw-Hill, 1964. 1968. Asian Drama: An Inquiry into the Poverty of Nations. New York: Twentieth Century Fund.   (0 COMMENTS)

Arthur Okun is known mainly for Okun’s Law, which describes a linear relation between percentage-point changes in unemployment and percentage changes in gross national product. It states that for every percentage point that the unemployment rate falls, real GNP rises by 3 percent. Okun’s Law is based on data from the period between World War II and 1960, and he cautioned that the law is good only within the range of unemployment rates—3 to 7.5 percent—experienced in that time period. Like many economic laws, Okun’s is an observation of an empirical (real-world) regularity that is not based on any strong economic reasoning. Nevertheless, it has held up well, within the appropriate range of unemployment rates, since Okun discovered it. Yale’s james tobin, who was Okun’s colleague both at Yale and on President John F. Kennedy’s Council of Economic Advisers (CEA), called Okun’s Law “one of the most reliable empirical regularities of macroeconomics.” Okun discovered the law while he was a senior economist with Kennedy’s CEA. The CEA wanted to convince Kennedy that the economy-wide gains from lowering unemployment from 7 to 4 percent were greater than previously imagined. Okun’s Law was a major part of the empirical justification for Kennedy’s tax cuts. At the end of President Lyndon B. Johnson’s administration, Okun was chairman of the CEA. Okun believed that wealth transfers by taxation from the relatively rich to the relatively poor are an appropriate policy for government. But he recognized the loss of efficiency inherent in the distribution process. In Equality and Efficiency, the Big Tradeoff Okun introduced the metaphor of the leaky bucket, which has become famous among economists: “The money must be carried from the rich to the poor in a leaky bucket. Some of it will simply disappear in transit, so the poor will not receive all the money that is taken from the rich” (p. 91). Okun attributed these losses to the administrative costs of taxing and transferring, and to incentive effects. The poor who are receiving welfare or other transfer payments have less incentive to work because their transfer payments are reduced as they make more money. The rich have less incentive to work because high marginal tax rates take a large fraction of their additional income (top tax rates were between 50 and 70 percent at the time he was writing). The relatively rich also have more of an incentive to spend on tax-deductible items and on tax shelters as a way of avoiding taxes. “High tax rates,” wrote Okun, “are followed by attempts of ingenious men to beat them as surely as snow is followed by little boys on sleds.” For these insights, Okun can be considered one of the original supply siders (see supply-side economics). Selected Works   1970. The Political Economy of Prosperity. Washington, D.C.: Brookings Institution. 1975. Equality and Efficiency, the Big Tradeoff. Washington, D.C.: Brookings Institution. 1983. Economics for Policymaking: Selected Essays of Arthur M. Okun. Edited by Joseph A. Pechman. Cambridge: MIT Press.   (0 COMMENTS)

Robert Mundell was awarded the 1999 Nobel Prize in economics “for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.” In much of the work on macroeconomics before Mundell’s work of the early 1960s, economists assumed—implicitly or explicitly—a closed economy, that is, an economy with no trade with other countries and no capital movements between countries. This was never a good assumption, and it became an even worse assumption as trade and capital flows expanded relative to various countries’ gross national products. Possibly because he grew up in Canada (even then America’s major trading partner) and did his undergraduate education at the University of British Columbia, Mundell was more aware than most American macroeconomists of the importance of international trade and international capital flows. The vast majority of Mundell’s work over his lifetime has been on some aspect of trade or capital flows. One of the first major questions Mundell addressed was how governments should stabilize economies—keeping them growing while avoiding high inflation—in a world of trade and capital flows. He showed that when the exchange rate is fixed, as it was throughout the 1950s and 1960s between all major trading countries, stabilizing the economy with monetary policy is futile. The reason is that a government that fixes its exchange rate against other currencies must be prepared to provide whatever amount of money is demanded at this fixed price. This means that monetary policy is essentially passive. A government that wants to stabilize the economy must thus use fiscal policy—that is, changes in taxes or government spending. Mundell also considered the case of floating exchange rates. At the time this was regarded as a theoretical curiosum because, as mentioned, all major trading countries had fixed their exchange rates with each other. But Mundell’s native Canada had floated its dollar from 1950 to 1962. Possibly for that reason, and possibly because Mundell had a sense of the future, he thought it worthwhile to consider the floating exchange rate case. (Major countries’ exchange rates have floated since the early 1970s.) Mundell showed that if the country has a floating exchange rate, then the government has much more ability to use monetary policy. On the other hand, fiscal policy now becomes impotent. If the government wants to increase aggregate demand by increasing government spending, for example, then, if it does not change monetary policy, the increase in the exchange rate due to the increase in aggregate demand reduces exports. Thus, all fiscal policy can do is change the composition of aggregate demand, not its level. The model Mundell used in 1960 to show this is now called the Mundell-Fleming model, after Mundell and Marcus Fleming,1 who developed a similar, though less extensive, model around the same time. Mundell also did some early work in what is now known as “the monetary approach to the balance of payments,” which was actually laid out in rudimentary fashion by eighteenth-century economist David Hume. Mundell showed how, with fixed exchange rates, an economy will adjust as balance-of-payments surpluses or deficits cause changes in the money supply. Assume, for example, that capital moves across borders slowly. Then assume that the Federal Reserve increases the domestic money supply to reduce interest rates. With interest rates lower, domestic spending increases and imports increase. The resulting balance-of-payments deficit will cause money to leave the country, which in turn will cause domestic demand to fall, bringing the balance of payments back toward equilibrium. The net long-term result is a higher price level and no real economic effects. Mundell also considered which government policy “tool” should be used on which policy “target.” He showed, contrary to what many economists before him had believed, that when exchange rates are fixed, monetary policy should be used to ensure equilibrium in the balance of payments (also known as the “external balance”), and fiscal policy should be used to adjust aggregate demand to attain full employment (“internal balance”). In thinking through all these issues of assigning tools to targets and of fixed versus floating exchange rates, Mundell pointed out the so-called incompatible trinity: (i) unregulated mobility of capital, (ii) a particular fixed exchange rate, and (iii) a particular price level. Mundell showed that, at most, only two of these can be achieved. This has become standard thinking among economists and policymakers. It means that a government that wants, say, to keep inflation low and allow free capital movement must settle for a floating exchange rate, which is what most governments now do most of the time. Mundell’s other big idea in the 1960s involves optimum currency areas. Rather than take it as given that each country should have its own currency, Mundell noted that if states within countries all shared the same currency, more than one country could do the same. Again, this seemed like a theoretical curiosum at the time (1961), but as the history of the euro has shown, it is anything but. Mundell cited the reduction in transactions costs for trade across borders and the related ease of knowing various prices as the major advantages of a currency area (see monetary union). The major disadvantage, he noted, is the difficulty of maintaining full employment when one country suffers from some event that other members of the currency area do not suffer from. What if, for example, Canada and the United States are in a currency area, but the demand for softwood lumber suddenly declines? This would hurt Canada proportionally much more than the United States and, with a floating exchange rate, Canada could let the value of the Canadian dollar fall and save somewhat on the need for Canadian lumber workers’ wages to fall. But with Canada and the United States in the same currency area—the ultimate in fixed exchange rates—the Canadian dollar cannot fall relative to the U.S. dollar because they are the same dollar. One immediate implication, noted Mundell, is that high labor mobility (i.e., allowing workers to move from one country in the currency area to another country in the area) is key so that workers can have an easier time finding jobs. Of course, the euro is now the world’s largest currency area, and, in line with Mundell’s thinking, many EU supporters are advocating that workers be free to move from one EU country to another. Opposition to such worker mobility, though, was strong among French voters who voted down the EU constitution in 2005. The issue of mobility of labor also dovetails with another issue to which Mundell contributed. He showed that if labor and capital are mobile across national borders, then even if there are trade barriers, labor and capital can shift to equalize prices of tradable goods. This means that trade barriers lead to more movement of labor and capital. Mundell was and is an ally of various supply siders who not only want to use fiscal policy to keep the economy growing—which is consistent with his original 1960s insight—but also want a particular fiscal policy: namely, keeping marginal tax rates low or cutting them to a low level. In his Nobel address,2 Mundell highlighted the fact that inflation during the late 1960s and the 1970s had pushed people into higher and higher tax brackets, even when their real income had not increased. In the early 1970s, Mundell advocated that Canada’s tax brackets be indexed to inflation so that inflation alone would not increase people’s marginal tax rates, and the Canadian government adopted this policy. In 1981, President Ronald Reagan and Congress also adopted indexing, effective in 1985. Mundell earned his Ph.D. from MIT in 1956. His early positions were at Stanford University, the Johns Hopkins Bologna Center of Advanced International Studies, and the International Monetary Fund. From 1966 to 1971, he was a professor of economics at the University of Chicago. He has been on the faculty of Columbia University since 1974. Selected Works   1960. “The Monetary Dynamics of International Adjustment Under Fixed and Flexible Exchange Rates.” Quarterly Journal of Economics 84, no. 2: 227–257. 1961. “A Theory of Optimum Currency Areas.” American Economic Review 51: 657–665. 1962. “The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability.” IMF Staff Papers 9, no. 1: 70–79. 1963. “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates.” Canadian Journal of Economics 29: 475–485. 1968. International Economics. New York: Macmillan.   Footnotes 1. J. Marcus Fleming, “Domestic Financial Policies Under Fixed and Under Floating Exchange Rates,” IMF Staff Papers 9 (1962): 369–379.   2. See http://nobelprize.org/economics/laureates/1999/mundell-lecture.pdf.   (0 COMMENTS)

Arthur C. Pigou, a British economist, is best known for his work in welfare economics. In his book The Economics of Welfare Pigou developed alfred marshall’s concept of externalities, costs imposed or benefits conferred on others that are not taken into account by the person taking the action. He argued that the existence of externalities is sufficient justification for government intervention. If someone is creating a negative externality, such as pollution, for instance, he is engaging in too much of the activity that generated the externality. Pigou advocated a tax on such activities to discourage them. Someone creating a positive externality—say, by educating himself and making himself more interesting or useful to other people—might not invest enough in education because he would not perceive the value to himself as being as great as the value to society. Pigou advocated subsidies for activities that created such positive externalities. These are now called Pigovian taxes and subsidies, respectively. Pigou’s analysis was accepted until 1960, when ronald coase showed that taxes and subsidies are not necessary if the people affected by the externality and the people creating it can easily get together and bargain. Adding to the skepticism about Pigou’s conclusions is the new view, introduced by public choice economists, that governments fail just as markets do. Nevertheless, most economists still advocate Pigovian taxes as a much more efficient way of dealing with pollution than government-imposed standards. Pigou studied economics at Cambridge and lectured at Cambridge until World War II. In 1908, at the age of thirty, he was appointed to Marshall’s chair in economics. Pigou taught straight Marshallian economics, often insisting to his students that “it’s all in Marshall.”1 Pigou was throughout his life an avid free trader. Selected Works   1912. Wealth and Welfare. London: Macmillan. 1914. Unemployment. New York: Holt. 1921. The Political Economy of War. New York: Macmillan. 1932. The Economics of Welfare. 4th ed. London: Macmillan. Available online at: http://www.econlib.org/library/NPDBooks/Pigou/pgEW.html 1933. The Theory of Unemployment. London: Macmillan. 1950. Keynes’s General Theory: A Retrospective View. London: Macmillan.   Footnotes 1. See Alfred Marshall, Principles of Economics (reprint, Amherst, N.Y.: Prometheus Books, 1997).   (0 COMMENTS)

  John Nash, john harsanyi, and reinhard selten shared the 1994 Nobel Prize in economics “for their pioneering analysis of equilibria in the theory of non-cooperative games.” In other words, Nash received the Nobel prize for his work in game theory. Except for one course in economics that he took at Carnegie Institute of Technology (now Carnegie Mellon) as an undergraduate in the late 1940s, Nash has no formal training in economics. He earned his Ph.D. in mathematics at Princeton University in 1950. The Nobel Prize he received forty-four years later was mainly for the contributions he made to game theory in his 1950 Ph.D. dissertation. In this work, Nash introduced the distinction between cooperative and noncooperative games. In cooperative games, players can make enforceable agreements with other players. In noncooperative games, enforceable agreements are impossible; any cooperation that occurs is self-enforced. That is, for cooperation to occur, it must be in each player’s interest to cooperate. Nash’s major contribution is the concept of equilibrium for noncooperative games, which later came to be called a Nash equilibrium. A Nash equilibrium is a situation in which no player, taking the other players’ strategies as given, can improve his position by choosing an alternative strategy. Nash proved that, for a very broad class of games of any number of players, at least one equilibrium exists as long as mixed strategies are allowed. A mixed strategy is one in which the player does not take one action with certainty but, instead, has a range of actions he might take, each with a positive probability. A simple example of a Nash equilibrium is the prisoners’ dilemma. Another example is the location problem. Imagine that Budweiser and Miller are trying to decide where to place their beer stands on a beach that is perfectly straight. Assume also that sunbathers are located an equal distance from each other and that they want to minimize the distance they walk to get a beer. Where, then, should Bud locate if Miller has not yet chosen its location? If Bud locates one-quarter of the way along the beach, then Miller can locate next to Bud and have three-quarters of the market. Bud knows this and thus concludes that the best location is right in the middle of the beach. Miller locates just slightly to one side or the other. Neither Bud nor Miller can improve its position by choosing an alternate location. This is a Nash equilibrium. Nash’s other major contribution is his reasoning about “the bargaining problem.” Before Nash, economists thought that the share of the gains each of two parties to a bargain received was always indeterminate. But Nash got further by asking a different question. Instead of defining a solution directly, Nash asked what conditions the division of gains would have to satisfy. He suggested four conditions and showed mathematically that if these conditions held, a unique solution existed that maximized the product of the participants’ utilities. The bottom line is that how gains are divided depends on how much the deal is worth to each participant and what alternatives each participant has. As readers of Sylvia Nasar’s biography of Nash, A Beautiful Mind, know, Nash contended with schizophrenia from the late 1950s to the mid-1980s. As Nash put it in his Nobel autobiography, “I later spent time of the order of five to eight months in hospitals in New Jersey, always on an involuntary basis and always attempting a legal argument for release.” His productivity suffered accordingly. But he emerged from his mental illness in the late 1980s. In his Nobel lecture, Nash noted his own progress out of mental illness: Then gradually I began to intellectually reject some of the delusionally influenced lines of thinking which had been characteristic of my orientation. This began, most recognizably, with the rejection of politically-oriented thinking as essentially a hopeless waste of intellectual effort.1 Selected Works   1950. “The Bargaining Problem.” Econometrica 18: 155–162. 1950. “Equilibrium Points in N-Person Games.” Proceedings of the National Academy of Sciences 36: 48–49. 1950. “Non-cooperative Games.” Ph.D. diss., Mathematics Department, Princeton University. 1951. “Non-cooperative Games.” Annals of Mathematics 54: 286–295. 1953. “Two-Person Cooperative Games.” Econometrica 21: 128–140.   Footnotes 1. See http://nobelprize.org/economics/laureates/1994/nashautobio.html.   (0 COMMENTS)