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Households and ¬rms
of Large Numbers, markets and the government, taken together,
are far superior to communities, despite those administration costs.
People are able to cover their risks to a remarkable degree in
markets. Being able to do so, they are emboldened to accept
ventures that are risky but offer high expected yields. This is one
reason why Becky™s world is now so rich.

(ii) Borrowing, saving, and investing
If you don™t take out insurance, your income will depend heavily on
whether you are lucky or unlucky. Purchasing insurance helps to
reduce dependence on luck. The human desire to reduce that
dependence is related to the equally common desire to smooth (that
is, equalize) consumption across time. You don™t want to feast and
fast or experience booms and busts periodically; you want to eat
and drink moderately every day, enjoy vacations on a regular basis,
and so on. Of course, people do incur large expenditures at certain
periods of their life, such as buying a home, paying children™s school
fees, celebrating marriages, and meeting funeral costs. The ¬‚ow of
income over a lifetime tends not to match expenditure needs. So,
people look for ways to transfer expenditure across time.

Mortgages, saving for children™s education, and pensions help to do
that. Becky™s parents took out a mortgage on their house, because at
the time of purchase they couldn™t ¬nance it without a loan. The
resulting debt decreased their future consumption but enabled
them to buy the house at the time they did. Becky™s parents also pay
into a pension fund, which transfers present consumption to their
retired future. Desta™s father joined the iddir in order to pay for
funerals. Borrowing for current consumption transfers future
consumption to the present; saving and investing achieve the
reverse. Since capital assets are productive, a dollar invested today
becomes something more than a dollar tomorrow. This is one
reason why in Becky™s world borrowing involves having to pay
interest, saving in ¬nancial institutions means receiving interest,
and investing in the stock market yields positive returns

In order to formalize these ideas about market economies, let us

ignore uncertainty and imagine that you can buy a piece of
machinery “ say from abroad “ for $100,000, which, after annual
costs have been met for labour, intermediate goods, maintenance
and replacement of parts, and marketing, will yield you a net
income of $5,000 every year. This means that if you buy the
machinery, your investment will yield a return of 5% (5,000/
100,000) a year. Imagine now that there are large numbers of
investment opportunities. For you to purchase the machinery and
put it to work, it must be that no available investment opportunity
yields a return greater than 5% a year. Presumably there are lots of
projects that yield less than 5% a year. Those you simply dismiss out
of hand.

You happen to have lots of money (in fact, you are a bank!) and
someone comes to you for a loan of $100,000 to ¬nance the
purchase of a home. You should charge the borrower an interest
rate of 5% on the capital you advance. Anything less and you would
lose income (you would be better off investing in another one of
those pieces of machinery or any other investment opportunity

yielding 5% a year); anything more and a rival bank will attract the
borrower by undercutting you with a lower interest rate. But you
like to specialize as a banker. So you don™t want to go into
production yourself; rather, you lend money to entrepreneurs who
wish to go into production. What interest rate do you charge those
entrepreneurs? 5% of course. If you charge less, you will face an
unlimited demand for loans; if you charge more, no one will come
to you for a loan.

A simple way to formulate the issues Becky™s parents face when they
deliberate over their consumption and saving decisions is to
imagine that they regard themselves as members of a dynasty. This
is another way of saying that Becky™s parents are concerned not only
with their own well-being and that of Becky and Sam, but also the
well-being of their potential grandchildren, great grandchildren,
and so on. They don™t do that explicitly of course. Becky™s parents

Households and ¬rms
take only their children™s well-being directly into account; but (and
this is the point) they know that Becky and Sam, when they in turn
come to make their consumption and saving decisions, will take
into account the well-being of their children, that the grandchildren
in turn will take into account the well-being of the great
grandchildren, and so on, down the generations. Becky™s parents
make a considerable investment in their children™s education; but
they don™t expect to be repaid for this, nor do they set aside funds
for their grandchildren™s education, for the latter are regarded as
Becky™s and Sam™s future responsibilities. In Becky™s world,
resources are transferred from parents to children. Children are a
direct source of parental well-being; they are not investment goods.
Needless to say, expectations about future events play a huge role in
these intergenerational deliberations.

There is evidence that people prefer to consume now rather than
wait, other things being equal. This is a way of saying that we are
impatient. It may be that we are so disposed because of the small
chance that there will be no tomorrow for us, or it may be because
we fear that the consumption prospect may not be available if we

wait (recall the expression: ˜a bird in the hand is better than two
in the bush™). Whatever the innate reason, impatience means that
we discount future consumption simply because it is to appear in
the future. But people also have a desire to equalize their
consumption across time, other things being equal; which is
another way of saying that we have less of a want for a marginal
increase in consumption when consumption is already high than
when consumption is low. However, neither impatience nor the
desire for smoothing consumption squares with the fact that in
Becky™s world people have been growing richer and richer and
consuming more and more over many decades, nor with the fact
that they expect to continue doing so over the foreseeable future.
Why didn™t people save less in the past so as to smooth
consumption? Equally, why don™t Becky™s parents raise their
current consumption at the expense of some of their children™s
future consumption?

In order to ¬nd an explanation, we assume, realistically, that the
rate of return on saving is greater than the rate at which people are
impatient to consume now. For theoretical purposes we may as well
then imagine that the rate of impatience is negligible and that the
capital market offers a positive return on saving “ say, 5% a year.
Consider now a household that can afford a consumption level of
$120,000 this year and $120,000 next year (which we write as
($120,000, $120,000) ). As the rate of return on saving is 5% a year,
the household can certainly also afford the prospect ($119,999,
$120,001). The desire for equality of consumption over time means
that the household regards ($120,000, $120,000) to be a bit more
desirable than ($119,999, $120,001). So, if the household were
asked to consume $119,999 worth of goods and services now, it
would desire something in excess of $120,001 worth of goods and
services next year as compensation. Is there a consumption
prospect that the household can afford and that it regards to be
more desirable than ($120,000, $120,000)? The answer is ˜yes™. We
can even say something more: the desire for smoothing and the
prospect of a positive return on saving mean that of all those

consumption prospects a household can afford, the one it would
¬nd most desirable would have consumption rising over time.

To prove that, it will help to de¬ne a new term. Let us call the
percentage rate at which the household is willing to substitute this
year™s consumption for consumption next year the household™s
consumption discount rate between the two years. If that rate is r,
the household requires $(1 + r) worth of additional consumption
next year for a reduction in $1 worth of consumption this year.
Which is another way of saying that an extra dollar™s worth of
consumption for the household next year is worth $1/(1 + r) of
consumption this year (a reasoning we deployed in Chapter 2). The
magnitude of r depends on the consumption prospect. For example,
the consumption discount rate of a household facing the prospect
($120,000, $120,000) is zero (the household is not impatient,
remember, and desires to smooth consumption over time, other

Households and ¬rms
things being equal); whereas the consumption discount rate of a
household facing the prospect ($120,000, $125,000) is positive
(the household is not impatient and desires to smooth consumption
over time, other things being equal).

We can now state a general result, whose present form is due to the
economist Irving Fisher and the mathematician-philosopher-
economist Frank Ramsey: among all consumption prospects the
household can afford, the most desirable is the one along which, at
every date, the consumption discount rate equals the rate of return
on saving. The proof is simple: if the consumption discount rate is
less than the rate of return on saving, the household would wish to
save a bit more now. But to save a bit more now is to consume a bit
less today, and this tilts consumption more toward the future, which
in turn raises the consumption discount rate. Alternatively, if the
discount rate is greater than the rate of return on saving, the
household would wish to save a bit less now. But to save a bit less is
to consume a bit more now, and that tilts consumption more toward
the present, which in turn lowers the consumption discount rate.
We have therefore proved that the best consumption prospect is the

one along which the household™s consumption discount rate equals
the rate of return on saving.

The desire for consumption smoothing and an absence of
impatience mean that the household™s consumption discount rate is
positive only if consumption increases with time. This explains why
the desire to smooth consumption over time translates into growing
consumption in a productive economy. We can generalize the result
further: if the rate of impatience to consume is less than the rate of
return on saving, then a household that desires to smooth its
consumption would save so as to enjoy increasing consumption
over time.

For Desta™s parents the calculations are very different. Their
household is heavily constrained in its ability to transfer
consumption across time because they have no access to capital
markets. Admittedly, Desta™s parents invest in their land (clearing

weeds, leaving portions fallow, and so forth), but that™s to prevent
the productivity of land from declining. Moreover, the only way
Desta™s family is able to consume maize following each harvest is
to store the produce. The cruel fact is, though, that rats and
moisture are a potent combination. Stocks depreciate, which
means that the rate of return on storage is negative (a kilogram of
maize stored today becomes less than a kilogram of maize
tomorrow). An argument identical to the one we have just invoked
for Becky™s parents can now be used to show that Desta™s parents
would ¬nd it best to consume more in the weeks immediately
following each harvest than in later weeks. This explains why
Desta™s family consume less and less and become physically
weaker as the next harvest grows nearer. But Desta™s parents have
realized that the human body is a more productive bank than the
¬‚oor where they store their maize. So the family consume even
more maize than they otherwise would during the months
following each harvest, but draw on the accumulated body mass
during the weeks before the next harvest, by which time maize
reserves will have been depleted. Across the years maize

consumption assumes a saw-tooth pattern, a practice that has
been observed widely among households in subsistence
agriculture. As Desta and her siblings contribute to daily
household production, they are economically valuable assets. The
transfer of resources in Desta™s household, in contrast to Becky™s,
will be from the children to their parents.

Earlier we noted several reasons why people in sub-Saharan Africa
aim to have large numbers of children. Desta has ¬ve siblings.
Unfortunately, high population growth has placed so much
additional pressure on the local ecosystem, that the local commons
that used to be managed reasonably well are now deteriorating.
That they are is re¬‚ected in Desta™s mother™s complaint that the
daily time and effort required to collect from the local commons has
increased in recent years.

Households and ¬rms
We de¬ne ¬rms as institutions whose sole purpose is to produce
goods and services for the market. Firms that move savings from
those whose income and liquid assets exceeds their expenditure
(young households, such as Becky™s) and transfer them to those
who wish to spend more than their income and liquid assets
(retired people, such as Becky™s grandparents) make up an
economy™s ¬nancial system. Financial institutions include banks,
credit card companies, and savings and loan associations (in the
UK they are known as ˜building societies™). Similarly, insurance
¬rms enable people to transfer income across uncertain
contingencies. Then there are ¬rms that produce commodities
(machine tools, repair services, food, and so on). Bankruptcy is a
widespread phenomenon among ¬rms. To give you a sense of the
order of magnitude in Becky™s world, although about 646,000 new
businesses were incorporated in the US in 1990, about 642,000
businesses ¬led for bankruptcy that year. Evidently, ¬rms appear
and disappear.

Limited liability and joint stock companies

As with infrastructure (Chapter 4), manufacturing industries and
even the retail sector enjoy economies of scale. In order to grow, a
¬rm typically has to make large investments, meaning that it needs
to spread its ¬nancial source of new investments widely.
Proprietorships (single owners) and partnerships are unable to do
that. A ¬rm™s owners are able to absorb greater risks if they acquire
a charter that gives them the privilege of limited liability; which is
when the ¬rm is called a corporation. Corporations can raise capital
by going ˜public™ and issuing shares (known as the ¬rm™s stock). By
purchasing a corporation™s stock, an investor is entitled to a share of
the ¬rm™s dividends. The corporation is liable for all its debts. In
case it goes bankrupt, its assets are sold. The money obtained by
selling its assets goes ¬rst to creditors (banks, bondholders);
following which, if there is any money left, it goes to shareholders. If
a corporation goes bankrupt, shareholders could well lose all the

money they invested by purchasing its shares, but they won™t lose
any more than their original investment (that™s limited liability).

That a ¬rm has gone public means that its shares can be traded in
the stock market. By allowing people to buy shares in diverse ¬rms
and to sell them when they wish to, the stock market enables
investors to spread their risks even while saving for the future. The
return from buying shares in a corporation is the dividend plus the
capital gains (or losses) on the shares.

Corporations are able to ¬nance new investments by (i) borrowing
from the ¬nancial sector or by issuing bonds; (ii) retaining some of
their earnings; or (iii) issuing more shares. From the point of view
of shareholders, the ideal behaviour on the part of a corporation™s
management would be one that maximizes the ¬rm™s stock market
value. The problem is that no two shareholders are likely to agree
what that ideal behaviour is, nor is the management likely to agree
with shareholders. Moreover, shareholders face a moral hazard
because many of the management™s activities are likely to be

Households and ¬rms
12. Trading at the Frankfurt Stock Exchange

unveri¬able. Share prices in the stock market aggregate the
investors™ beliefs about the risks involved in purchasing shares.
The ratio of a corporation debt to equity in¬‚uences its
management™s incentives: too little debt, and management has little
incentive to work hard for greater ef¬ciency; too much debt, and the
greater risk of bankruptcy disrupts the ¬rm™s behaviour. A
corporation™s ¬nancial structure is therefore a signal to the outside
world. It in¬‚uences the market™s beliefs about the ¬rm™s prospects.
Seen from the point of view of management, issuing debt signals to
stockholders that management have the incentives to work hard to
protect and promote the ¬rm™s prospects. Moreover, in the US,
interest payments on a ¬rm™s debt are tax deductible, but until
recently dividends were not. These facts help to explain why

established corporations ¬nance most of their investments (in
excess of retained earnings, that is) by borrowing from banks and
issuing bonds. Today in the US more than 90% of new investment
in corporations is ¬nanced by debt.

The emergence of the joint stock company with limited liability,
which was consolidated in 1855 by the British Parliament™s Limited
Liability Act, is widely regarded to have been one of the most
signi¬cant institutional innovations in business history. In the
public™s mind corporations re¬‚ect Big Business. That isn™t entirely
unjusti¬ed, but it misses much of the point. In the US, the number
of corporations is less than 20% of the number of private ¬rms, but
they earn over 80% of the revenue. That said, the ability of
households to spread their risks even while investing in far off
places via the agency of corporate ¬rms is an enormous advantage
to society. It has been a signi¬cant factor behind the economic
success of Becky™s world.

Chapter 7
Sustainable economic

Economic growth is a good thing. It may not buy happiness
(Chapter 2), but it usually purchases a better quality of life. Table 1
showed that growth in real GDP per capita comes hand in hand
with improvements in the way people are able to live. But can
economies grow inde¬nitely, or are there limits to growth? To put
the question in a more contemporary form, is growth in real GDP
compatible with sustainable economic development?

Con¬‚icting viewpoints
The question is several decades old. If discussions on it continue to
be shrill, it is because two opposing empirical perspectives have
shaped them. On the one hand, if we look at speci¬c examples of
natural resources (fresh water, ocean ¬sheries, the atmosphere as a
carbon sink “ more generally, ecosystems), there is strong evidence
that the rates at which we are currently utilizing them are
unsustainable. During the 20th century world population grew by a
factor of four to more than 6 billion, industrial output increased by
a multiple of 40 and the use of energy by 16, methane-producing
cattle population grew in pace with human population, ¬sh catch
increased by a multiple of 35 and carbon and sulphur dioxide
emissions by 10. The application of nitrogen to the terrestrial
environment from the use of fertilizers, fossil fuels, and leguminous
crops is now at least as great as that from all natural sources

combined. Ecologists have estimated that 40% of the net energy
created by terrestrial photosynthesis is currently being
appropriated for human use. These ¬gures put the scale of our

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