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 nd of
Rational conomics!.
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. owever! 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. #esearch conducted according to this
three-question test finds that in the $%%& edition of the 'ournal of (conomic Theory! only
)$* of the articles satisfy the three requirements.+
,))-
Ignoring the fact that the ceteris
paribus assumption is being made is another big failure often made when a model is
applied. .t the minimum an attempt must be made to loo/ at the various factors that
may not be equal and ta/e those into account.
In $%%0! a massive earthqua/e reduced the financial world to rubble. Standing in the
smo/e and ash! .lan 1reenspan! the former chairman of the 2.S. 3ederal #eserve
once hailed as 4the greatest ban/er who ever lived!+ confessed to 5ongress that he was
4shoc/ed+ that the mar/ets did not operate according to his lifelong expectations. e
had 4made a mista/e in presuming that the self-interest of organi6ations! specifically
ban/s and others! was such that they were best capable of protecting their own
shareholders.+ (7an .riely! $%%8)
.ccording to ariely 49e are now paying a terrible price for our unblin/ing faith in the
power of the invisible hand. 9e:re painfully blin/ing awa/e to the falsity of standard
economic theory;that human beings are capable of always ma/ing rational decisions
1
and that mar/ets and institutions! in the aggregate! are healthily self-regulating. If
assumptions about the way things are supposed to wor/ have failed us in the
hyperrational world of 9all Street! what damage have they done in other institutions and
organi6ations that are also made up of fallible! less-than-logical people< .nd where do
corporate managers! schooled in rational assumptions but who run messy! often
unpredictable businesses! go from here<+
.riely ($%%8) mentioned that 45ompanies need to armed itself with the /nowledge 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 organi6ations operate. .riely: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 =ob of ma/ing their products and
services more effective! their customers happier! and their employees more productive
but that they can also avoid catastrophic mista/es.
4>ehavioral economics eschews the broad tenets of standard economics! long taught as
guiding principles in business schools! and examines the real decisions people ma/e;
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 ma/e healthy choices in diet or sex! and
so on. 3or example! in one study where people were offered a choice of a fancy ?indt
truffle for )@ cents and a ershey:s /iss for a penny! a large ma=ority (AB*) chose the
truffle. >ut when we offered the same chocolates for one penny less each;the truffle
for )& cents and the /iss for nothing;only B)* of participants selected it. The word
4free!+ we discovered! is an immensely strong lure! one that can even turn us away from
a better deal and toward the 4free+ one.(.riely! $%%8).
3or 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 stic/ 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
carried out under controlled conditions and without the most important regulator of
rational behavior" the large! competitive environment of the mar/et.
2
Then! in Cctober $%%0! 1reenspan made his confession. >elief in the ultimate rationality
of humans! organi6ations! and mar/ets crumbled! and the attendant dangers to
business and public policy were fully exposed. (.riely! $%%8).
9ith the confession from 1reenspan! 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.
3
"#. $lthough 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.
&carce resources will be consumed% and the world's climate will continue to change.
(ow should we view these challenges?
)an they be dealt with through standard operating procedures% or
do they represent potentially ma*or 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-aharan Africa !A". #oth the prevalence and depth of poverty in many parts of the
developing world remain unacceptably high.
$he fear that the poor have been bypassed, or actually hurt, by globalization was highlighted by
the findings from a number of recent studies, which point towards a continuing prevalence of
high ine%uality in world income distribution and limited if not a lack of income convergence
among participating national economies and across regions !&issanke'$horbecke, ())*". $he
regional trends in income ine%uality measured by the +ini coefficient show that within country
ine%uality has increased markedly since the early ,-.)s in all regions e/cept in the group
consisting of the advanced high income, the 0rganisation for 1conomic 2o-operation and
Development !012D" countries.!3ilanovic, ())4a, ())4b5 #irdsall, ())*". 6ithin high income
countries too, there are many that e/perienced growing ine%uality.
Despite some improvements in aggregate measures of integration intensity, A presents a clear
e/ample in support of the argument that the shift to an open policy regime alone is not sufficient
to bring about economic growth and conse%uent poverty reduction!7osu'3old, ()).".After two
decades of reforms dominated by liberalization, privatization and deregulation, the economies of
A have not yet been able to escape from the growth tragedy syndrome8the term popularly
used in characterizing the regions dismal economic performance in the comparative growth
literature.
$he failure of A economies to diversify and undergo structural transformation, and hence, to
benefit from the technology driven, highly dynamic aspects of the on-going globalization process
has led to ma9or drawbacks in terms of low economic growth and persistent poverty. $he
4
incidence and depth of poverty has deepened in the region. According to estimates provided by
2hen and :avallion !());", the number of poor below the <=, a day international poverty line
almost doubled in A from about ,*; million in ,-., to >,> million in ()),. $he poverty
incidence !the headcount ratio" in A reached ;* per cent in ()),8the highest of the ma9or
regions in the world. Ali and $horbecke !()))" argue that poverty in A is both most prevalent
and severe in rural areas.
2learly, a strategic position towards globalization cannot be e%uated with a mere adoption of
liberal trade and investment regimes, or a simple fine-tuning of the pace and se%uence 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. ?mport substitution strategy can work only when protection is granted to
firms with a clearly specified graduation clauseina performance based system. $hat is,
protection should always be seen as temporary and @time-bound by agents in return for better
performances.
+enerally, given the observed trends towards ine%uality 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 globalizations dynamic forces.
$hey 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.
$o 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. $he positive benefits from globalization are neither automatic
nor guaranteed, whilst passive liberalization would risk perpetual marginalization.
7urthermore, 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. $he importance of
this critical step in relation to the globalizationApoverty ne/us 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. $he non-linear Baffer-type relationship between globalization
and poverty shows that openness helps those with basic and higher education, but reduces the
income share of those with no or little education and it is only when basic education becomes the
norm for the poor that openness e/ert an income e%ualizing effect !3ilanovic, ())(".$hus, at
low income levels, openness affects e%uality negatively, while at medium and high income level
it could potentially promote e%uality.
5
"+. 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 iniia!!y "ro"o#ed $e "rod%& !i'e(&y&!e $eory in $e mid(1)*+#, A&&ordin-
o $e $eory a# "rod%&# ma%re .o$ $e !o&aion o' #a!e# and $e o"ima! "rod%&ion !o&aion
/i!! &$an-e a''e&in- $e '!o/ and dire&ion o' rade,
0) A&&ordin- o Vernon1 ear!y in $e !i'e &y&!e o' a y"i&a! ne/ "rod%&1 /$i!e demand i# #arin-
o -ro/ in $e Unied 2ae#1 demand in o$er ad3an&ed &o%nrie# i# !imied o $i-$(in&ome
-ro%"#, T$e !imied iniia! demand in o$er ad3an&ed &o%nrie# doe# no ma4e i /or$/$i!e 'or
'irm# in $o#e &o%nrie# o #ar "rod%&in- $e ne/ "rod%&1 .% i doe# ne&e##iae #ome e5"or#
'rom $e Unied 2ae# o $o#e &o%nrie#, O3er ime1 $o/e3er1 demand 'or $e ne/ "rod%&
#ar# o -ro/ in o$er ad3an&ed &o%nrie#, A# i doe#1 i .e&ome# .ene'i&ia! 'or 'orei-n
"rod%&er# o .ein- "rod%&in- 'or $eir $ome mar4e#, In addiion1 U,2, 'irm# mi-$ #e %"
"rod%&ion 'a&i!iie# in $o#e ad3an&ed &o%nrie# /$ere demand i# -ro/in-, Con#e6%en!y1
"rod%&ion /i$in o$er ad3an&ed &o%nrie# .e-in# o !imi $e "oenia! 'or e5"or# 'rom $e
Unied 2ae#,
C) A# $e mar4e in $e Unied 2ae# and o$er ad3an&ed naion# ma%re#1 $e "rod%&
.e&ome# more #andardi7ed1 and "ri&e .e&ome# $e main &om"eii3e /ea"on, One re#%! i#
$a "rod%&er# .a#ed in ad3an&ed &o%nrie# /$ere !a.or &o## are !o/er $an $e Unied 2ae#
mi-$ no/ .e a.!e o e5"or o $e Unied 2ae#,
D) I' &o# "re##%re# .e&ome inen#e1 $e "ro&e## mi-$ no #o" $ere, T$e &y&!e .y /$i&$ $e
Unied 2ae# !o# i# ad3ana-e o o$er ad3an&ed &o%nrie# mi-$ .e re"eaed on&e more a#
de3e!o"in- &o%nrie# .e-in o a&6%ire a "rod%&ion ad3ana-e o3er ad3an&ed &o%nrie#,
E) T$e &on#e6%en&e# o' $e#e rend# 'or $e "aern o' /or!d rade i# $a $e Unied 2ae#
#/i&$e# 'rom .ein- an e5"orer o' $e "rod%& o an im"orer o' $e "rod%& a# "rod%&ion
.e&ome# more &on&enraed in !o/er(&o# 'orei-n !o&aion#,
E3a!%ain- $e Prod%& Li'e Cy&!e T$eory
F) 8$i!e $e "rod%& !i'e &y&!e $eory a&&%rae!y e5"!ain# /$a $a# $a""ened 'or "rod%&# !i4e
"$oo&o"ier# and a n%m.er o' o$er $i-$ e&$no!o-y "rod%&# de3e!o"ed in $e Unied 2ae# in
$e 1)*+# and 1)9+#1 $e in&rea#in- -!o.a!i7aion and ine-raion o' $e /or!d e&onomy $a#
made $i# $eory !e## 3a!id in oday:# /or!d,
*