The global economic crisis has shattered two articles of faith in standard economic theory that human beings usually make rational decisions and that the markets invisible hand serves as a trustworthy corrective to imbalance.

Do we need to replace these and other assumptions and adopt a new approach?Provide some examples from the market place. Refer to the case study on the “End of Rational Economics”.

Are economic models falsifiable?The sharp distinction between falsifiable economic models and those that are not is by no means a universally accepted one. Indeed one can argue that the ceteris paribus (all else being equal) qualification that accompanies any claim in economics is nothing more than an all-purpose escape clause (See N. de Marchi and M. Blaug.) The all else being equal claim allows holding all variables constant except the few that the model is attempting to reason about. This allows the separation and clarification of the specific relationship. However, in reality all else is never equal, so economic models are guaranteed to not be perfect. The goal of the model is that the isolated and simplified relationship has some predictive power that can be tested, mainly that it is a theory capable of being applied to reality. To qualify as a theory, a model should arguably answer three questions: Theory of what?, Why should we care?, What merit is in your explanation? If the model fails to do so, it is probably too detached from reality and meaningful societal issues to qualify as theory. Research conducted according to this three-question test finds that in the 2004 edition of the Journal of Economic Theory, only 12% of the articles satisfy the three requirements.” [11] Ignoring the fact that the ceteris paribus assumption is being made is another big failure often made when a model is applied. At the minimum an attempt must be made to look at the various factors that may not be equal and take those into account.

In 2008, a massive earthquake reduced the financial world to rubble. Standing in the smoke and ash, Alan Greenspan, the former chairman of the U.S. Federal Reserve once hailed as “the greatest banker who ever lived,” confessed to Congress that he was “shocked” that the markets did not operate according to his lifelong expectations. He had “made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders.” (Dan Ariely, 2009)

According to ariely “We are now paying a terrible price for our unblinking faith in the power of the invisible hand. We’re painfully blinking awake to the falsity of standard

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economic theory—that human beings are capable of always making rational decisions and that markets and institutions, in the aggregate, are healthily self-regulating. If assumptions about the way things are supposed to work have failed us in the hyperrational world of Wall Street, what damage have they done in other institutions and organizations that are also made up of fallible, less-than-logical people? And where do corporate managers, schooled in rational assumptions but who run messy, often unpredictable businesses, go from here?”

Ariely (2009) mentioned that “Companies need to armed itself with the knowledge that human beings are motivated by cognitive biases of which they are largely unaware (a true invisible hand if there ever was one), businesses can start to better defend against foolishness and waste”.

The emerging field of behavioral economics offers a radically different view of how people and organizations operate. Ariely’s in his articles examine a small set of long-held business assumptions through a behavioral economics lens. In doing so he hope to show not only that companies can do a better job of making their products and services more effective, their customers happier, and their employees more productive but that they can also avoid catastrophic mistakes.

“Behavioral economics eschews the broad tenets of standard economics, long taught as guiding principles in business schools, and examines the real decisions people make—how much to spend on a cup of coffee, whether or not to save for retirement, deciding whether to cheat and by how much, whether to make healthy choices in diet or sex, and so on. For example, in one study where people were offered a choice of a fancy Lindt truffle for 15 cents and a Hershey’s kiss for a penny, a large majority (73%) chose the truffle. But when we offered the same chocolates for one penny less each—the truffle for 14 cents and the kiss for nothing—only 31% of participants selected it. The word “free,” we discovered, is an immensely strong lure, one that can even turn us away from a better deal and toward the “free” one.(Ariely, 2009).

For the past few decades, behavioral economics has been largely considered a fringe discipline. Though practitioners of traditional economics reluctantly admitted that people may behave irrationally from time to time, they have tended to stick to their theoretical guns. They have argued that experiments conducted by behavioral economists and psychologists, albeit interesting, do not undercut rational models because they are

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carried out under controlled conditions and without the most important regulator of rational behavior: the large, competitive environment of the market.

Then, in October 2008, Greenspan made his confession. Belief in the ultimate rationality of humans, organizations, and markets crumbled, and the attendant dangers to business and public policy were fully exposed. (Ariely, 2009).

With the confession from Greenspan, it could be said that economic theory need to be re-access to cope with the current economic stage. The economics theory that once hold truth are nowadays questionable. Therefore the new approach as suggested by the behavioral economic theory is a good way to view the current economic situations.

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Q7. Although the global market system generates enormous benefit to the world population,

the benefits of growth will not be evenly spread across countries or within countries, and

collateral damage to the environment will be significant.

Scarce resources will be consumed, and the world’s climate will continue to change.

How should we view these challenges?

Can they be dealt with through standard operating procedures, or

do they represent potentially major threats to continued global growth or even to market capitalism itself?

A longside the issue of climate change, ‘globalization’ and ‘poverty’ epitomize two of the most pressing international development issues today. Despite the enormous potential of globalization in accelerating economic growth and development through greater integration into the world economy, the spread and transfer of technology, and the transmission of knowledge, its impact on poverty reduction has been uneven and even marginal in some regions such as in much of sub-Saharan Africa (SSA). Both the prevalence and depth of poverty in many parts of the developing world remain unacceptably high.

The fear that the poor have been bypassed, or actually hurt, by globalization was highlighted by the findings from a number of recent studies, which point towards a continuing prevalence of high inequality in world income distribution and limited if not a lack of income convergence among participating national economies and across regions (Nissanke&Thorbecke, 2006). The regional trends in income inequality measured by the Gini coefficient show that within country inequality has increased markedly since the early 1980s in all regions except in the group consisting of the advanced high income, the Organisation for Economic Co-operation and Development (OECD) countries.(Milanovic, 2005a, 2005b; Birdsall, 2006). Within high income countries too, there are many that experienced growing inequality.

Despite some improvements in aggregate measures of integration intensity, SSA presents a clear example in support of the argument that the shift to an open policy regime alone is not sufficient to bring about economic growth and consequent poverty reduction(Fosu&Mold, 2008).After two decades of reforms dominated by liberalization, privatization and deregulation, the economies of SSA have not yet been able to escape from the ‘growth tragedy’ syndrome—the term popularly used in characterizing the region’s dismal economic performance in the comparative growth literature.

The failure of SSA economies to diversify and undergo structural transformation, and hence, to benefit from the technology driven, highly dynamic aspects of the on-going globalization process

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has led to major drawbacks in terms of low economic growth and persistent poverty. The incidence and depth of poverty has deepened in the region. According to estimates provided by Chen and Ravallion (2004), the number of poor below the US$1 a day international poverty line almost doubled in SSA from about 164 million in 1981 to 313 million in 2001. The poverty incidence (the headcount ratio) in SSA reached 46 per cent in 2001—the highest of the major regions in the world. Ali and Thorbecke (2000) argue that poverty in SSA is both most prevalent and severe in rural areas.

Clearly, a strategic position towards globalization cannot be equated with a mere adoption of liberal trade and investment regimes, or a simple fine-tuning of the pace and sequence of liberalization measures. At the sametime, there is no place for an old style, poorly designed and implemented protection policy, which is mired inunproductive rent seeking activities, patron-client relationships between governments and private agents or consolidation of ‘vested’ interests of the protected sectors. Import substitution strategy can work only when protection is granted to firms with a clearly specified ‘graduation’ clauseina performance based system. That is, protection should always be seen as temporary and `time-bound’ by agents in return for better performances.

Generally, given the observed trends towards inequality both globally and within many nations, developing countries have to take strategic steps to position themselves more favourably in the globalization process, in order to derive greater benefits from globalization’s dynamic forces. They need a long term vision for upgrading their comparative advantages towards high value added activities by climbing the technology ladder step-by-step through learning and adaptation. To succeed, developing country governments should consciously engage in building institutional capacities for integration, including a capable nation state that is ready to take on the enormous challenges posed by globalization. The positive benefits from globalization are neither automatic nor guaranteed, whilst passive liberalization would risk perpetual marginalization.

Furthermore, since openness could potentially benefit the poor in countries which have already reached the take-off stage, it is very critical that in addition to a long term vision for strategic integration, low income countries should embark on the path towards structural transformation of their agrarian economies, as a necessary condition for successful integration. The importance of this critical step in relation to the globalization–poverty nexus is underscored by the fact that there are critical thresholds that need to be reached before the positive effects of globalization on poverty reduction can be realized. The non-linear Laffer-type relationship between globalization and poverty shows that openness helps those with basic and higher education, but reduces the income share of those with no or little education and it is only when basic education becomes the norm for the poor that openness exert an income equalizing effect (Milanovic, 2002).Thus, at low income levels, openness affects equality negatively, while at medium and high income level it could potentially promote equality.

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Q8. Discuss the product cycle theory as an explanation for why comparative advantage in knowledge-intensive products shifts rapidly.

THE PRODUCT LIFE CYCLE THEORY

A) Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s. According to the theory as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade.

B) According to Vernon, early in the life cycle of a typical new product, while demand is starting to grow in the United States, demand in other advanced countries is limited to high-income groups. The limited initial demand in other advanced countries does not make it worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the United States to those countries. Over time, however, demand for the new product starts to grow in other advanced countries. As it does, it becomes beneficial for foreign producers to being producing for their home markets. In addition, U.S. firms might set up production facilities in those advanced countries where demand is growing. Consequently, production within other advanced countries begins to limit the potential for exports from the United States.

C) As the market in the United States and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon. One result is that producers based in advanced countries where labor costs are lower than the United States might now be able to export to the United States.

D) If cost pressures become intense, the process might not stop there. The cycle by which the United States lost its advantage to other advanced countries might be repeated once more as developing countries begin to acquire a production advantage over advanced countries.

E) The consequences of these trends for the pattern of world trade is that the United States switches from being an exporter of the product to an importer of the product as production becomes more concentrated in lower-cost foreign locations.

Evaluating the Product Life Cycle Theory

F) While the product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the United States in the 1960s and 1970s, the increasing globalization and integration of the world economy has made this theory less valid in today's world.

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