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Learning Objectives
1. What is the source of gains to trade across two countries?
2. Why do governments put restrictions on trade across borders?
3. How do governments restrict international trade?
Restrictions do not appear only within a country. We see restrictions on trade across countries as well. In our shopping list at the beginning of the chapter, we mentioned several goods that are imported from other countries, such as Cuban cigars and French cheese. We begin by reviewing the motivations for trade between countries. Just as individuals are motivated to trade by the fact that it can make them better off, countries can also benefit from trading with each other.
Comparative Advantage
The principle of comparative advantage provides one reason why there are gains from trade among individuals.We discuss this in Chapter 6 "eBay and craigslist". Because different individuals have different skills and abilities, everyone can benefit if people specialize in the things that they do relatively well and trade with others to obtain the goods and services that they do not produce. Such specialization is a cornerstone of our modern economy, in which people are specialists in production but generalists in consumption.
The idea of comparative advantage also provides a basis for trade among countries. In the absence of trade, countries end up producing goods and services that they can provide only very inefficiently. When countries trade, they can instead specialize in the goods and the services that they can produce relatively efficiently. All countries can take full advantage of their different capabilities.
We illustrate comparative advantage in a simple way, with a story about trade between Guatemala and Mexico. If you understand this story, you should also be able to see that we could make the example more complex and yet still keep the same basic insight. Table 12.3.1 "Beer and Tomato Production in Mexico and Guatemala" provides information about the technology in each country: how much a typical individual can produce in a 36-hour workweek. The table shows how much time is required in each country to produce two goods: beer and tomatoes.
Hours of Labor Required
Tomatoes (1 kilogram) Beer (1 liter)
Guatemala 6 3
Mexico 2 2
Table \(1\): Beer and Tomato Production in Mexico and Guatemala
In both Mexico and Guatemala, people like to consume beer and tomatoes in equal quantities: 1 liter of beer to accompany each kilogram of tomatoes. In Guatemala, it takes 6 hours of labor to produce 1 kilogram of tomatoes, and 3 hours of labor to produce 1 liter of beer. In 9 hours, therefore, it is possible to produce 1 kilogram of tomatoes and 1 liter of beer. In a 36-hour week, the worker can enjoy 4 kilograms of tomatoes accompanied by 4 liters of beer.
Mexico is much more efficient at producing both tomatoes and beer. It takes only 2 hours to produce 1 kilogram of tomatoes, and it takes only 2 hours to produce 1 liter of beer. In 36 hours, therefore, a Mexican worker can produce 9 kilograms of tomatoes and 9 liters of beer.
Because Mexico is better at producing both tomatoes and beer—it has an absolute advantage in the production of both goods—it would be natural to think that Mexico has nothing to gain from trading with Guatemala. But this conclusion is wrong. Mexico is a bit better at producing beer but a lot better at producing tomatoes. Guatemala has a comparative advantage in the production of beer. One way to see this is through opportunity cost. In Guatemala, the opportunity cost of producing 1 kilogram of tomatoes is 2 liters of beer. In Mexico, the opportunity cost of producing 1 kilogram of tomatoes is only 1 liter of beer. Thus Guatemala should specialize in the production of beer.
In a 36-hour week, Guatemala produces 12 liters of beer. Now suppose Mexico devotes 30 hours to producing tomatoes and only 6 hours to producing beer. Then Mexico will produce 15 kilograms of tomatoes and 3 liters of beer. The two countries produce, in total, 15 kilograms of tomatoes and 15 liters of beer. Previously, they were producing 13 kilograms of tomatoes and 13 liters of beer. Both countries can be better off if they trade and take advantage of comparative advantage. We illustrate this in Figure 12.3.1 "The Production Possibilities Frontier".If you have read Chapter 6 "eBay and craigslist", then this figure should look familiar. A similar figure shows up there for trade between two individuals. It shows the joint production possibilities frontier for Guatemala and Mexico. When they produce individually and do not trade, they end up at a point inside the production possibilities frontier. If they specialize and trade, they end up on the production possibilities frontier instead.
Toolkit: Section 31.12 "Production Possibilities Frontier", and Section 31.13 "Comparative Advantage"
You can review the idea of the production possibilities frontier and the concepts of comparative and absolute advantage in the toolkit.
Figure \(1\): The Production Possibilities Frontier
Individually, Mexico and Guatemala produce 13 kilograms of tomatoes and 13 liters of beer. Jointly, they can produce 15 kilograms of tomatoes and 15 liters of beer by exploiting comparative advantage.
Why Do Governments Intervene in International Trade?
To economists, the logic of comparative advantage is highly compelling. Yet noneconomists are much less convinced about the desirability of free trade between countries. We see this reflected in the fact that countries erect a multitude of barriers to trade. Where economists see the possibility of free trade and mutual gain, others often see unfair competition. For example, many countries in the developing world have very low wages compared to the United States, Europe, and other relatively developed economies. Economists see this as a source of comparative advantage for those countries. Because labor is cheap, those countries can produce goods that require a large amount of labor. Countries like the United States, by contrast, can specialize in the production of goods that require less labor. The logic of comparative advantage suggests that both countries would be made better off. To noneconomists, however, the cheap labor looks like “unfair” competition—how can workers in rich countries compete with workers in poor countries who are paid so much less?
This concern has some merit. Comparative advantage tells us that a country as a whole is made better off by trade because that country can have more goods available for consumption. Yet comparative advantage, in and of itself, says nothing about who gets those benefits or how they are shared.
Hypothetically, it is possible to share these goods so that everyone is made better off.Actually, even this statement carries an implicit assumption that it is possible to share out these goods without distorting economic activity too much. In Chapter 13 "Superstars", we explain that redistribution typically involves some loss in efficiency. As a practical matter, even if the country as a whole has more goods and services to consume, some individuals within the country are made worse off. There are winners and losers from trade, and there is frequently political pressure to limit international trade from or on behalf of those who lose out.
Another reason governments intervene in international trade is because of political lobbying. Generally, the beneficiaries from trade barriers are a small and identifiable group. For example, the United States provides sugar subsidies that increase the price of sugar. Sugar producers are the clear beneficiaries of this policy and have an incentive to lobby the government to ensure that the subsidies stay in place. The losers from this policy are those who consume sugar—that is, all of us. But there is no lobby representing sugar consumers.
Whatever the reasons, governments frequently intervene in international trade. Sometimes they completely close certain markets. Sometimes they impose limits on how much can be imported from abroad. And sometimes they impose special taxes on imports. We look at each in turn.
Sanctions and Bans
In some cases, governments close down certain categories of overseas trade completely. They may do so in an attempt to further international political goals. An example from our shopping list is the Cohiba cigars. You cannot buy these directly from Cuba due to a ban on the import of Cuban goods into the United States.The sanctions began in 1962 in response to the takeover of US property by the Cuban government of Fidel Castro. The Cuban Democracy Act of 1992 extended the sanctions. US Department of State, “Title XVII—Cuban Democracy Act of 1992,” accessed March 14, 2011, http://www.state.gov/www/regions/wha/cuba/democ_act_1992.html. This policy is designed to make it harder for Cuba to function in the world economy and thus puts pressure on the Cuban government.
Governments quite often use international sanctions in an attempt to achieve political goals. These measures can be enacted by individual governments or by international bodies such as the United Nations. Currently, the international community is putting pressure on Iran because of concerns about the development of nuclear capabilities in that country.An embargo on trade with Iran was imposed by the United States in 1987. Details can be found at US Department of the Treasury, Resource Center, “Iran Sanctions,” accessed March 14, 2011, http://www.treasury.gov/resource-center/sanctions/Programs/Pages/iran.aspx. From 1990 to 2003, there were international sanctions placed on trade with Iraq.
Governments also ban certain products from overseas for reasons of health and safety. The United States does not allow the importation of cheeses made with raw milk because it argues that such cheeses pose a health risk; thus it is difficult to find the French raw milk camembert on our shopping list. When the United Kingdom had an outbreak of bovine spongiform encephalopathy (better known as mad cow disease), many countries banned the import of beef from that country. More generally, countries have their own health and safety laws, so foreigners who wish to compete in these markets must ensure that they satisfy these standards.
Quotas
Another way in which governments frequently intervene in international transactions is by means of a quota—that is, a quantity restriction on imports. Figure 12.3.2 "The Effects of a Quota" gives an example of how quotas work. Suppose that Australian consumers buy both domestically produced cars (Holdens) and cars imported from the United States (Fords). These cars are not perfect substitutes for each other, so we draw a market for each kind of car. To begin with, both markets are in equilibrium where demand equals supply. Suppose that Australia were then to impose a quota on the import of Fords. The price of Fords is determined by consumers’ willingness to pay at the quantity set in the quota—that is, we can find the price by looking at the demand curve. Australian consumers must pay more for Fords. Meanwhile, the fact that fewer Fords are being sold means that Australian households will demand more Holdens. The demand curve shifts to the right. This increases the price of domestic vehicles.
After the imposition of the quota, the price of cars increases in the market for foreign cars (a) and the demand for domestic cars increases (b).
Who are the winners and the losers in this process? The clear winners are domestic producers of automobiles. They get to sell more cars at a higher price, and their surplus increases. Australian consumers, meanwhile, are losers. We cannot see this immediately by looking at the buyer surplus because the buyer surplus decreases in the market for foreign cars but increases in the market for domestic cars. However, we can tell that consumers are worse off because both domestic and foreign cars have become more expensive. Finally, the effects on foreign producers are in general ambiguous. They sell fewer cars but at a higher price. American producers might even benefit from the Australian quota.
In general, governments that impose quotas are transferring resources from domestic consumers to domestic producers. This illustrates the point we made earlier: the beneficiaries of this kind of policy are typically a small group—in this case, producers of Holdens. The losers are everyone who wants to buy a car. The producers are likely to have much more political influence than the consumers.
Tariffs
Where quotas are the equivalent of quantity restrictions, applied in the context of international trade, tariffs are the equivalent of taxes. A tariff on a good is an amount that must be paid by someone who wishes to import that good from another country. The main implication of a tariff is that the price received by foreign sellers is less than price paid by domestic consumers. We illustrate a tariff in Figure 12.3.3 "The Effects of a Tariff".
Figure \(3\): The Effects of a Tariff
A tariff means that there is a wedge between the price paid by domestic buyers and the price received by foreign sellers. Just as with a tax, the quantity traded is lower because some transactions are no longer worthwhile. There is a deadweight loss.
The main implications are very similar to those of a tax. Consumers are made worse off, as are foreign producers. There is a deadweight loss, as indicated in Figure 12.3.3 "The Effects of a Tariff". As with quotas, tariffs are often designed to protect domestic producers. Thus, as we saw when looking at a quota ( Figure 12.3.2 "The Effects of a Quota"), a tariff on foreign goods induces a substitute toward goods produced in the domestic country. This is the law of demand at work: when the price of a good increases, the demand for substitute products will be increased.
One element that distinguishes a tariff from a quota is the collection of government revenue. When a quota is imposed, trade is limited at a particular quantity, but the government collects no revenue. Instead, as shown in Figure 12.3.2 "The Effects of a Quota", the surplus from the trade is distributed among buyers and sellers. When a tariff is imposed, the government collects revenue equal to the product of the tariff and the quantity traded. Comparing Figure 12.3.2 "The Effects of a Quota" with Figure 12.3.3 "The Effects of a Tariff", part of the surplus that was shared by buyers and sellers under the quota is now captured as revenue by the government. This parallels the results that we saw when looking at domestic quotas and taxes earlier in the chapter.
Key Takeaways
• There are gains to trade across countries due to comparative advantage.
• Governments place restrictions on trade for political reasons, to protect jobs, and to increase revenue by taxing trade.
• Governments may impose outright bans on trade, place limits on the quantities traded, or put taxes on trade.
Exercises
1. Looking at Table 12.3.1 "Beer and Tomato Production in Mexico and Guatemala", we said that Mexico had an absolute advantage in both goods, but still there were gains from trade. Change two numbers in the table so that Guatemala has an absolute advantage in both goods. Explain how each country still has a comparative advantage in your new example.
2. Do the economic effects of a tariff depend on who pays it? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/12%3A_Barriers_to_Trade_and_the_Underground_Economy/12.03%3A_Limits_on_Trade_across_Borders.txt |
Learning Objectives
1. What are the forms of government restrictions in labor markets?
2. What are the effects of government restrictions on migration?
3. Who bears the burden of a tax on labor income?
Some of the most important sets of markets in the economy are those for different kinds of labor. There are many ways in which governments intervene in these markets.
Toolkit: Section 31.3 "The Labor Market"
You can review the labor market in the toolkit.
Licensing
Some occupations cannot be carried out without licensing or accreditation of some kind. You cannot set up in business as a doctor or a lawyer without any training. Here, the government’s reason for intervening is because of information problems: we do not have the knowledge to determine if someone is indeed trained in medicine or law. Chapter 16 "A Healthy Economy" has more to say about this.
Migration Restrictions
Other things equal, people want to move to where they can earn a high wage. Within the United States, people are free to move from state to state in search of good jobs and good wages. Workers are likewise free to move among the countries of the European Union. In both places, we see many examples of people moving to where wages are higher. Young Polish students move to the United Kingdom in search of work; workers in Louisiana move to Washington state because wages are higher there. Obviously, many factors influence where people choose to live and work, but wages are one of the most important.
If a firm is willing to pay a worker \$15 per hour in New Jersey but firms in Idaho will pay that same worker only \$12 per hour, then this is an indication that the worker’s time is more valuable in New Jersey than it is in Idaho. The market, through the higher wage, sends a signal to the worker that it is desirable to move. The movement of workers from Idaho to New Jersey will cause the supply curve of labor in Idaho to shift to the left, so wages in Idaho will increase, and the supply curve of workers in New Jersey to shift to the right, so wages in New Jersey will decrease. The movement of workers thus also serves to make wages more equal.
Workers in the United States are permitted to move anywhere in the country. The same is true for workers in New Zealand, Mexico, and most other countries. In some places, however, laws enacted by national or local governments make such migration harder. In China, certain government benefits are highly localized, making it difficult for a worker to move from one town to another.
In a world with no restrictions on labor movement, workers would move across countries as they do within a country. Consider the market for labor within the European Union. Figure 12.4.1 "Migration Eliminates Wage Differences" shows the markets for workers in Portugal and France. If labor is unable to migrate, then the equilibrium wage in France is higher than the wage in Portugal. Once labor mobility is allowed within Europe, workers naturally move to the labor market with the higher wage. This forces wages to decrease in France and increase in Portugal.
Workers move from Portugal to France in search of higher wages.
If workers care only about wages, then migration would completely equalize wages in France and Portugal. In practice, some differences in wages persist. For example, if most people think living in Portugal is better than living in France, then the wage rate in Portugal will be lower than that in France. Despite this wage differential, individuals living in Portugal will not move to France. The higher wage is France is an example of a compensating wage differential: it is the difference in wages needed to compensate individuals for living and working in France.
Free migration across countries exists in the European Union, but international migration is typically much more restricted. One of the items on our shopping list at the beginning of the chapter was the hiring of an illegal domestic worker. This is yet one more example of a restriction on trade because people are not allowed to work wherever they want. Most countries restrict the amount of immigration permitted into the country; some countries restrict emigration as well.
Income Taxes
Governments also affect the labor market through the imposition of taxes. In most countries, there is an income tax. In some cases, income taxes may also be imposed more locally: some individual states within the United States have an income tax in addition to the federal tax. An income tax works like the taxes we saw earlier. Fundamentally, it means that the amount paid by the employer exceeds the amount received by the worker. Exactly as before, this gives rise to a deadweight loss. Some workers will choose not to work or work fewer hours because of the tax. It follows that some mutually beneficial transactions go unrealized.
Because the market for labor is so fundamental to the economy and because the income tax is, in most economies, a major source of revenue for the government, economists and politicians pay a lot of attention to this market. Figure 12.4.2 "The Effect of an Income Tax in the Labor Market" summarizes the effects of a tax on wages using a diagram of the labor market. When there is a tax on wages, there is a gap between the wage paid by the firm and the wage received by the worker. As shown in the figure, the effect of the tax is to reduce the quantity of labor traded. The wage paid by the firm is higher than the wage in the original equilibrium, and the wage received by the worker is less than the wage in the original equilibrium.
Figure \(2\): The Effect of an Income Tax in the Labor Market
An income tax means that there is a wedge between the wage paid by the firm and the wage received by a worker.
As in our earlier example, the incidence of the tax will depend on the elasticity of labor supply and labor demand. We can understand incidence by looking at how the tax on labor income affects the wage. If the wage paid by the firm increases by the amount of the tax, then the firm is paying the tax. This will happen if the demand for labor is very inelastic. If the wage received by the worker decreases by the amount of the tax, then the worker is paying the tax, not the firm. This will happen if the supply of labor is very inelastic.
Tax Evasion in the Underground Economy
In some countries, governments have difficulty collecting income taxes from their citizens. This is partly an enforcement issue: if many people in a country misrepresent their income, it is difficult to hire enough people to enforce the tax laws. In this case, income taxes become ineffective, and governments resort to other forms of taxation, such as sales taxes.
Another form of tax evasion is to conduct trades in the underground economy. When income taxes are very high, small business owners and other individuals may offer to do work “under the table.” They will ask to be paid in cash, so there is no record of the transaction and no basis for collecting income tax. In return, they will do the work for a cheaper price. This is illegal, but the likelihood of getting caught is low enough that many people decide that avoiding the income tax is worth the crime. The magnitude of this underground activity can be substantial: “In a report to the Senate in May, Deputy Finance Minister Vincenzo Visco said that the hidden, untaxed economy accounted for around 27 percent of Italy’s gross domestic product of nearly \$2 trillion.”Elisabetta Povoledo, “Italy Changes Rules of Tax-Evasion Game,” New York Times, June 13, 2007, accessed January 29, 2011, http://www.nytimes.com/2007/06/13/world/europe/13iht-taxes.4.6129007.html?_r=1.
Thus there are two different aspects of the underground economy. There is the exchange of goods and services that cannot be traded legally (drugs, scalped tickets, etc.). And there are trades that are legal but not reported to the tax authorities (illegal).
The underground economy tends to be larger when income taxes are higher and where tax enforcement is difficult, but it exists everywhere. If your neighbor pays you \$20 to mow his lawn, and you do not declare this on your taxes, you are participating in the underground economy. Besides allowing you to avoid income taxes, working in the underground economy has an additional benefit. If you do not work a regular job, then you can collect unemployment insurance. This means that you can work and earn income without paying taxes in the underground economy and also collect unemployment insurance.
A recent study by the International Monetary Fund (IMF) concluded, “In the European Union in the late 1990s, 20 million people engaged in shadow [underground] economy activities. In all European OECD countries combined, about 35 million people did so. In some individual countries, the shadow economy labor force was very large: in Italy, 30–48 percent of the total labor force (1997); Spain, 12–32 percent (1997–98); and Sweden, 20 percent (1997–98). In many countries, these high shares coexisted with high official rates of unemployment.”Friedrich Schneider and Dominik Enste, “Hiding in the Shadows: The Growth of the Underground Economy,” International Monetary Fund, March 2002, accessed January 29, 2011, http://www.imf.org/external/pubs/ft/issues/issues30. According to this study, the underground economy is between 35 percent and 44 percent of gross domestic product (GDP) in developing countries and around 15 percent in the advanced Organisation for Economic Co-operation and Development (OECD) countries.
Finally, people sometimes barter goods and services rather than trade them. If you are a web designer and your next-door neighbor is a plumber, you might agree to build a website for her in exchange for her installing a new shower for you. Again, if you fail to report this “income in kind,” you are evading taxes. Bartering schemes can be very sophisticated, involving the creation of groups that set up their own special money to pay for transactions.
Key Takeaways
• Governments often limit the movement of people across borders and tax labor income.
• Restricting the flow of labor across international borders can lead to an inefficient allocation of labor across its productive uses.
• The burden of a labor income tax, like other taxes, depends on the elasticities of supply and demand.
Exercises
1. If the government required licenses to sell fruit in outdoor markets, who would benefit from this restriction and who would lose?
2. If there are no migration restrictions between two states in the United States, must wages be equal in the two states?
3. Use a version of Figure 12.4.2 "The Effect of an Income Tax in the Labor Market" to show that if labor supply is very inelastic, then a worker is bearing most of the burden of the income tax. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/12%3A_Barriers_to_Trade_and_the_Underground_Economy/12.04%3A_Government_and_the_Labor_Market.txt |
In Conclusion
The underground economy is not new; it has been around for as long as rulers have been levying taxes and banning trades. If you read about the prohibition of alcohol in the United States, for example, you will quickly learn that there was still a thriving market for alcohol and alcoholic beverages, despite the illegality of these trades. This was partly due to the fact that the production of alcohol was legal in nearby countries, such as Canada. Alcohol produced in Canada and elsewhere was imported and sold in the United States.
The establishments that served alcohol at that time were called speakeasies. Today you can find local bars that advertise themselves as having started as speakeasies during the Prohibition years. Of course, while Prohibition was in force, the speakeasies did not advertise so loudly. They were generally run by gangs that were willing to take the risk of being arrested to get the profits from selling alcohol.
Associated with Prohibition are several infamous individuals, such as Al Capone and his competitor, Bugs Moran. They were leaders of gangs in Chicago that provided alcohol to speakeasies. But you can, if you like, think of them as managers of firms that were involved in the importation, manufacturing, production, and sale of a consumer good. In many ways these firms operated according to the same principles as firms in this textbook. They were interested in producing efficiently and maximizing their profits.
Capone was eventually indicted and convicted. But the legal action against Capone was not directed at his violation of Prohibition. Instead, the federal government indicted him for tax evasion. Even if you are a leading producer in the underground economy, you still have to pay your taxes.
This story of Prohibition reminds us that the government does more than simply restrict trades in the economy. The government also provides the framework that allows trades. It provides a system of laws that allows people to enter into contracts, and it provides courts as a mechanism for enforcing these contracts.
Capone and Moran could not turn to the government to enforce their contracts and agreements. The firms in the industry had to create their own mechanisms for settling disputes. You won’t be surprised to hear that these mechanisms were not pretty. One famous incident was the Saint Valentine’s Day Massacre in 1929 when the Capone gang engaged the rival gang led by Bugs Moran. This was like a strategic interaction between rival producers. In this case, their respective competitive strategies left seven people dead. When the government is not there to enforce contracts, agreements will be enforced by other, often violent, means.
Key Links
exercises
1. List three additional examples of government restrictions on your ability to buy or sell something.
2. The sharing of the burden of a tax also depends on the elasticity of supply. Draw diagrams like Figure 12.2.7 "The Deadweight Loss from a Tax" looking at the case of elastic and inelastic supply—that is, draw two diagrams with identical demand curves but different supply curves. How does the elasticity of supply affect the changes in the buyer surplus and the seller surplus? Can you explain why?
3. (Advanced) In some countries, there are restrictions on the length of a contract to rent an apartment. Suppose the restriction is that contracts must last for five years. In response, some people sign private agreements to rent for shorter durations, such as a year. What are the problems that might arise from signing these private agreements? What happens if there is a dispute? What role might reputations play in the enforcement of these private agreements?
4. Suppose there is a forecast that a hurricane will hit in a day. Everyone expects the government to ration the supply of coffee. What will likely happen to the price of coffee once the forecast is announced?
5. How does rent control affect the incentives for an owner to invest in upgrades of an apartment?
6. The payout from a social security system depends on years worked. How would an increase in social security payments affect the choice of workers between jobs in the formal and informal (underground) parts of the economy?
7. If the underground part of an economy is large due to tax evasion, could a tax cut increase tax revenue?
8. If two states have different rates of labor taxation, what can you say about wages before and after taxes in the two states?
9. Can you think of a good or a service that the government requires you to consume? Why do you think the government has this policy?
10. There are substantial differences in food and product safety standards across countries. Can you think of reasons why this might be the case?
11. Liquor sales are state controlled in Pennsylvania but not in New Jersey. What effects do you think this has on the buying and selling of liquor near the border of the two states?
12. Suppose that Principles of Economics is a very popular course at your school. More people want to take the course than there are seats available. Do you think it would be a good idea if those initially enrolled in the class were able to sell their seats to those who didn’t get a spot? What would be the advantages of such a system? What would be the problems?
13. Sometimes armies are raised by a draft, while in other times armies are volunteer. Which way of raising an army do you think is most efficient in terms of getting the best people to participate in the army? Which way of raising an army is most “fair”?
14. (Advanced) When Question 13 talks about “the best people to participate in the army,” does it make a difference whether we are talking about comparative advantage or absolute advantage?
15. Explain how the incidence of a new tax on textbooks, collected at the point of sale, will be determined.
16. Which type of trade barrier creates more revenue for the government—a tariff or a quota? Why would a government ever impose a quota?
17. (Advanced) One benefit of working in the formal labor market in some developing countries is eligibility for both unemployment insurance and retirement pensions. All else being the same, would you predict that wages are higher in the formal or the informal sector of the economy? In addition, workers in the informal sector do not pay income taxes. What is the effect of this on wage levels in the two sectors?
18. Due to mobility restrictions, the labor markets in China are not fully integrated. If restrictions on mobility of workers in China were relaxed, what would happen to wage differences across regions? What predictions would you have for the flow of workers across parts of China?
19. If you are a member of a professional union, would you be in favor of licensing requirements to join that profession? How might you defend the need to have a license?
Economics Detective
1. Suppose you live in Mexico. If you wanted to get a job in Canada, what would you have to do to obtain permission to work? What if, instead, you wanted to work in the United States? Does your answer depend on your occupation?
2. Try to find estimates of the size of the underground economy in two different countries (for example, Portugal and Sweden). Is the underground economy of very different sizes in the two countries? Why? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/12%3A_Barriers_to_Trade_and_the_Underground_Economy/12.05%3A_End-of-Chapter_Material.txt |
Table 13.1.1 "Wealthiest Individuals in the United States" shows the top 10 wealthiest people in the United States in 2006 and 2010. These names come from lists compiled each year by Forbes magazine of the 400 wealthiest individuals.Forbes has many such lists available for your study ( http://www.forbes.com/lists). You almost certainly recognize some of the names, such as Bill Gates and Michael Dell from your dealings with the computer industry. Other names may be less familiar to you.
Rank 2006 List 2010 List
1 William H. Gates III William H. Gates III
2 Warren E. Buffett Warren E. Buffett
3 Sheldon Adelson Lawrence J. Ellison
4 Lawrence J. Ellison Christy Walton
5 Paul G. Allen Charles Koch
6 Jim C. Walton David Koch
7 Christy Walton Jim C. Walton
8 S. Robson Walton Alice Walton
9 Michael Dell S. Robson Walton
10 Alice L. Walton Michael Bloomberg
Table \(1\): Wealthiest Individuals in the United States
Whether or not you know their names, you surely have difficulty conceiving of their wealth. Bill Gates’s net wealth in 2010 was estimated at \$54 billion, which is \$9 billion more than the wealth of financier Warren Buffett. To give some idea of what this means, if Gates were to receive no further income for the rest of his life but wanted to use up all his wealth before he died, he would need to spend it at a rate of about \$5 million a day. The person at the bottom of the Forbes list—that is, the 400th wealthiest person in the United States—had a net worth of a mere \$1 billion.
Comparing the two lists, you can see that some of the names and rankings changed between 2006 and 2010. The top two names are the same in both years, but the rest of the list is different. Sheldon Adelson, Paul Allen, and Michael Dell were in the top 10 in 2006 but not in 2010. In 2010, Charles and David Koch joined the top 10. Even among the very rich, there is some instability within the distribution of wealth.
The Forbes list was of the wealthiest Americans. Only the top 3 from the 2010 list are on the list of the world’s wealthiest individuals. In 2010, the wealthiest individual in the world was Carlos Slim Helu, a Mexican businessman who made his fortune from real estate speculation and the telecom industry. Others in the world top 10 come from India, France, Brazil, Spain, and Germany. Forbes also publishes many other lists, including a list of the most powerful celebrities. At the top of that list in 2010 was Oprah Winfrey, who earned \$315 million. (Notice that this is her income—the amount she earned in the year—while Table 13.1.1 "Wealthiest Individuals in the United States" is based on the total wealth accumulated.) Also on the list were Beyonce Knowles, Lady Gaga, Tiger Woods, Johnny Depp, and others from the entertainment industry.
When Forbes published its 2007 list, it also published an article by economist Jeffrey Sachs discussing the other extreme of the wealth distribution: the world’s poorest households. Sachs pointed out that there are about a billion households in the world living on about \$1 a day. He calls this group the Forbes One Billion. Sachs calculates that the richest 946 households have the same earnings as the Forbes One Billion. The discussion in Forbes and the calculations by Sachs make it clear that there are immense differences in income and wealth across people in the world. This is true both if we look across countries, comparing the richest to the poorest nations, and if we look within countries.
These differences are persistent, meaning that an individual’s place in the income or wealth distribution is not likely to change significantly from one year to the next. If you are poor this year, you will probably be poor next year. It is not impossible for people to become rich overnight, but it does not happen often. In fact, such differences persist not only from year to year but also from generation to generation. This doesn’t mean that everyone is completely stuck in the same place in the economic hierarchy. There are opportunities for children to become much richer—or much poorer—than their parents. But when we look at the data, we will see that the income level of parents is an important indicator of the likely income of their children.
One goal of this chapter is to document some facts of inequality. This is not a straightforward task. For one thing, it is not even clear what measure of a household’s economic success we should look at. Is it more useful to look at inequalities in income, wealth, consumption, or some other variable altogether? We also get a different picture if we look at these differences at a point in time or across time.
Data on inequality matter for discussions about taxation and redistribution. Governments throughout the world levy a number of different taxes, including taxes on the income people earn and the purchases that they make. Some of the revenues from these taxes are transferred to poorer households in the economy. The taxation of some households and the transfer of the resulting revenue to other households make up the redistribution policies of the government. We are interested in documenting facts about inequality in large part because we need these facts to have a sensible discussion about how much redistribution we—as a society—would like.
In this chapter, we therefore consider the following questions.
What determines the distributions of income, wealth, and consumption?
Is the market outcome “fair” or is there a need for government intervention?
What are the consequences of government redistributions of income and wealth?
Road Map
A road map for this chapter is shown in Figure 13.1.1 "Road Map". We begin with some facts about inequality and introduce some techniques to help us describe the amount of inequality both in a country and across countries. Then we consider some explanations of why we observe inequality in society. We observe first that people have different abilities, which translate into differences in income. Then we consider how individual choices—about education, training, and effort—are a further source of difference.
This figure shows a plan for this chapter. We investigate the different underlying causes of inequality and explain how these translate, through labor markets in the economy, into differences in wages. We then explain how government policies affect the distribution of income in the economy. We also look at what determines the distribution of income, consumption, and wealth.
We then turn to a more abstract discussion of some different philosophical views of inequality. These different views influence current thinking about the distributions of income, wealth, and consumption and help us understand why people have such different opinions about equality and redistribution. We consider how redistribution might affect people’s incentives to work, study, and cheat. Finally, we turn to economic policies that affect inequality. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/13%3A_Superstars/13.01%3A_Rich_and_Richer.txt |
Learning Objectives
1. What is a Lorenz curve?
2. What is a Gini coefficient?
3. What has happened to income distribution in the United States?
There is no single, simple measure of the amount of inequality in a society. For example, we could study the distribution of consumption, income, or wealth, but each will tell us something different about the amount of inequality in our economy. These differences matter for the debate about inequality and our evaluation of policy.
The Lorenz Curve and the Gini Coefficient
Suppose you want to document the distribution of income in an economy. You could begin by asking every household its level of income. In many countries, the government already collects such data. In the United States, for example, this investigation is carried out by the US Census Bureau ( http://www.census.gov). If everyone on the list had exactly the same level of income, you would conclude that income was equally distributed. If all but one person on the list had zero income and the remaining person had all the income, then you would conclude that income was very unequally distributed. In reality, of course, you would find that different households have all sorts of different levels of income.
The Lorenz curve provides a useful way of summarizing the distribution. It plots the fraction of the population on the horizontal axis and the percentage of income received by that fraction on the vertical axis. We construct a Lorenz curve as follows.
1. Take the list of incomes and order them from the lowest to the highest.
2. Calculate the total income in the economy.
3. Calculate the income of the lowest 1 percent of the population. Then calculate the income of the lowest 1 percent of the population as a percentage of total income.
4. Calculate the income of the lowest 2 percent of the population. Then calculate the income of the lowest 2 percent of the population as a percentage of total income.
5. Continue for all income levels.
6. Plot these points on a graph with fraction of the population on the horizontal axis and fraction of income on the vertical axis.
We know that 0 percent of the population earns 0 percent of the income, so the Lorenz curve starts at the origin. We also know that 100 percent of the population earns 100 percent of the income, so the other end of the Lorenz curve is at that point. If income were exactly equally distributed, then any given fraction of the population would earn that same fraction of income. The lowest 28 percent of the population would earn 28 percent of the income, the lowest 74 percent of the population would earn 74 percent of the income, and so on. In this case, the Lorenz curve would be a 45-degree line connecting the two endpoints. The closer the Lorenz curve to the 45-degree line, the more equal the distribution of income.
Table 13.2.1 "Example of Income Distribution" illustrates how to calculate the points on a Lorenz curve. The table shows four households, ordered by their income levels. The total income earned is \$2,000. The lowest household (25 percent of the population) earns 5 percent of the total income because = 5 percent. If there were complete equality, this number would be 25 percent. So the lowest income household accounts for one quarter of the population but only one twentieth of the income. The first and second households together account for 50 percent of the population (see the last column of the table). They earn \$500 in total, which is 25 percent of the total income. The first, second, and third households account for 75 percent of the population and 50 percent of the total income. Finally, if we look at all four households (100 percent of the population), this group earns \$2,000, which is, of course, 100 percent of the total income. This Lorenz curve is illustrated in Figure 13.2.1 "The Lorenz Curve".
Household Income Level (\$) Percent of Total Income Earned by Household Percent of Total Income Earned by All Households with This Income or Lower Percentage of Population with This Income or Lower
1 100 5 5 25
2 400 20 25 50
3 500 25 50 75
4 1,000 50 100 100
Table \(1\): Example of Income Distribution
Figure \(1\): The Lorenz Curve
The more equal the distribution, the closer is the Lorenz curve to the 45-degree line.
We explained that the Lorenz curve coincides with the 45-degree line if there is complete equality. There is also a Lorenz curve for the case of complete inequality—in which a single person earns all the income. In this case, the Lorenz curve lies along the horizontal axis until the final household (that is, at 100 percent on the horizontal axis). At that point, the Lorenz curve lies along the vertical line at the right of the figure because the last person has all the income. Real economies exhibit neither complete equality nor complete inequality; a typical Lorenz curve lies below the 45-degree line and above the horizontal axis.
If we want to compare inequality over time or across countries, then we need something even simpler than the Lorenz curve. For this, we use the Gini coefficient, which is equal to the area between the 45-degree line and the Lorenz curve divided by the area below the diagonal. Figure 13.2.2 "The Lorenz Curve and the Gini Coefficient" shows how the Gini coefficient is related to the Lorenz curve.
The Gini coefficient is calculated as the area between the Lorenz curve and the 45-degree line divided by the area under the 45-degree line—that is, it equals A/(A + B).
If the Lorenz curve is exactly the same as the 45-degree line, then the Gini coefficient is zero. In this case, there is no area between the Lorenz curve and the 45-degree line. At the other extreme, if the Lorenz curve coincides with the horizontal axis until the final household, then the area above the Lorenz curve and the area below the diagonal are exactly the same. With complete inequality, the Gini coefficient is one. A higher Gini coefficient therefore means more inequality in the distribution of income.
Data on Inequality
We now use the Gini coefficient and other data to look at some facts about the distributions of income and wealth.
The Distribution of Income
Table 13.2.2 "Household Income by Quintile" presents data from the US Census Bureau on the distribution of various measures of income from 2003 to 2005. There are three measures of income given for each of the three years:
1. Market income. A measure of income earned from market activity, such as labor income and rental income.
2. Postinsurance income. Market income plus transfers received from the government.
3. Disposable income. Market income less taxes paid to the government plus transfers received from the government.
This table tells us how government redistribution affects the link between wage earnings and income.
Quintiles Market Income Postinsurance Income Disposable Income
2003 2004 2005 2003 2004 2005 2003 2004 2005
Lowest 1.5 1.5 1.5 3.3 3.3 3.2 4.6 4.7 4.4
Second 7.5 7.4 7.3 8.9 8.6 8.6 10.3 10.3 9.9
Third 14.5 14.1 14.0 14.8 14.5 14.3 15.8 16.1 15.3
Fourth 24.2 23.6 23.4 23.5 23.0 22.8 23.8 24.0 23.1
Highest 52.5 53.4 53.8 49.6 50.6 51.0 45.6 44.9 47.3
Gini coefficient 0.492 0.496 0.493 0.446 0.449 0.447 0.405 0.400 0.400
Table \(2\): Household Income by Quintile
Source: US Census Bureau, Current Population Survey, 2004–2006 Annual Social and Economic Supplements.
These measures of income for each of the three years create the columns of the table. The rows of the table are quintiles (fifths) of the population. As in the construction of the Lorenz curve, the population is ordered according to income. This means the first quintile is the bottom 20 percent of the population in terms of income. The fifth quintile is the top 20 percent of the population in terms of income. To see how these quintiles are created, imagine taking 100 people and arranging them by their income, starting at the lowest level. Then create five groups of 20 people each where the first 20 people in the income distribution are in the first group, the second 20 in the income distribution are in the second group, and so on. Each group of 20 is a quintile of this population.
For each measure of income and for each year, there is an entry in the table showing the fraction of income in that year for a particular quintile. For example, looking at disposable income in 2004, the third (middle) quintile had 16.1 percent of the disposable income, and the highest quintile had 44.9 percent.
There are two striking features of this table. First, there is substantial inequality in the US economy. Looking at market income, the lowest 20 percent of the population receive about only 1.5 percent of the total market income. Contrast this with the highest quintile, which receives more than 50 percent of the total market income. This inequality is reflected in the Gini coefficient of about 0.49. If we look at the very top of the income distribution, the inequality is even more marked: the top 5 percent of the population in 2005 received about 30 percent of income after taxes and transfers, and the top 1 percent received about 16 percent of income.These figures come from Congressional Budget Office, Historical Effective Federal Tax Rates, 1979 to 2005, table 4C, accessed March 14, 2011, www.cbo.gov/ftpdocs/88xx/doc8885/Appendix_wtoc.pdf; the definitions of income therefore differ slightly from the US Census Bureau numbers in the table.
Second, the Gini coefficient decreases if we look at postinsurance income relative to market income and at disposable income relative to postinsurance income. This is because transfers represent—on average—a flow from richer to poorer households, and taxes are progressive: they redistribute from the rich to the poor. Government policies bring about some redistribution from richer households to poorer households. That said, there is still substantial inequality even after this redistribution: the lowest quintile receives less than 5 percent of total income, while the highest quintile receives about 45 percent.
Table 13.2.3 "Gini Coefficient over Time" shows changes in the Gini coefficient over time. (The data are on household incomes and come from the Census Bureau. See http://www.census.gov.) This table shows that inequality in the United States, as measured by the Gini coefficient, has increased steadily over the last few decades. In fact, if you go back to the end of World War II, the end of the 1960s represents a turning point in the income distribution.Thomas Piketty and Emmanuel Saez, “Income Inequality in the United States, 1913–98,” Quarterly Journal of Economics 118 (2003):1, together with their updated data set available at Emmanuel Saez’s faculty home page, http://www.econ.berkeley.edu/~saez/TabFig2008.xls. From 1940 through the 1960s, the income share of the top 10 percent fell from about 45 percent to about 33 percent. But starting in the 1970s, the pattern reversed, so that by 2007, the share of the top 10 percent exceeded 45 percent of total income.
Year Gini Coefficient
2009 0.469
2001 0.466
1997 0.459
1992 0.434
1987 0.426
1982 0.412
1977 0.402
1972 0.401
1967 0.399
Table \(3\): Gini Coefficient over Time
Figure 13.2.3 "The Distribution of Income from 1913 to 2008" focuses on the top of the income distribution: the top 1 percent. In part (a) of Figure 13.2.3 "The Distribution of Income from 1913 to 2008", we can see that the real income of the bottom 99 percent of the population increased dramatically between the 1930s and the 1970s, increasing from \$9,000 in 1933 to over \$40,000 in 1973. (These numbers are adjusted for inflation and are in 2008 dollars.) Income over this period, for this group, grew an average of 3.7 percent per year. Over the next 35 years, the real income of this group hardly grew at all: the average growth rate was 0.2 percent per year. By contrast, the income of the top 1 percent grew only 1.7 percent per year on average between 1913 and 1973 but grew at an average 2.8 percent from 1973 to 2008. As a consequence, the top 1 percent of the income distribution roughly doubled their share of total income over this period.
At the very top of the income distribution, we have the true superstars: rock stars, movie stars, sports stars, top CEOs, and so on. The top 0.01 percent of the population—that is, the richest 30,000 or so people—has seen their share of income increase sevenfold since 1973.
(a) The average real income in 2008 dollars for the bottom 99 percent of the population rose substantially between the 1930s and the 1970s but has been much flatter over the past few decades. (b) The top 1 percent has seen substantial income growth in recent decades.
The Distribution of Wealth
Table 13.2.4 "Gini Coefficients for Net Worth" looks at wealth data for a cohort of individuals between 1989 and 2001. At the beginning of the study, this group was between 34 and 43 years old. Arthur B. Kennickell, A Rolling Tide: Changes in the Distribution of Wealth in the U.S., 1989–2001 (Washington, DC: Federal Reserve Board, 2003). Wealth is defined as assets minus liabilities. We can see that the Gini coefficients for wealth are considerably larger than the ones we saw earlier for income. There is more equality in income than in wealth.
Year Gini Coefficient
1989 0.74
1992 0.75
1995 0.75
1998 0.76
2001 0.78
Table \(4\): Gini Coefficients for Net Worth
Income is a flow, meaning that individuals receive labor income on a weekly or monthly basis. Wealth is a stock: it is a measure of the assets that an individual or a household has accumulated and is measured at a particular point in time. Wealth comes partly from what people inherit and partly from decisions they make about allocating income between consumption and saving. The table also shows that wealth inequality increased for this group. There are two reasons that this could happen: (1) it may reflect greater inequality as a whole in society and (2) it may be due to inequality increasing as people become older.
Dynamics of Inequality
The position of a household in the income distribution is not static. A household in the lowest quintile of income one year will not necessarily be there the following year. Households can move up and down in the income distribution. For example, suppose you are fortunate enough to win the lottery or publish a hit song. Your income and thus your position in the income distribution will change quickly. For others without a hit song or luck with the lottery, changes in income can take more time. Perhaps you invest in a college education; after graduation and with a new job, you begin a climb through the income distribution. Bad luck can send you in the opposite direction. If your skills become less valuable, perhaps because of changes in technology, you may find that you have to move from a higher-paying to a lower-paying job, or you may become unemployed. There are many routes from rags to riches and from riches to rags.
One reason for mobility is the changes in income that most people experience in their lifetimes. For most people, the income they earn in their first job after school pays a lot less than the job they retire from. Thus most individuals experience a profile of income over their lifetime that takes them from one part of the income distribution to another. For most people, income also decreases in retirement.
Table 13.2.5 "Dynamics of Income in the United States" illustrates these dynamics over a five-year period. The top part of the table refers to earnings and the lower part to wealth. The data come from looking at distributions of earnings and wealth in two years: 1989 and 1994.
Measure 1989 Quintile 1994 Quintile
Highest Fourth Third Second Lowest
Earnings Highest 90 7 2 1 0
Fourth 27 34 30 6 2
Third 9 14 45 25 6
Second 5 6 15 51 23
Lowest 5 5 6 17 68
Wealth Highest 63 26 7 3 2
Fourth 27 45 17 8 3
Third 7 22 45 20 6
Second 3 5 26 45 21
Lowest 1 3 5 25 67
Table \(5\): Dynamics of Income in the United States
Source: Santiago Rodríguez, Javier Díaz-Giménez, Vincenzo Quadrini, and José-Víctor Ríos-Rull, “Updated Facts on the U.S. Distributions of Earnings, Income and Wealth,” Federal Reserve Bank of Minneapolis Quarterly Review, Summer 2002.
Under “Earnings,” there are five rows indicating the quintiles of the distribution in 1989. Along the top, there are five columns indicating the quintiles of the distribution in 1994. The entries refer to the percentage of people who go from one quintile in 1989 to another quintile in 1994. For example, 27 percent of the households in the second highest quintile in 1989 were in the top quintile in 1994, while 34 percent of the households in the second highest quintile in 1989 stayed there. A similar interpretation is given for the wealth part of the table.
The two parts of this table give a sense of income and wealth mobility through the distribution. If there were no mobility over time, so that households stayed in the same income and/or wealth quintiles), then the table would have 100 on the diagonal and 0 everywhere else. Mobility is indicated by the fact that the numbers along the diagonal are less than 100. From the part of the table referring to earnings, 90 percent of the people in the top income group in 1989 were there in 1994 as well. This means that very high income is extremely persistent. In contrast, only about two-thirds of the people in the lowest income class in 1989 remained in that group in 1994, while 17 percent moved up one quintile. As time passes, those who moved up will then move on to other parts of the income distribution.
Table 13.2.5 "Dynamics of Income in the United States" shows income and wealth dynamics over a relatively short period of time. It is also useful to look at dynamics across generations, though data are more difficult to obtain. One approach that researchers use over longer periods of time is to follow families. If your family was in the middle income group, we can see the likelihood that you will be in that same income group or in another income group. These dynamics take a longer amount of time because they are affected by things like parents’ choices about the education of their children.
One way to study intergenerational income mobility is to take a group of individuals at a point in time and see how much of their current income can be “explained” by the income of their parents. (Explained is in quotation marks because it is difficult to disentangle the effects of family income from other influences. There are many factors associated with parents’ income, such as the quality of schools and schoolmates, which are correlated with family income.)
One study reports an elasticity of 0.5 on the relationship between family and child income. This means that if parents’ income is 1 percent higher, the child’s income will be higher by about 0.5 percent. So if two families have an income difference of \$100,000, then the prediction is that their children will have a difference of \$50,000.The estimate is reported in Thom Hertz, Understanding Mobility in America (American University, Center for American Progress, April 26, 2006). This number is higher for the United States than for almost all the other (mostly European) countries studied. This same elasticity in Denmark is only 0.15, for example
Toolkit: Section 31.2 "Elasticity"
You can review the concept of elasticity in the toolkit.
The same study also looked at the mobility of families across the quintiles of income. A child whose family was in the middle quintile income had about a 40 percent chance of moving down the income distribution to a lower quintile and a 36.5 percent change of moving up. But 47 percent of the children born to a family in the lowest quintile remained there.
Inequality in Other Countries
Table 13.2.6 "Gini Coefficients in Different Countries" presents some evidence on the distribution of income in different countries. There are some significant differences across countries in income inequality. Eastern European countries, such as Hungary and Albania, and Western European countries, such as Sweden and France, have relatively equal distributions of income. At the other extreme, countries like Namibia and Brazil are highly unequal. The United States is about in the middle of these distributions.
Country Gini Coefficient in 2005
Namibia 0.71
Brazil 0.59
South Africa 0.58
Mexico 0.55
Zambia 0.53
Argentina 0.52
Malaysia 0.49
Philippines 0.46
China 0.45
Thailand 0.43
United States 0.41
United Kingdom 0.36
France 0.33
Russian Federation 0.31
Ethiopia 0.30
Albania 0.28
Hungary 0.27
Sweden 0.25
Table \(6\): Gini Coefficients in Different Countries
Source: “Inequality in Income—Selected Countries and Regions,” United Nations 2005 Human Development Report, figure 3, accessed January 30, 2011, http://hdr.undp.org/en/reports/global/hdr2005.
When we compare countries, remember that some countries have much higher income than others. Looking at Table 13.2.6 "Gini Coefficients in Different Countries", low-income countries generally seem to have more inequality than high-income countries. This is suggestive of a link between inequality and stages of development. Economist Simon Kuznets suggested that inequality would increase in the early stages of the development process but decrease in later stages. This became known as the Kuznets hypothesis. One story was that as a country grows, the labor force is split between a relatively high-income industrial sector and a relatively low-income agricultural sector. As a country grows, more labor is allocated to the more productive manufacturing sector, and thus inequality is reduced over time.
Whatever the mechanism, world inequality appears to be decreasing significantly. A recent study found that the Gini coefficient for the world had declined from about 0.58 in the 1970s to about 0.51 in the late 2000s.See Maxim Pinkovskiy and Xavier Sala-i-Martín, “Parametric Estimations of the World Distribution of Income” (National Bureau of Economic Research Working Paper 15433, October 2009), accessed March 14, 2011, http://www.nber.org/papers/w15433.pdf.
There are also some fascinating differences in the dynamics of inequality. The decline in inequality in the middle of the 20th century was common throughout much of the developed world. The more recent increase in equality that we have documented in the United States is also visible in some other countries, such as Australia, New Zealand, and the United Kingdom. By contrast, most of Western Europe has not seen the same kinds of increases in inequality.
Key Takeaways
• The Lorenz curve shows the distribution of income in an economy by plotting the fraction of income on the vertical axis (after households have been ranked by their income) and the fraction of the population on the horizontal axis. The closer the Lorenz curve to the 45-degree line, the more equal the distribution of income.
• The Gini coefficient is a statistic that indicates the degree of inequality by looking at how far the Lorenz curve is from the 45-degree line.
• A given household’s position in the distributions of income, wealth, and consumption changes over time. This is partly due to education and work experience and partly due to luck. Another dynamic element of the income distribution comes from transfers across generations of a household.
Exercises
1. If you have two countries, what does it imply about the Lorenz curves for the two countries if the Gini coefficient on income is higher in the first country compared to the second?
2. Is it possible for disposable income to be distributed more equally across households in a country than market income? How could this happen?
3. How do taxes influence the distribution of disposable income? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/13%3A_Superstars/13.02%3A_Facts_about_Inequality.txt |
Learning Objectives
1. Where do differences in income come from?
2. Why might the marginal product of labor differ across people?
3. What is the skill gap?
4. What is a winner-takes-all market?
We have provided some facts about differences in income across households. We now turn to a discussion of where those differences come from.
From Ability to Earnings
We begin by looking at earnings, by which we mean the income that households obtain from their work in the labor market. Figure 13.3.1 "Labor Market Equilibrium" shows the labor market. The real wage is on the vertical axis, and the number of hours worked is on the horizontal axis. The labor demand curve indicates the quantity of labor demanded by firms at a given real wage. As the real wage increases, firms demand less labor. The labor supply curve shows the total amount of labor households want to supply at a given real wage. As the real wage increases, the quantity of labor supplied also increases. See Chapter 4 "Everyday Decisions", Chapter 8 "Why Do Prices Change?", and Chapter 9 "Growing Jobs" for more discussion. Here we are interested in what the labor market can tell us about how much people earn.
Toolkit: Section 31.3 "The Labor Market"
You can find more details about the labor market in the toolkit.
When firms are deciding how many hours of work to hire, they use this decision rule: hire until
\[real\ wage\ =\ marginal\ product\ of\ labor.\]
The left side of this equation represents the cost of purchasing one more hour of work. The right side of this equation is the benefit to the firm of one more hour of work: the marginal product of labor is the extra output produced by the extra hour of work. If the marginal product is higher than the real wage, a firm can increase its profits by hiring more hours of work.
We use this equation as a starting point for thinking about distribution and inequality. Different individuals in the economy are paid different real wages. This reflects, among other things, the fact that there is not a single labor market in the economy. Rather, there are lots of different markets for different kinds of jobs: accountants, barbers, computer programmers, disc jockeys, and so on. We can imagine a diagram like Figure 13.3.1 "Labor Market Equilibrium" for each market. In all cases, the firms doing the hiring will want to follow the rule given by the equation. And if firms follow this hiring rule, then two individuals who earn different real wages must differ in terms of their marginal product. The worker who earns the higher wage is also the worker who is more productive.
But why would workers have different marginal products? One reason is that people differ in terms of their innate abilities. For any individual, we could come up with a long list of the skills and abilities that he or she is born with—natural talents. Some are good at mathematics, some are particularly strong, some are good at music, some are good at building things, some are very athletic, some are good at managing other people, and so on. Abilities that tend to make someone have a high marginal product allow that person to earn higher real wages. Differences in innate abilities, then, are the first explanation we can suggest for why there are differences in earnings when we look across individuals.
The possession of innate ability is not enough to guarantee someone a high marginal product; the market must value the individual’s talents as well. The demand for particular abilities or skills is high if they can be used to produce something that people want to buy. Think about a talented quarterback: his talents translate into an ability to draw paying customers to games, which in turn translates into a willingness to pay a lot for his labor. Or think about a skilled manager: her ability to make good business decisions translates into higher profits for a firm, which in turn translates into a willingness to pay for her labor. If an ability is valued in the market, then there will be high demand for the labor of people with that ability.
What is valuable changes over time and from place to place. Being a skilled quarterback is valued in the modern-day United States. The same innate talent was worth much less 50 years ago in the United States and is still worth little today in a village in the Amazon. Rock stars who can earn hundreds of millions of dollars today would have had very little earning power in 19th-century Australia. The same holds for more mundane skills. The innate abilities that make for a good software designer are more valuable than in the past; the innate abilities that make for a good clockmaker are less valuable than in the past.
Labor supply matters because the value of your innate abilities also depends on how many other people have similar talents. Another reason that highly talented quarterbacks command such high earnings is because their abilities are in short supply. Being a good taxi driver also requires certain skills, but these are much more common. As a result, the supply of taxi drivers is larger, so the real wage earned by taxi drivers is smaller.
Education, Training, and Experience
Star quarterbacks have innate abilities that most of us don’t possess. But they also have more training and experience in this role. Just about every one of us could be a better quarterback than we are now, if we were willing to train several hours a day. Indeed, most occupations require some skills and training. Computer programmers must learn programming languages, engineers must learn differential equations, tennis players must learn how to play drop shots, and truck drivers must learn how to reverse an 18-wheeler.
As well as such specific skills, an individual’s general level of education is usually an indicator of his or her marginal productivity and hence the wage that can be earned. Basic literacy and numeracy are helpful—if perhaps not absolutely necessary—for nearly any job. A high school education typically makes an individual more productive; a college education even more so. So the distribution of labor income is affected by the distribution of education levels. People also learn on the job. Sometimes this is through formal training programs; sometimes it just comes from accumulating experience. Generally, older and more experienced workers earn higher wages.
Education and experience affect both labor demand and labor supply. More highly skilled workers are typically more valuable to firms, so the demand curve for such workers lies further to the right. At the same time, experienced and trained workers tend to be in more limited supply, so the supply curve lies further to the left. Both effects lead to a higher real wage. Just as a worker’s real wage depends on how valuable and scarce are her abilities, so also does it depend on how valuable and scarce are her education and training.
The influence of experience on earnings is a reminder of an observation that we made when discussing the data. Even in a world where everyone is identical in terms of abilities and education, we would expect to see some inequality in earnings and income simply because people are at different stages of life. Younger, inexperienced workers often earn less than older, experienced workers.
The Skill Gap
In recent years, economists have looked closely at the differences in wages among skilled and unskilled workers. Loosely speaking, skilled workers are more educated and in occupations that rely more on thinking than on doing. So for example, an accountant is termed a skilled worker, and a construction worker with only a high-school diploma is an unskilled worker. Data on wages suggest that the return to skill, as measured by the difference in wages between skilled and unskilled workers, has widened dramatically since the mid-1970s. Many economists think that this is an important part of the explanation for the increasing inequality in the United States.
One way to measure the increased return to skills is to look at the financial benefit of education, given that more educated workers are typically skilled rather than unskilled. Table 13.3.1 "Relationship between Education and Inequality in the United States" summarizes some evidence on the distributions of earnings, income, and wealth from 1998. The table indicates that there is a sizable earnings gap associated with education. According to this sample, completing high school increased earnings by nearly \$20,000, and a college degree led to an additional \$34,000 in average annual income. Education is an important factor contributing to inequality. One way to decrease inequality is to improve access to education.
Education Earnings Income (1998 \$) Wealth
No high school 14,705 21,824 78,548
High school 34,211 43,248 189,983
College 68,530 88,874 541,128
Table \(1\): Relationship between Education and Inequality in the United States
Source: Santiago Rodríguez, Javier Díaz-Giménez, Vincenzo Quadrini, and José-Víctor Ríos-Rull, “Updated Facts on the U.S. Distributions of Earnings, Income and Wealth,” Federal Reserve Bank of Minneapolis Quarterly Review, Summer 2002. Here earnings come from both labor and business activities. Income includes transfers.
Effort
So far we have said nothing about how hard people choose to work, in terms of either the number of hours they put in on the job or their level of effort while working. Those who are willing to work longer hours and put in more effort will typically obtain greater earnings.
Effort is a matter of individual choice. Some other factors that can influence your earnings are likewise under your own control. Training and education are largely a matter of choice: you can choose to go to college or take a job directly out of high school. By contrast, the abilities you are born with are, from your point of view, a matter of luck. We have more to say about this distinction later when we evaluate the fairness of the distribution of income.
The Gender Gap
Study after study indicates that the gender of a worker also influences real wages. Figure 13.3.2 "Labor Market Outcomes for Women" shows the wage gap and the participation rates for married women in the United States.We are grateful to Michelle Rendell for this figure. The discussion in this section is drawn in part from her PhD dissertation research. The participation rate for married women—the fraction of married women in the labor force—has increased from slightly above 20 percent in 1950 to about 70 percent in 2000. Meanwhile, the ratio of wages paid to married women relative to married men displays an interesting pattern over this period. From 1950 to 1980, the ratio fell from 65 percent to 60 percent—that is, the wages of married women fell relative to married men. Thereafter, the ratio rose substantially, to about 80 percent in 2000. At the end of the 20th century, in other words, married women were earning about four-fifths of the wages of married men.
Economists and other social scientists are interested in understanding these facts. What was the source of the increased participation in the labor force by women and what factors increased their wages relative to men? One tempting approach is to use a supply-and-demand diagram like Figure 13.3.1 "Labor Market Equilibrium", thinking specifically about women’s labor. For example, we could explain the overall shift between 1950 and 2000 by a rightward shift of the labor demand curve. A shift to the right in the demand curve increases the real wage. The higher real wage would also induce women to supply more hours: this is the corresponding movement along the labor supply curve. More women would be induced to move away from work at home and toward work in the market, given the higher return for market work. To explain the increase in women’s wages relative to men’s, we would need to see a larger increase in the demand for women’s labor than for men’s labor.
But this is a somewhat odd story. There is no reason to think that there should be a separate labor market for women and men. Women and men can and do perform the same jobs and thus compete in the same labor market. Any supply-and-demand explanation needs to be subtler. One possibility is that there has been a shift in the kinds of jobs that are most important in the economy and hence a shift in the kinds of skills needed. Suppose, for example, that women are more likely to be accountants than construction workers. A shift in labor demand toward accountancy and away from construction will increase wages in accountancy relative to construction work and will therefore increase women’s wages, on average, relative to men’s. Researchers looking closely at the data see some evidence of such effects when they look at wages and employment patterns across jobs that require different skills.
There is another, perhaps even more basic question: why are women’s wages consistently lower than men’s wages? Researchers have also devoted a great deal of effort to this problem, looking to see in particular if differences in education and skills can account for the difference in wages. Typically, these studies have found that such differences can explain some—but not all—of the gap between wages for men and women. The remaining difference in wages is very possibly due to discrimination in the labor market. If this is the case, then recent increases in women’s wages relative to men’s wages could be due to a reduction in discrimination.
Of course, women are not the only group that has been subject to discrimination in the labor market. In the United States, African Americans and other minority groups have suffered from discrimination. In many other countries, there are similarly different groups that have been unfairly punished in the labor market. Economists point out that supply and demand is actually a positive force for combating discrimination. Discrimination against women workers, for example, means that women are being paid less than their marginal product. Nondiscriminatory employers then have an incentive to hire these workers and make more profit, which in turn would tend to increase women’s wages.
Economic forces can mitigate discrimination, but this is not an argument that discrimination is not or cannot be a real problem. First of all, discriminatory attitudes might make employers incorrectly perceive that the marginal product of women (or other groups) is lower than it actually is. Second, even if employers are not actively discriminating against women, coworkers may be discriminatory, and this could lead to lower productivity among women in the workforce. Research in social psychology tells us that such discrimination—by employers or colleagues—can occur even if people have no explicit discriminatory intent.
Winner-Takes-All Markets
There are some markets where compensation reflects ability in a very extreme way. These are often called winner-takes-all markets. In such a market, the person with the highest ability captures the whole market, and everyone else gets nothing. You can think of this as a race where the winner of the race gets all the prize money. The phrase winner takes all is not meant literally. The idea is more that a small number of people earn very large returns. Think, for example, of the professional golf or tennis circuits, where perhaps a few hundred people obtain the winnings from the tournaments—and the bulk of the winnings go to a small number of top players.
In these markets, we cannot assume that the wage equals the marginal product of labor. In a winner-takes-all market, you get a wage that depends not on your productivity in isolation but on how your productivity compares with that of others. If you are the most productive, you win the entire market.
Many markets have at least some aspects of a winner-takes-all market. Think of the market for rock musicians. If there were one group that everyone liked more than all the others, then that group would sell CDs and MP3s, give concerts, and completely dominate the music scene. Other groups would disappear. The actual music market is not this extreme. There are many groups who produce songs, give concerts, and so on. But there is a clear ranking between the first-class groups and the others. So even though there is not a single winner who takes all the market, there are a relatively small number of big winners who together take most of the market.
Why does the market for rock musicians have winner-takes-all characteristics? A good way to understand the phenomenon is to think about the market for musicians centuries ago—before recording technologies. Good musicians might still be rewarded well—perhaps they would play for the king or queen—but there was room for, relatively speaking, a large number of good musicians because each would be serving only a relatively small local market. Today, though, the very best musicians can record their music and sell it all around the world. A single group, at relatively low marginal cost, can serve a very large market. (This is particularly true for CDs or MP3 files. It is less true for concert appearances because these do not have such low marginal cost.)
In winner-takes-all markets, there is a very skewed distribution of income relative to ability. Small differences in ability can translate into substantial differences in income. Moreover, winner-takes-all forces may be becoming stronger as a result of technological advances. The most popular rock stars, sport stars, and movie stars are now worldwide celebrities. Lady Gaga is famous in Thailand and Toledo; Brad Pitt is known from Denver to Denmark. This is perhaps one reason the very rich are getting relatively richer.
From Income to Consumption and Wealth
We are interested not only in the distribution of income but also in the distribution of consumption and wealth. To connect these three, we use the following equation: See Chapter 5 "Life Decisions" for more discussion.
\[wealth\ next\ year\ =\ (wealth\ this\ year\ +\ income\ this\ year\ −\ consumption\ this\ year)\ ×\ interest\ factor.\]
The first term on the right-hand side is the wealth you have at the start of a given year. To this wealth you add the income you earn in the current year and subtract your consumption. Because \(income\ −\ consumption\ =\ savings\), this is the same as saying that you add your savings to your wealth. You earn interest income on your existing wealth and your new savings. Your initial wealth plus your savings plus your interest income gives you the wealth you can take into next year.
Suppose you currently have \$1,000 in the bank. This is your wealth this year. You receive income of \$300 and spend \$200 of this income. This means that you save \$100 of your income. So wealth this year plus income this year minus consumption this year equals \$1,100. With an interest rate of 5 percent, your wealth next year would be \(\$1,100\ ×\ 1.05\ =\ \$1,155.\)
This equation tells us several things.
• Wealth, income, and consumption are interconnected. A household’s decisions about how much it wants to save and how much it wants to consume determine what its consumption and wealth will look like. Imagine two otherwise identical households with different preferences about consuming this year versus the future. The impatient household consumes a lot now and saves little. It has high consumption early in life, low consumption later in life, and relatively low wealth. A more patient household has a very different pattern of wealth and consumption. It has lower consumption early in life, higher consumption later in life, and higher wealth on average.
• Differences in earnings cumulate over time to generate a distribution of wealth. High-ability households are more productive and thus earn more income. Some of this income is saved, and the rest consumed. Higher-income households thus tend to have higher wealth than lower-income households because the higher-income households have higher levels of saving each year.
• Inherited wealth can be a source of differences in income and consumption. Some individuals start out their working lives as beneficiaries of inheritances from their parents (or others). These people can enjoy higher consumption. They also obtain more income in the form of interest earnings on their wealth.
The equation also conceals at least one relevant fact for inequality: wealthier households typically enjoy higher returns on their wealth. The interest rate is not the same for all households. There are several reasons for this, such as the fact that richer individuals find it worthwhile—and can afford—to hire professionals to manage their portfolios of assets or the fact that richer people may be able to purchase assets that are riskier but offer higher returns on average. It is not surprising that, as we saw, the wealth distribution is more unequal than the income distribution.
Figure 13.3.3 "The Different Sources of Inequality" brings together all the ideas we have discussed so far. It shows us three things. (1) Discrimination and winner-takes-all situations can break the simple link between the marginal product and the wage. (2) Government policies can break the simple link between wages and income. (3) Household decisions about how much to consume and save affect the observed amounts of income, consumption, and wealth. The figure also makes it clear that some of the forces leading to inequality are under the control of the individual, while others are outside the individual’s control.
Key Takeaways
• Differences in income can reflect, among other things, differences in ability, education, training, and gender.
• Wage differences across people reflect differences in marginal products across people.
• The skill gap shows the differences in earnings from differences in education. This gap has widened in recent years.
• In a winner-takes-all market, the most talented individual captures all (or almost all) of the market.
exercises
1. Draw two versions of the labor market: one for lawyers and one for taxi drivers. How would you use these labor markets to explain the differences in labor income between lawyers and taxi drivers? Are these two labor markets related in any ways?
2. Does Figure 13.3.2 "Labor Market Outcomes for Women" imply that as more women participate in the market, there are increases in the ratio of wages earned by women relative to men?
3. Where do differences in wealth come from? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/13%3A_Superstars/13.03%3A_The_Sources_of_Inequality.txt |
Learning Objectives
1. What is the evidence from economic experiments about “fairness”?
2. What are some of the leading theories about “fairness”?
So far we have described some facts about inequality in the United States and the world, and we have offered some explanations of why we observe these inequalities. In this section, we take a more philosophical perspective on the distribution of income and wealth. We ask questions of a kind that economists generally ignore, such as the following: “Is the distribution of income fair?”
As you might expect, questions like this are extremely contentious. Different people have very different ideas about what is fair and just, and this topic is highly politicized. It is not our job, nor is it our intention, to tell you what is and is not fair. What we can do is give you a (very brief) introduction to some of the ways that philosophers, economists, political scientists, and others have thought about these very hard questions. More particularly, we can give you some “thought experiments” to help you determine your own views on these topics. Hundreds of books have been written on these issues, however, so we simply scratch the surface here.
Experimental Evidence on Fairness
Noneconomists frequently speak about a “fair wage” or a “fair price” for a particular product. To economists, this language is unfamiliar, even confusing. Economics provides no theory about what is fair or unfair; it gives us no basis to ask whether particular prices in the economy are fair.
Yet ideas about fairness motivate people in many economic transactions. As one example, some people are willing to pay extra for “fair trade” goods, such as coffee or chocolate bars. The idea of these goods is that the seller makes some guarantees about payments to producers, working conditions, or other variables that are not intrinsic to the good itself. As another example, people are often willing to take part in boycotts, meaning that they voluntarily forgo a good that they like to send a message to the producer of the good.
Experimental economists have conducted many studies to try to understand some of these ideas of fairness. Sometimes they have used a dictator game. This game has two players. Player A, the dictator, is given a sum of money and decides how much of that money to give to player B. Player B keeps the money he is given, and player A keeps the rest. From the perspective of economic reasoning, this game is completely trivial. Suppose you are the dictator, and you are given \$100 to allocate. The self-interested thing to do is to keep all the money for yourself and give nothing to player B.
Yet study after study has shown that people typically give away some of their money, often dividing it up in equal shares. You may be able to think of several reasons why people behave this way. Perhaps they are worried about what the other person will think about them. Perhaps they are worried about what the experimenter will think about them. Researchers have gone to great lengths to design studies where no one except player A can possibly know her decision. Even in this case, most people do not keep all the money. It is hard to dismiss the view that people’s decisions are motivated in some way by what they think is the fair thing to do.
A related but slightly richer game is known as the ultimatum game. It also has two players. Player A is given a sum of money and then decides how much of that money to offer to player B. Player B then decides whether to accept or reject player A’s offer. If player B accepts that offer, he keeps the amount offered, and player A keeps the rest. If player B rejects the offer, then both player A and player B receive nothing.
Toolkit: Section 31.18 "Nash Equilibrium"
You can read more about these games and others in the toolkit.
The difference between the ultimatum game and the dictator game is that player B has the right to veto the offer. If he vetoes the offer, then both players get nothing. Economic theory again has a simple prediction about what completely self-interested players will do. Player B is better off accepting any positive offer than he is rejecting the offer. Suppose player A starts with \$100 and offers \$1 to player B. If player B accepts, he gets \$1. If he rejects, he gets \$0. Because \$1 is better than nothing, player B should accept the offer. Knowing this, player A should offer the smallest amount possible. For example, if player A has \$100 to allocate, she should offer \$0.01. Player B should accept the offer (\$0.01 is bigger than \$0.00), and player A will then end up with \$99.99. In fact, this is not what usually happens. People in the role of player A typically offer much more than the minimum amount. One reason is the risk that if player B is made a stingy offer, he will reject it out of spite. Another reason, like in the dictator game, is that people may care about fairness when making their offers. The evidence suggests that both factors seem to matter in this game.
Hundreds of studies have been conducted using different variants of these two games. The big conclusion from all these studies is that people seem to be motivated by more than just narrow self-interest when they play games such as these in the laboratory. Instead, they care about allocating the rewards from the experiment in a way that is fair. Understanding exactly what underlies these ideas of fairness is an exciting area of research in experimental and behavioral economics, as well as in psychology and other disciplines.
Meritocracy
We begin with a very simple framework. Imagine an economy in which there are two kinds of people: high ability and low ability. Half the people in the economy are high ability: they can produce 100 chocolate bars in a year. The other half are low ability: they can produce only 50 chocolate bars in a year. In this economy, productivity and ability are the same thing. High-ability people are more productive than low-ability people. We use this simple economy to think about different approaches to the allocation of society’s resources.
Libertarianism
One view of distribution is summarized by the statement “you are entitled to whatever you earn.” In this world, the distribution of income and consumption will be the same as the distribution of output. High-ability people have income of 100 chocolate bars. If our fictional economy were to last for only one year, their consumption would also be 100 chocolate bars. Similarly, low-ability people will have income and consumption of 50 chocolate bars. This economy has an unequal distribution of income and consumption.
If we were to associate this position with a particular philosophical school of thought, it would be libertarianism. Libertarians generally believe that people are entitled to whatever they can earn, the state should intervene as little as possible, and the state should not actively seek to redistribute resources. The fact that there is inequality in this society is simply a reflection of differing abilities, which is not any reason for the government to get involved. (To be clear, libertarians have no objection to people making charitable contributions. If the high-ability people in the economy wanted to voluntarily give money to the low-ability people, libertarians would have no complaint about this.)
Consumption, Saving, and Insurance
Now let us consider a slight variant on this economy. Suppose the economy lasts for two periods: in each period, every individual has a 50-50 chance of being either high or low ability. If we measured income in either period, we would see the same amount of inequality as before.
Consumption, however, is a different story. Suppose you are a high-ability person in the first period. You know that you face a risk of being low ability in the second period. Should you eat your entire 100 chocolate bars in the first period? Most people prefer to keep their consumption at least somewhat smooth, so they will “save for a rainy day.” We expect that high-income people in this economy will consume less than their income.
Similar reasoning applies to low-ability people. They earn only 50 bars in the first year but have a 50-50 chance of higher income next year. By the same consumption-smoothing argument, they would like to somewhat increase consumption today. Thus low-ability people will consume more than their income in the first period. There will be a credit market (or loan market) in which high-income people lend money to low-income people in the first year, and those loans are repaid the following year.
Toolkit: Section 31.6 "The Credit Market"
You can review the idea of the credit market in the toolkit.
This example of borrowing and lending driven by the desire for smooth consumption affects the distributions of income and consumption. Economic theory tells us that consumption will be more equal than income. This is consistent with the evidence: consumption is indeed more evenly distributed than income. Again, believers in a libertarian philosophy would see no reason for any intervention in this economy.
If this economy were more sophisticated, it might even develop an insurance market. All the individuals in the first year would recognize that their future income was uncertain. If they are risk-averse, then they would all prefer to eliminate this uncertainty. Being risk-averse means you prefer the average of a gamble to the gamble itself. Suppose a person is faced with a choice between
• 100 chocolate bars with a probability of 0.5 and 50 chocolate bars with a probability of 0.5
• 75 chocolate bars
A risk-averse person prefers the option that delivers 75 chocolate bars with certainty. The first option also yields 75 chocolate bars on average (more technically, it has an expected value of 0.5 × 100 + 0.5 × 50 = 75), but this option has uncertainty that risk-averse people will want to avoid. In this economy, there would be some redistribution of income in the second year. However, it would be a voluntary redistribution based on the insurance contract that everybody agreed to in the first year. Again, there would be no role for government.
Toolkit: Section 31.7 "Expected Value"
You can review the concepts of probability and expected value in the toolkit.
The Rawlsian Veil of Ignorance
One of the most famous approaches to the questions of fairness and justice was pioneered by the philosopher John Rawls in his celebrated book, A Theory of Justice.John Rawls, A Theory of Justice (Cambridge: MA, Harvard University Press, 1971). Rawls’s work is rich, complicated, and much debated, and the presentation here is very simplified and stylized. For example, Rawls focused more on the institutions that people behind the veil would want, rather than on the actual distribution of income. Rawls introduced a powerful thought experiment to help people decide how they feel about different distributions of society’s resources.
It is difficult for any of us to think about redistribution without framing it in terms of our own personal circumstances and interests. Rawls’s idea was designed to help us shed those considerations. He proposed thinking about redistribution from behind a veil of ignorance. Behind this veil, you know what the distribution of resources and abilities will look like in society, but you do not know where you will be in this distribution. You might be born rich, or you might be born poor. You could end up as Bill Gates, or as a homeless person in New York. If you want to play this game globally, you might end up as a member of a royal family in Europe or as someone scavenging for food on a garbage heap in Cambodia. If we frame this in terms of our previous example, then, behind the veil of ignorance, you know that 50 percent of the people will be high ability, and 50 percent will be low ability, but you do not know which you will end up being.
Now suppose that decisions on how to allocate chocolate bars across households are made before people know whether they are high or low ability. Rawls suggested that people behind the veil would adopt a social contract in which they agree to the following.
• Once born, they will produce chocolate bars according to their ability and then put the chocolate bars they produce into a big pile.
• Each individual will take out an equal share of 75 bars.
This contract involves taxation and redistribution. The high-ability people are each taxed 25 bars, and the low-ability people receive a transfer of 25 bars. The taxes are sufficient to finance the transfers.
Figure 13.4.1 "Taxes and Transfers in a Rawlsian Social Contract" shows a taxation and transfer scheme that could be used with this social contract. On the horizontal axis is production, which is income. On the vertical axis is the tax paid by each income group. With this scheme, anyone with income above 75 bars pays a tax of 25 bars. Anyone with income below 75 bars gets a transfer of 25 bars. Because there are an equal number of high- and low-ability households, taxes collected equal transfers. The government’s budget balances.
Because everyone is risk-averse, all will prefer this deal to the allocation that gave the high-ability people 100 bars and the low-ability people 50 bars. Though additional chocolate bars are not produced, the redistribution of the contract is preferred to everyone before they know their ability. The key, emphasized in the previous sentence, is that the contract is agreed on before people know their ability. Because of this timing, the risk sharing through the redistribution of the chocolate bars makes everyone better off, compared to the—imaginary—initial condition.
You have almost certainly noticed that this Rawlsian social contract very closely resembles the insurance contract that we described in 13.3 Section "Meritocracy". In effect, Rawls suggested that people behind the veil would want to write the same kind of insurance contract that they would write in a similar situation in real life. But because we obviously can’t write contracts before we are born, Rawls thought that we should agree to government policies that would mimic these kinds of insurance contracts. Notice that, in the Rawlsian world, the distribution of income has a higher Gini coefficient than does consumption. In fact, in this example, there is no inequality in consumption.
From Each According to His Ability and to Each According to His Needs
Karl Marx, the famous philosopher and social theorist, suggested that society should distribute its resources as follows: “From each according to his ability, to each according to his needs.” Marx’s prescription recognizes that individuals differ in their ability to produce and in their consumption needs. He said that workers should produce at a rate commensurate with their ability, so high-ability individuals would be expected to produce more output than low-ability individuals.
In the Marxian view, there is a complete disconnect between production and consumption. There is no sense that those who produce more of society’s resources should be entitled to consume more of those resources. It stands in complete contrast to the libertarian view that individuals have a right to whatever they produce. The distribution of production is independent of the allocation of income and consumption.
How would the Marxian view work in our chocolate bar economy? “From each according to his ability” means simply that the high-ability individuals should produce 100 chocolate bars and the low-ability individuals should produce 50 chocolate bars. Meanwhile, “to each according to his needs” means that the total number of chocolate bars produced in the economy ought to be allocated in a way that reflects the needs of the individuals. In our simple example, individuals do not differ in their valuation of a chocolate bar. All individuals like chocolate bars the same amount. Therefore, the allocation that satisfies the Marxian prescription is that everyone should have the same number of chocolate bars.
In our simple example, Marx and Rawls agree on how to allocate chocolate bars. We can imagine, however, ways in which individuals might differ in terms of their needs. For example, some people are fortunate enough to be healthy and fit, while others suffer from illness or disease. A Marxian prescription would allocate more of society’s resources to the sick, on the grounds that their needs were greater. (It is also possible, of course, that people behind the Rawlsian veil of ignorance would make a similar allocation.)
Luck versus Merit
In all of our examples so far, we have supposed that people differed only in terms of their abilities, which are—by assumption—completely outside their control. In our earlier discussion of the sources of inequality, however, we listed many different possible reasons why people might have different earnings. Some of these factors were outside any individual’s control; others were not. Table 13.4.1 "Luck versus Merit" provides a partial listing.
Table \(1\): Luck versus Merit
Outside an Individual’s Control Within an Individual’s Control
Innate abilities Effort and hours worked
Demand for these abilities Education (in part)
Supply of these abilities by others Experience and training
Discrimination Consumption/saving decisions
Inherited wealth
An individual does not control his or her basic abilities. Some are lucky, possessing the abilities that allow them to be great basketball players, pianists, authors, or scientists. Abilities that are scarce are likely to be more valuable. The value associated with a particular set of abilities is also heavily dependent on time and place—for example, being a great rock drummer would not have been worth much in the Roman Empire, and an ability to throw a spear hard and accurately is not especially valuable in modern-day San Francisco. All of these come down to luck when viewed from the perspective of any individual.
We have hinted at many other factors that are also a matter of luck. Those born of wealthy parents in wealthy countries are likely to attend high-quality schools and receive inherited wealth. They may also be able to earn higher real interest rates on their savings. Meanwhile, those who are subject to discrimination will earn lower incomes.
There are also many factors that influence the distribution of income, consumption, and wealth that are under the control of an individual. Individuals can choose how hard to work and how many hours to work. They can choose whether to sacrifice current earnings to go to college. They can decide to go back to school to earn a master’s degree. They can choose careers that allow them to develop skills and experience on the job.
Why does this distinction matter? Most people would agree that there is little or no problem with inequalities that result from people’s choices. There is nothing self-evidently unfair about one person having a higher income than another because he works harder or chose to take time off from work to pursue a graduate degree. But opinions differ much more about the fairness of inequalities that result from luck or chance. Tiger Woods is an immensely talented golfer, but is it fair that he should earn so much on the basis of his genetic luck? Is it fair that someone who struggles in school and possesses little in the way of valuable skills should earn only minimum wage? These are not questions that we can answer, but thinking about these questions should help you form your own opinions on what is a fair and just distribution of society’s resources.
Equality of Opportunity versus Equality of Outcome
The distinction between luck and merit gives us a more nuanced view of equality. It is closely related to another distinction that is often made when discussing the distribution of society’s resources: equality of opportunity versus equality of outcome. Here is an example to help make the distinction clear.
At major soccer tournaments, such as the World Cup, teams often line up behind banners proclaiming “fair play.” The international soccer association, FIFA (Fédération Internationale de Football Association), places a lot of emphasis on this idea. Fair play means that players should always play within the rules, and these rules provide equality of opportunity on the soccer field. At the start of any game, both teams line up with the same number of players, try to score in the same sized goal, and enjoy the benefits of impartial referees. This does not mean that soccer games always end in a tie: FIFA’s rules do not mean that there is equality of outcome. The outcome depends on the two teams’ abilities. So although the opportunity to win is shared equally by the teams, the outcome is not: the winner takes all.
Equality of opportunity without equality of outcome is pervasive in the economy as well. Institutions exist to enhance equality of opportunity with no guarantees about outcomes. For example, going to a public school is an option for everyone (though there are significant differences across schools in terms of their quality). But there is no guarantee that two people graduating from the same school will have the same outcome. When you apply for a job, you have an opportunity to compete along with anyone else for that job, but the outcome is different for the person who is hired compared to those who are not.
It is tempting to identify equality of opportunity with the view that merit should be rewarded but luck should not. There is certainly a connection. Both imply that discrimination should not affect the distribution of income in the economy. But equality of opportunity still allows those with high abilities to get higher rewards, even though those abilities are a matter of luck. If your college soccer team were to play Real Madrid, either team would have the chance to win the game, according to the rules. That equality of opportunity would be of little consolation to your team’s goalkeeper as he picked the ball out of the net for the 20th time.
Yet there is one very good reason why equality of opportunity is so important. Imagine what would happen if FIFA started instructing referees to ensure that every soccer game ended in a draw. To ensure equality of outcome, the referee would alter the rules of the game to help the side that was losing. Fair play would be gone, together with lots of other things: teams would have no incentive to play hard, they would have no incentive to find quality players, and fans would not enjoy the game as much. We get the best from a team because it knows that if it performs well, under the rules, it will win and receive financial and emotional rewards. These provide the incentives for team members to train and play hard, within the rules of the game. Combining equality of opportunity with the ability to compete for a prize strikes the right balance—at least for soccer—between equality and incentives. In the next section, we will examine why incentives matter so much for decisions about redistribution.
Key Takeaways
• In experimental bargaining games, players seem to be motivated by more than narrow self-interest. In many cases, they give money to the other player.
• Equality of opportunity argues that everyone should have an equal chance of succeeding without guaranteeing that success. It contrasts with the view that everyone should work as hard as they can, and goods and services should be allocated according to need.
Exercises
1. Does the grading in your economics class exhibit equality of opportunity? Why or why not?
2. If you think about the allocation of resources within a household, which of the theories of distributive justice best applies? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/13%3A_Superstars/13.04%3A_Distributive_Justice.txt |
Learning Objectives
1. What actions does the government take to influence the distributions of income, wealth, and consumption?
2. What is the rationale for these government interventions?
3. What limits the effects of government redistribution?
Governments play a significant role in the distribution of income, consumption, and wealth. The argument for government intervention usually takes the form that the market outcome is too inequitable, relative to, for example, a Rawlsian view. We now look at various forms of redistribution through government actions, paying particular attention to their effects on incentives.
Incentives
Redistribution is more than setting taxes and transfer payments to give money from one person to another. The problem is that redistribution can affect people’s incentives in various ways.
The Incentive to Be Truthful
Go back once more to our chocolate bar economy. We proposed a scheme whereby high-ability individuals would be taxed 25 chocolate bars, with this being paid to low-ability individuals. A tax-and-transfer scheme of this kind would allow us to achieve the equitable outcome mandated by the Rawlsian or Marxian view.
Low-ability households evidently have an incentive to participate in this scheme: they give up 50 bars and get back 75 bars. The redistribution is in their favor. The story is different for high-ability people. They give up 100 bars and get 75. Before abilities are known, everyone likes this social contract. But once ability is known, high-ability people prefer not to participate. If they can produce and then hide some of their chocolate bars, they have an incentive to
• produce 100 chocolate bars,
• pretend to be a low-ability person and declare production of 50 bars, and
• take the transfer of 25 bars and consume 125 chocolate bars.
High-ability people can get away with this if chocolate bar production cannot be monitored. They have an incentive to rip off the system by pretending to be low ability. Because all high-ability people behave this way, the contract will fail: no one will pay taxes, and everyone will demand a transfer.
In this extreme example, the incentive problem completely destroys the redistribution policy. In reality, there is some redistribution through taxes and transfers because the government, acting through the taxation authority, is able to tax households at different rates: low-income households face lower tax rates than higher income households. In addition, low-income households receive transfers from the government. Governments can carry out such policies because they have access to information about the income households earn. Yet incentive problems like the one we have outlined pose very real difficulties for governments. Rich people have an incentive to hide their true income and do so through legal and illegal means. For example, a recent story in the New York Times began as follows: “In the wealthy, northern suburbs of [Athens, Greece], where summer temperatures often hit the high 90s, just 324 residents checked the box on their tax returns admitting that they owned pools. So tax investigators studied satellite photos of the area—a sprawling collection of expensive villas tucked behind tall gates—and came back with a decidedly different number: 16,974 pools.”See Suzanne Daley, “Greek Wealth Is Everywhere but Tax Forms,” New York Times, May 1, 2010, accessed January 30, 2011, http://www.nytimes.com/2010/05/02/world/europe/02evasion.html?hp.
The Incentive to Work
As the real return to working increases, households will generally work more. Labor supply is upward sloping: increases in the real wage lead to more people participating in the labor market and individuals’ choosing to work more hours. Households care about the real wage after taxes—that is, they decide how much to work based on the wage they receive after paying tax. Everything else being the same, an increase in the tax rate on labor income reduces the real wage received by households, and they will work less in response.
Contrast high-ability and low-ability workers. High-ability workers are more productive. From society’s point of view, it is better for them to work more. But if tax rates are higher for higher-income people, then these people will have an incentive to work less, so total output for the economy will be lower. This lost output is the efficiency loss from the progressive tax system.
The Incentive to Train
Redistribution can also affect the incentive to study and acquire additional skills. Once again, we use our chocolate bar example. We still have two types of individuals: high ability and low ability. Which type you are when you are born is completely beyond your control; it is just a matter of luck. But the actions you take, given your ability, are something you control.
Suppose that high-ability people can only produce 100 chocolate bars if they first go through some training. Further, assume that this training is not fun: everything else being the same, people would prefer not to spend time training. Instead, they would prefer to use their leisure time in other ways. Under the social contract, the efficient way to organize society would be for high-ability people to incur the cost of training to produce more output.
If the tax-and-transfer system completely equalizes incomes, however, high-ability people will not think it worthwhile to train. This highlights a problem with the Marxian view of “from each according to his ability, to each according to his needs.” The incentives needed to induce people to produce according to their ability may be inconsistent with allocating goods according to need.
Assuming that a little inequality is better than a lot of lost chocolate bars, the social contract needs to be amended to create an incentive for high-ability people to train. The solution is to give them some extra chocolate bars as an inducement to train and thus produce more for society. The result is inequality in consumption.
The Leaky Bucket
The incentive problems that we have discussed so far result in an equity-efficiency trade-off. Arthur Okun, a famous economist in the 1960s, proposed a very useful thought experiment for thinking about such trade-offs. He imagined that redistribution from the rich to the poor is like carrying a bucket of water from one person to another. Unfortunately, the bucket leaks. So the process of transferring water from one person to another also means that there is less total water available.
At one extreme, if the bucket does not leak, then there is no trade-off. You can redistribute water evenly in society without any loss in efficiency. At the other extreme, all the water gets lost in the transfer. The only way to achieve equality in this society is simply by destroying the wealth of the rich. Okun invited his readers to contemplate how much leakage they would be willing to tolerate to make society more equal. If you are in favor of a more equal society, then you too should think about the extent to which you think it is worth sacrificing some of our output to share the rest out more equally.
The Inheritance Tax
At the beginning of this chapter, we listed the wealthiest people in the United States in 2006 and 2010. Do you think that 50 years from now, the families of these people will appear on the Forbes list of the wealthiest people in the United States in 2060? The answer to this question partially depends on the choices of these wealthy people: how much of an estate will they decide to leave to their families? It also depends on how much of the estate the government will tax.
When we talked earlier about the dynamics of inequality, we noted that there were links across generations of a family. Some of those links come directly from expenditures on children. Everything else being the same, richer families have more income to spend on their children’s education, and thus their children are likely to be more productive. The transfer of wealth is a second link that leads income (earned on financial investments) to be higher for children of wealthier families.
According to the current tax code in the United States, the tax rate applied to an estate appears to be progressive, with higher tax rates levied on larger estates. But there is an exclusion of \$5 million, and only estates above this level are taxed at a 35 percent tax rate. So if you were left an estate valued at \$6 million, you would pay a tax of \$350,000 (= 0.35 × [\$6,000,000 − \$5,000,000]). Not surprisingly, the inheritance tax is hotly debated. Opponents of the tax argue that individuals ought to have the right to spend their lifetime income on whatever they want, including their children. Proponents of the tax see it as a way to increase mobility within the wealth distribution and argue that it promotes equality of opportunity.
Transfers
The government redistributes across households using taxes and transfers. This redistribution is reflected in the difference between the Gini coefficient for market income and postinsurance income in Table 13.1.3 "Household Income by Quintile". Transfers arise through unemployment insurance payments to unemployed workers, government-financed health care to the poor and the elderly, and other government schemes. Chapter 16 "A Healthy Economy" returns to the topic of government transfers associated with health care.
Transfers, like taxes, can affect incentives. Suppose the government makes transfers of \$100 to everyone in the economy with income less than or equal to \$1,000. Think about an individual who works 40 hours at a wage of \$25 per hour to earn a weekly income of \$1,000. What are the gains to working 41 hours? If the individual works an hour more, then her income (before taxes and transfers) will increase by \$25 to \$1,025. But by working an extra hour, she no longer qualifies for the transfer of \$100. So she would lose \$100 in transfers: the extra hour’s work would reduce her income by \$75.
Not all transfers are public; some are private. Many of the wealthiest people in the world are also some of the most generous in terms of setting up private foundations. For example, the Bill and Melinda Gates Foundation ( www.gatesfoundation.org/Pages/home.aspx) was created in 2000 “to help reduce inequities in the United States and around the world.” The reported value of the trust endowment is \$34.6 billion, which includes \$1.6 billion from Warren Buffett, the number two person on the 2006 and 2010 Forbes lists. Another common form of private transfers comes from tuition reductions from private universities. As a leading example, Princeton University replaced student loans, which had to be repaid, with outright grants to qualified students. Other universities provide both grants and subsidized loans.
Key Takeaways
• Governments use a variety of tools, such as income taxes and inheritance taxes, to influence the distributions of income and wealth.
• Governments are motivated by the view that market outcomes are not equitable enough.
• Actions to redistribute are limited by the adverse incentives created by taxes and transfers.
Exercises
1. Does a progressive income tax lead to a more or less equitable distribution of disposable income?
2. Will an inheritance tax create an incentive for people to work more or less? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/13%3A_Superstars/13.05%3A_Government_Policy.txt |
In Conclusion
Most of the time in the study of economics, we focus on efficiency. We ask if there are better or worse ways for society to organize its production of goods and services, and we ask if society has institutions in place that allow people to obtain all the available gains from trade. Although these can be complex questions, there is broad agreement among most people that efficiency is a desirable goal.
In this chapter, we tackled a rather different and more contentious set of issues: what is fair and just? Economists can (relatively) easily explain how society ends up distributing its resources, but the tools of economics do not allow us to say whether a given distribution is fair or not. People certainly seem to care about fairness and hold strong opinions about how society should share out its resources. Unfortunately, different people have very different ideas about what is fair.
The questions we address here go beyond economics; they vex philosophers and political scientists as well. They go to the heart of what we think of as right and good. They also force us to think about the appropriate role of the state and how that matters for the distribution of resources. Is the role of the state simply to provide an environment where people are free to pursue their own self-interest and to keep what they earn? Or does the existence of the state mean that we are all in a social contract, so all have some rights to the output of society as a whole?
As we have said previously, we cannot and do not want to answer these questions for you. Indeed we, as authors of this book, do not even agree among ourselves on the answers. Instead, we have given you some tools so you can think about these questions—which are some of the most important you will ever confront—yourself.
Key Links
• US Census Bureau: http://www.census.gov
• Forbes lists: http://www.forbes.com/lists
• The World Bank on poverty: web.worldbank.org/WBSITE/EXTERNAL/TOPICS/EXTPOVERTY/0,,menuPK:336998~pagePK:149018~piPK:149093~theSitePK:336992,00.html
• Gates Foundation: www.gatesfoundation.org/Pages/home.aspx
exercises
1. Draw a Lorenz curve for the data given in Table 13.1.2 "Example of Income Distribution".
2. Often income data are reported by household. How does the US Census Bureau define a household? Is this the same as a family?
3. Draw the Lorenz curve for the wealth of the top 10 people in the United States for 2006 and 2010 using the data in Table 13.1.1 "Wealthiest Individuals in the United States".
4. Can you think of two other markets with significant winner-takes-all elements?
5. During the past 100 years, there has been tremendous technical progress in creating machines to run in the household, such as dishwashers, washing machines, clothes dryers, and so on. How do you think these inventions have affected the labor participation decisions of women and the wages they are paid?
6. Suppose that the cost of training is 20 chocolate bars. Assume high-ability people produce 100 bars if they get training and 50 bars if they don’t. Low-ability people produce 50 bars regardless of training. If under the social contract you decide to provide an incentive for high-ability people to train, what is the distribution of consumption in the economy? Is society better off with inequality in consumption or is it better to have equal consumption and no training by high-ability people?
7. Start with the example of the social contract given in Question 6 but suppose that 75 percent of the people are high ability and 25 percent are low ability. What does the social contract look like for this economy? How much is produced by high- and low-ability people? What is the total amount of output per capita? What is the consumption per capita?
8. Identify two institutions that provide equality of opportunity but not outcome. Identify two institutions that favor equality of outcome over equality of opportunity.
9. Use college admissions to illustrate the difference between “equality of opportunity” and “equality of outcome.”
10. Suppose a household holds a share of stock in a particular company and receives a dividend from that share. Which of these is a stock, and which is a flow? Which is part of income, and which is part of wealth?
11. (Advanced) Consider two countries: one has a higher Gini coefficient and the other has less mobility across income groups over time. Which country has greater equality?
12. If the return to education depends on innate ability, then what is the point of going to college?
13. Do you think that trading in the stock market exhibits equality of opportunity? Why or why not?
14. Can you come up with your own example of a trade-off between equity and efficiency?
Economics Detective
1. Pick one of the wealthiest people in the United States. How did this person get his or her wealth? How much do you think this person earns each year from his or her assets?
2. Find a list of the world’s wealthiest people. What countries are these people from? Pick one person and see how the person got his or her wealth. Are the wealthiest people in the world distributed across lots of countries or isolated in a just a few?
3. The Rockefeller family was one of the wealthiest in the United States around 1900. How did the family accumulate its wealth? Where did the wealth go??
4. Try to find data on the share of income of the bottom 20 percent of the income distribution in two different countries. Also try to find the Gini coefficients for the two countries. How might you explain the differences in income distribution between the two countries you chose?
5. Go to the website of the Internal Revenue Service. Find the tax rates currently in effect for different income levels in the United States. Are these progressive?
Spreadsheet Exercise
1. Create (or find on the Internet) data on income. Input the data into a spreadsheet and plot the Lorenz curve.
2. Create a spreadsheet to follow the income and wealth of two households. Suppose the first household earns 50 chocolate bars each year, and the second household earns 100 chocolate bars each year. Suppose that each household saves a fixed fraction of its income (you can vary this in the spreadsheet). Follow these households for 50 years. Calculate familial wealth year by year using the equation at the beginning of Chapter 13 "Superstars", 13.2 Section "The Sources of Inequality".6. To do this, you will have to specify the interest rate (which you can also vary). In what sense is the distribution of wealth more unequal than the distribution of income? What if the high-income households also had a higher return on saving? What if households sometimes produced 50 chocolate bars and other times produced 100 bars? As a very advanced topic, can you build this uncertainty into your spreadsheet program? What happens to wealth? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/13%3A_Superstars/13.06%3A_End-of-Chapter_Material.txt |
Here are some places you probably would have difficulty finding on a map:
• Sumgayit, Azerbaijan
• Linfen, China
• Tianying, China
• Sukinda, India
• Vapi, India
• La Oroya, Peru
• Dzerzhinsk, Russia
• Norilsk, Russia
• Chernobyl, Ukraine
• Kabwe, Zambia
These 10 places have the dubious distinction of being the world’s most polluted cities, according to a nongovernmental organization called the Blacksmith Institute. See http://www.worstpolluted.org. As a child, one of the authors of this book lived for a year in one of these towns. Figure 14.1.1 "The 30 Most Polluted Cities in the World" shows these cities plus 20 more, giving us the 30 cities in the world with the worst pollution. In some of these places, mining and smelting industries have contaminated the air or the groundwater. In some, dangerous chemicals have been improperly disposed of—often illegally. In some, there is radioactive contamination. In some, garbage and sewage pollute the groundwater, or automobile emissions pollute the air. In sum, you would not want to live in any of them.
Figure \(1\): The 30 Most Polluted Cities in the World
This map shows the locations of the 30 most polluted cities in the world, according to the Blacksmith Institute.
The consequences of such pollution are tragic. Pollution of this magnitude causes severe health problems, birth defects, and high mortality rates. For example, according to the Blacksmith Institute, life expectancy in Dzerzhinsk, Russia, is 42 for men and 47 for women. Lead pollution is directly linked to a reduction in children’s intelligence and has also been linked to increased violence.
The map reveals that many of these highly polluted cities are found in India, China, and the countries of the former Soviet Union. The richer countries of the world, such as the United States, Canada, Japan, Australia, New Zealand, and all of Western Europe, are not featured. Neither, for the most part, are the very poorest countries of the world, such as much of Africa. Severe industrial pollution seems to be at its worst in middle-income, developing countries. This does not mean that rich countries did not recently have—or do not still have—pollution problems of their own. Only a few decades ago, the Cuyahoga River in Ohio was so polluted that it caught fire; indeed river fires were once relatively commonplace in the United States. The US Environmental Protection Agency lists well over 1,000 sites as eligible for Superfund cleanup ( http://www.epa.gov/superfund) because environmental contamination is judged hazardous to health. Little more than 50 years ago, air pollution killed an estimated 4,000 people in London, England, during the so-called Great Smog.
We emphasize in many places in this book that market transactions generate value in an economy. Firms produce things that people want to buy, so both firms and consumers benefit. People voluntarily work for companies, earning money they can then use to purchase goods and services while simultaneously allowing firms to produce the products that people want. These claims are correct, yet the citizens in Linfen, China, or La Oraya, Peru, could be forgiven for thinking that this is a very rosy view of how economies function in practice. Those who live in these communities around the world obviously do not like living in such polluted environments. So what is going wrong? How is it that voluntary trades made by individuals and firms can sometimes lead to such unpleasant and dangerous outcomes?
To begin our answer to this question, let us take a particular example: Mexico City, a city that also makes the list of the worst 30. The air in Mexico City contains particulate matter (think of this as soot and smog) that can cause lung disease and other bronchial problems. This pollution largely comes from automobile emissions, which are a severe problem in part because so many cars in Mexico City are old. According to the Blacksmith Institute report,Blacksmith Institute, “The World’s Worst Polluted Places,” September 2007, accessed March 14, 2011, www.blacksmithinstitute.org/wwpp2007/finalReport2007.pdf. even a moderate reduction in the amount of particulate matter in the Mexico City air could save thousands of lives each year.
But if everyone dislikes the pollution, why is it being produced? After all, no one is forcing the residents of Mexico City to drive their cars. They could all decide to drive much less, and if they did so, the result would be a cleaner city. Indeed, not everyone is a polluter. Particularly in richer countries, more and more people are driving electric cars or hybrids, which use a combination of electricity and fossil fuels. Such cars emit less pollution from their tailpipes. According to one study, the main reason that people purchase these cars is because they “want an environmentally friendly car.” This reason was cited by 66 percent of the respondents. The next most popular response was “I want to save money on gas,” which was cited by 16 percent of the respondents. The survey also found that half of all hybrid owners also donated money to environmental causes.Jonathan Klein, “Why People Really Buy Hybrids,” Topline Strategy Group, accessed January 31, 2011, www.toplinestrategy.com/green_form.htm. Of course, people can have multiple motivations for purchase. The same study concludes that only about 27 percent of hybrid users do not have a financial motivation for their purchase.
Some of these reasons are clearly self-motivated: when gasoline costs \$4 or more a gallon, fuel-efficient vehicles look very attractive. However, the desire to behave in an environmentally conscious way is rather different. People like to feel that they are behaving responsibly, even if they understand that their impact on total pollution is negligible. But there is another aspect of this desire to be green that is even more intriguing. If you interview one of these individuals, you will typically learn that he sees two ways in which hybrids are a good choice for the environment: (1) they generate less pollution, and (2) they consume less oil.
Both are environmental concerns. Both address how we use up different natural resources: clean air and fossil fuels. Yet they are very different problems. In this chapter, we consider both pollution and our consumption of natural resources—including but not limited to oil—and ask,
Can we rely on markets to deal with pollution and natural resources?
Road Map
We start our analysis with a familiar idea: the gains from trade. Figure 14.1.2 "The Gains from Trade", which also appears in other chapters in this book, illustrates one of the biggest insights of economics: voluntary transactions create value. In every voluntary transaction, both buyer and seller obtain surplus from trading. Even more striking, if these transactions take place in a competitive market, then buyers and sellers reap all the gains from trade.
In a competitive market, total surplus (the sum of the buyer surplus and the seller surplus) is maximized.
The first section of the chapter looks at the use of clean air. To start off, we tackle this in a small-scale situation: we consider what happens if a smoker and a nonsmoker share an office. We ask under what circumstances they might be able to resolve their disagreement without outside assistance. We then explain that air pollution in Mexico City is really the same problem, albeit much larger. We show that the problem of pollution has two related aspects: (1) we cannot easily force polluters to pay for their “use” of clean air, and (2) as a result, there is a divergence between the cost of an action to an individual polluter and the cost to society as a whole.
We discuss different kinds of policies that are used to address these problems. Then we turn to our use of natural resources such as oil. We consider various kinds of resources and consider what economic theory can teach us about how these resources are likely to be used. Finally, we consider the implications for economic policy. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/14%3A_Cleaning_Up_the_Air_and_Using_Up_the_Oil/14.01%3A_Dirty_Travels.txt |
Learning Objectives
1. What is the Coase theorem?
2. Why is the Coase theorem important?
3. What is a social dilemma?
If we lived in a world where all economic transactions took place in competitive markets and in which there were “enough” markets, then we would obtain all the possible gains from trade. This logic falls down in reality because markets sometimes fail, for various reasons.
• Something prevents the economy from reaching the competitive outcome.
• Something prevents trade altogether, so the market is missing.
• Some people other than the buyer and seller are affected by the transaction.
We will get to Mexico City shortly. We begin, however, by thinking about a more isolated case of air pollution: cigarette smoke in an office.
Smokers, Nonsmokers, and the Coase Theorem
Cigarettes are sold and smoked almost everywhere. Yet in most countries around the world, you are not able to smoke when and where you please. Governments around the world place limitations on who can buy cigarettes, where they can be bought, and where they can be consumed. From an economic point of view, governments are deliberately restricting the ability of individuals to engage in voluntary transactions.There are many different ways in which governments intervene in market transactions. Chapter 12 "Barriers to Trade and the Underground Economy" contains more discussion. Why do governments restrict an individual’s ability to smoke where and when that person wants?
Mixed messages.
Our answer to this question begins by imagining two people who must share an office. One is a nonsmoker who dislikes the smell of cigarette smoke, while the other likes to smoke while working. On the way to work one day, the smoker purchases a pack of cigarettes that she plans to smoke at work. We can reasonably deduce from this that her valuation of these cigarettes is greater than the price she has to pay. She gets buyer surplus from the purchase. To be concrete, suppose a pack of 20 cigarettes costs \$4 and her valuation of a pack of cigarettes is \$10. Her surplus is then \$6.
We can also reasonably assume that the seller’s cost is less than the price, otherwise he would not choose to make the sale. He gets seller surplus. For example, if his wholesale price for a pack of cigarettes is \$2, then he earns \$2 surplus (= \$4 − \$2) on every pack that he sells. The total surplus from the sale is the buyer surplus plus the seller surplus—that is, \$8. So far so good.
The problems begin when the worker smokes her pack of cigarettes in the office. She obtains her \$6 worth of enjoyment. However, a third party has now been affected by her decision to consume cigarettes: her office mate. The office mate dislikes the smell of smoke and may even face health risks from second-hand smoke. Thus even though the smoker and the store that sold the cigarettes are both better off, the office mate has been made worse off.
We should not automatically assume that the best thing is to ban smoking in the office just because the office mate is adversely affected. We need to know how much the nonsmoker is inconvenienced. Suppose the most the nonsmoker would be willing to pay for a smoke-free office is \$2 per day. In this case, the \$6 gain to the smoker exceeds the \$2 loss to the nonsmoker. It seems like it should be easy enough for the two individuals to find a way for everyone to be happy. For example, imagine that the smoker agreed to pay the nonsmoker \$4 a day for the right to smoke in the office. Both would then get \$2 surplus per day.
On the other hand, suppose a smoke-free office is worth \$10 per day to the nonsmoker. In this case, his valuation of clean air (\$10) exceeds the smoker’s gain (\$6). The smoker would be unwilling to pay the nonsmoker enough to compensate for dirtying the air in the office. It would be better not to allow smoking in the office.
We have assumed here that the default situation is that the office should be smoke-free. In the language of economics, the nonsmoker owns the property rights to the clean air in the office. Property rights over a resource mean that, by law, the owner can make all decisions regarding the use of the resource. Because of this, the smoker must pay the nonsmoker compensation if she wishes to be allowed to smoke in the office.
We could imagine the opposite situation, where the smoker starts off with the right to smoke in the office. Would we expect a different result from their negotiations? If the smoke-free office was worth only \$2 to the nonsmoker, then he would not be willing to pay enough to persuade his office mate not to smoke: the most he would pay is \$2, which is less than the smoker’s surplus. If, on the other hand, the nonsmoker valued the smoke-free office at \$10, then he values a smoke-free office more than the smoker values smoking in the office. The nonsmoker could pay the smoker not to smoke. For example, imagine he pays her \$8 per day to not smoke. He pays \$8 for the clean air, which is worth \$10 to him, so he gets \$2 of surplus. The smoker receives \$8, which exceeds the surplus she would get from smoking in the office. Again, they would both be happy.
Thus if the smoker “owns” the clean air, the nonsmoker must pay the smoker if he wants a smoke-free office. If the nonsmoker has the property rights, it is the smoker who must pay. In either case, the basic outcome will be the same: there will be smoking in the office if the smoker’s valuation exceeds the nonsmoker’s valuation; there will be no smoking if the nonsmoker’s valuation exceeds the smoker’s valuation. But the property rights are valuable. It is the owner of the property rights—whoever that may be—who gets compensation from the other.
As long as they know who has the property rights, it seems likely that the two individuals will be able to come to an agreement that benefits them both. You might imagine, though, that they would find it far harder to come to an agreement if it was ambiguous who had the property rights in the first place. The smoker would likely claim the right to smoke in the office, while the nonsmoker would assert his right to clean air. If they could not settle this basic question, it is unlikely that they would be able to reach a more complicated agreement involving compensation payments.
Let us imagine a further twist. Suppose the nonsmoker has property rights but values clean air at only \$7 per day. This is still greater than the smoker’s surplus, so, as before, we expect that they would agree to a smoke-free office. But the nonsmoker’s valuation for clean air is less than the total surplus of the smoker and the store that sold her the cigarettes (recall that the smoker gets \$6 surplus and the store gets \$2 surplus). If the storekeeper, the smoker, and the nonsmoker all got together, they should again be able to find an arrangement that benefits everyone. For example, the storekeeper and the smoker could jointly give the nonsmoker \$7 and still have \$1 of surplus to bargain over.
It seems perfectly reasonable to imagine that two people who share an office could come to a mutually beneficial agreement about smoking in the office. It seems much more far-fetched, though, to imagine that they would come to an agreement together with the storekeeper who sold the cigarettes. Economists say that the difference between the two cases is due to transaction costs—the costs of making and enforcing agreements.
We began this section by observing that a transaction may affect not only the buyer and the seller but also third parties. When this is the case, we cannot be sure that trade benefits everyone. Even if the buyer and the seller are both made better off, third parties may be made worse off. However, if property rights are clearly established and transaction costs are low, then we can expect that private negotiations could solve these problems. This idea was first articulated by the Nobel prize–winning economist Ronald Coase ( http://www.coase.org) and is called the Coase theorem: if property rights are clearly established and transaction costs are low, private bargaining will lead to efficient outcomes.
It is notable that in reality, we do not see office workers buying and selling the right to smoke in an office. Instead, blanket bans on smoking have been enacted throughout the United States and in many other countries throughout the world. Why do we get this government response? One argument for these bans is that smoking poses health risks. In this case, antismoking campaigns are based on an idea that individuals are not always capable of making good choices for themselves. Chapter 5 "Life Decisions" has more to say about whether individuals are good judges of their own actions, particularly when making decisions with long-term consequences. But another reason is a recognition of the transaction costs involved in these private negotiations. Even if you think two coworkers could reach an agreement, imagine an office with 10 people—perhaps there are 3 smokers and 7 nonsmokers—all of whom place a different valuation on clean air in the office. If we knew everybody’s true valuations, then in theory it would be possible to create a system of payments that made everybody better off. In practice, however, people might lie about their valuations. Finding the right system of payments would be very hard indeed and would take a lot of time and effort.
Perhaps you can now see the parallel with Mexico City. The major pollution problem is the emissions from the cars that people drive. Individual residents of Mexico City make decisions to buy gasoline and drive. These transactions create value for the drivers and the sellers of gasoline—but third parties are adversely affected. The Coase theorem can work when the parties involved are easily identifiable and small in number. In contrast, it is impossible to imagine the 20 million residents of Mexico City all meeting and coming to some kind of private agreement to limit their collective driving behavior.
Social Dilemma
Air pollution and second-hand smoke have a common structure, which we explain in this section. Once you understand these common elements, you will probably be able to think of many other examples. We show the interactions between an individual and the rest of society in Table 14.2.1 "The Payoffs in a Social Dilemma Game". This is called a social dilemma game.
Everyone Else Drives (Air Is Polluted) Everyone Else Takes Public Transportation (Air Is Clean)
You Drive \$0 \$2
You Take Public Transportation −\$1 \$1
Regardless of which action you choose, your payoffs are higher if everybody else takes public transportation (\$2 > \$0; \$1 > −\$1). Regardless of the actions of others, your payoffs are always higher if you drive (\$0 > −\$1; \$2 > \$0).
Table \(1\): The Payoffs in a Social Dilemma Game
In Mexico City, it is very possible that people would agree that they would prefer a situation where everybody drives less. Yet this is not what happens. To see why, look at Table 14.2.1 "The Payoffs in a Social Dilemma Game" and imagine you are a car owner in Mexico City. You have to decide how to get to work—by driving or taking public transportation. There are two rows in the table. One is labeled “You Drive,” and the other is labeled “You Take Public Transportation.” The rows represent your possible choices. The columns refer to everybody else’s choices. Everyone else who owns a car similarly chooses between driving and taking public transportation. To keep things simple, we suppose that everyone else makes the same choice. If everybody chooses to drive, then the air is polluted. If everybody chooses to take public transportation, then the air is clean. The current situation in Mexico City is that you and all other car owners are driving to work. You enjoy the convenience of driving rather than taking public transportation, but you suffer from the polluted air.
The numbers in the table refer to your payoffs from the different possible combinations. As in our smoking example, we can think of these as the valuations per day that you place on different outcomes. What matters is how these different possibilities compare with the status quo, where you and everyone else drive. We therefore begin by setting your payoff at the status quo (the number in the top left cell) at \$0. Suppose also that the following are true.
• You value clean air rather than dirty air at \$2 per day—that is, you would be willing to pay \$2 per day to have clean air rather than dirty air.
• After taking into account the relative costs and inconveniences of driving versus public transportation, you value driving compared to public transportation at \$1 per day—that is, you would need to be compensated \$1 per day to make you just as happy to take public transportation rather than drive.
Based on these conditions, we can calculate the payoffs in the other three cells of the table:
• The top right cell is the case where you drive and everyone else takes public transportation. Compared to the status quo, you are better off because you get to enjoy clean air. This is worth \$2 to you, so your payoff is \$2.
• The bottom left cell is the case where you take public transportation and everyone else drives. You still have to breathe polluted air, and you no longer get the convenience of driving (which is worth \$1). Compared to the status quo, you are worse off. Your payoff is −\$1.
• The bottom right cell combines the two previous cases. In this case, you and everyone else take public transportation. You get the benefit of clean air (worth \$2), but you lose the benefit of driving (worth \$1). Your payoff is \(\$2 − \$1 = \$1\).
What would you do in this situation? Suppose you think that everyone else is going to drive. You are better off if you drive (payoff is \$0) rather than take public transportation (payoff is −\$1). What if everyone else takes public transportation? Then you still prefer to drive (payoff is \$2) rather than take public transportation (payoff is \$1). We conclude you will drive regardless of what others in society choose to do.
Here is the crux of the problem: the situation looks the same to everybody else as it does to you. As you evaluate these relative payoffs and choose to drive, so too does everyone else. We therefore expect that everyone will follow their individual incentives and choose to drive. We end up in the top left cell, where your payoff is \$0.
What is striking, though, is that you would prefer the outcome where everybody—including you—uses public transportation. Your payoff in the bottom right cell is \$1, which is better than the current situation. Everyone else would prefer this outcome as well. Society ends up in a bad situation, with everybody driving, even though everyone agrees that there is a better option out there. This is the essence of the social dilemma.
You are one of many people. Although you may value clean air, you are powerless as an individual to keep it clean. And because you are only one person, your decision has a tiny effect on the overall quality of the air. Thus you choose to drive, without paying attention to your effect on the environment. But because everybody makes the same decision, the cumulative effect is that there is a lot of air pollution.
The social dilemma is also sometimes known as the “tragedy of the commons.” This refers to the time when cattle farmers had access to common grazing land. Because every farmer had the right to graze his cattle on this land, no one was in a position to ensure that the land was well managed. Every farmer paid attention only to the health of his own cattle and did not worry about the effect of his cattle on the overall quality of the grazing land. Because every farmer made the same decision, the result was overgrazing, which destroyed the land for everyone.
How do we solve problems such as this? To avoid the bad outcome of the social dilemma, we must find some way of changing the payoffs of the game. We have already seen that, if transaction costs are low, people may be able to negotiate privately. In the case of Mexico City smog, however, such negotiation is impractical. In this case, one possible solution is for the government to alter the payoffs. For example, in the run-up to the 2008 Olympics in Beijing, the Chinese government wanted to improve air quality in the city. It therefore allowed cars to drive in the city only every other day (whether a car was permitted on a given day depended on whether the last digit of the license number was odd or even). If you tried to drive on the wrong day, you might have to pay a large fine, so the payoff to driving changed. We have more to say about government policy later in the chapter.
Toolkit: Section 31.18 "Nash Equilibrium"
You can review the social dilemma and other games in the toolkit.
Private Benefits and Social Costs
When people face a social dilemma, the actions that are the best for all individuals lead to an outcome that is bad for everyone. Much of the rest of the chapter addresses why this happens.
We begin by remembering our theory of how people make consumption choices. In general, people consume a good up to the point where their marginal valuation from the last unit of that good equals the price of that unit. This is a specific statement of a more general principle for decision making: “consume until marginal benefit equals marginal cost.”
In the social dilemma of Table 14.2.1 "The Payoffs in a Social Dilemma Game", you had two choices: driving or not driving. Let us now expand that to think about a situation where you are deciding how much to drive. Driving your own car brings private benefits (that is, benefits that are obtained only by you), such as comfort and convenience. Driving also brings private costs, such as the costs of gasoline and maintenance of your vehicle. If this were all that was going on, there would be no problem: you would drive up to the point where your marginal (private) benefit from driving was equal to your marginal (private) cost of driving.
When you drive, though, you also impose costs on other people. Your decision to drive one more mile has a marginal social cost as well as a marginal private cost. Marginal social cost is the cost to society of consuming or producing one more unit of a good or a service. By “society,” we simply mean “you and everybody else.”
When you choose to drive your car, you contribute to air pollution. This is a cost to the rest of society. However, you have no incentive to worry about this. You care only about the extra cost to you. The same is true when the smoker smokes one more cigarette in the office: She imposes a cost on her office mate, but—unless they make an agreement otherwise—she does not pay this cost. She takes into account the marginal private cost to her (that is, how much she must pay for one more cigarette), but she ignores the cost to other people.
Ignoring for a moment some tricky questions about how to measure the cost of your actions to society, we can set out a principle for how much you should consume if your concern were the overall well-being of society: “consume until marginal benefit equals marginal social cost.” The marginal social cost of your driving is the extra cost if you drive more. It is the cost both to you and the cost that you impose on others in society. There can be many components to this cost. One component is the marginal private cost to you. In addition, you pollute the air, contributing to public health problems. You add greenhouse gases to the atmosphere, contributing to the risks of climate change. You make the roads more congested, thus wasting the time of other drivers on the roads. You cause wear and tear on the roads, which will ultimately be paid for by taxes on all drivers.
You might be puzzled at this point. If you drive one extra mile, does that really have any appreciable cost on society? The extra emissions from your driving obviously have a tiny effect on pollution and greenhouse gases. The wear and tear you impose on the roads is minimal. How can these minuscule effects possibly matter? The first and more obvious answer to this question is that the quality of the atmosphere and the roads is affected by everybody’s decisions—not only yours. Hundreds of thousands of cars around the world are polluting the atmosphere and damaging the roads. The second, more subtle, answer is that though your individual influence on air and road quality is very small, you are affecting a very large number of people. If you drive an extra mile in Mexico City, you are affecting the air that is breathed by 20 million people. The marginal social cost of your driving includes the effect on every single one of these people. Likewise, one more mile of driving may add only a tiny amount to the greenhouse gases in the atmosphere, but that tiny effect must be added up over the entire population of the world.
As a result, the marginal social cost of your driving is greater than your marginal private cost. Figure 14.2.1 "A Divergence between Marginal Private Cost and Marginal Social Cost" shows the implications of this. Think of consumption in this diagram as referring to the amount of driving you do. The marginal private cost of your driving is the cost of fuel, depreciation of your car, and so on. But the marginal social cost also includes the pollution of the air and the congestion of the roads. Because the marginal social cost is greater than the marginal (private) cost, you will drive too much, from the perspective of society as a whole. This is exactly what we saw in the social dilemma. People choose to drive and pollute the air, even though all members of society could be happier if everyone were to take public transportation and generate less pollution.
The gap between private costs and social costs means that too much driving is undertaken, from the perspective of society as a whole. The outcome is inefficient because people only have an incentive to take account of the private costs of their actions.
Toolkit: Section 31.11 "Efficiency and Deadweight Loss"
You can review the concept of efficiency in the toolkit.
The gap between marginal private cost and marginal social cost is a measure of the impact that an individual has on the rest of society.
Figure 14.2.1 "A Divergence between Marginal Private Cost and Marginal Social Cost" also illustrates another point. Economic analysis tells us that there is “too much” pollution, from a social point of view. This observation probably comes as no surprise. Economic analysis also makes it clear, though, that it is possible to have too little pollution as well as too much. There is an optimal amount of driving for each individual, to be found where marginal social cost and marginal benefit are equal. At this amount of driving, there will be some pollution: the optimal amount of pollution for society as a whole. If we were to ban driving altogether, we would have less pollution, but we would also lose all the benefits from driving.
Our discussion here has been about decisions of consumers, but firms also are sources of pollution. Firms use trucks and other vehicles that, like cars, impose costs on the rest of society. Some firms pollute the air or the water. Exactly the same principles still apply. Any individual firm has no incentive to take into account the costs that it imposes on the rest of society. As a result, firms pollute too much from a social point of view.
Key Takeaways
• The Coase theorem states that if property rights are well defined and transaction costs are low, then bargaining will lead to an efficient outcome.
• The Coase theorem provides the rationale for a market solution to pollution and other similar social problems.
• A social dilemma arises when there are many individuals each making choices that are in their self-interest but leading to an outcome that is bad for society.
Exercises
1. Why does the Coase theorem require that transaction costs be low?
2. Consider Table 14.2.1 "The Payoffs in a Social Dilemma Game". Suppose your payoff from taking public transportation when everyone else drives is −\$2 rather than −\$1. Would this change the basic message of this example?
3. Look at Figure 14.2.1 "A Divergence between Marginal Private Cost and Marginal Social Cost". How would you modify this figure to make the difference between social and privately optimal quantities larger? Explain your reasoning.
4. Suppose you are in the library and there are two people making out between the shelves. Describe this situation in terms of social versus private costs. How would you use the Coase theorem to find an efficient allocation? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/14%3A_Cleaning_Up_the_Air_and_Using_Up_the_Oil/14.02%3A_The_Economics_of_Clean_Air.txt |
Learning Objectives
1. What is an externality?
2. What are the ways in which problems caused by externalities can be solved?
3. What are some of the difficulties in designing policies to deal with externalities?
At the heart of the social dilemma is a divergence between private costs and social costs. Individuals and firms take into account only private costs when making decisions. But the social costs should matter as well. Thus actions that are individually optimal are damaging to society as a whole. Now that we have diagnosed the problem, how do we fix it? The economist’s answer is that we must change people’s incentives. A social dilemma arises when individual incentives are not well aligned with the interests of society as a whole. Economic policies focus on how to adjust those incentives so that there is a better match between individual and social aims.
Before discussing these policies in detail, we look again at the problem of the social dilemma, focusing now on the actions that people choose to take. In our Mexico City example, people decide whether or not to drive. If they choose to drive, this action affects the well-being of others. Economists say that there is an externality associated with the action of driving.
Toolkit: Section 31.19 "Externalities and Public Goods"
An externality occurs when one person takes an action that directly affects another’s welfare, but the effect does not operate through prices.
An externality must come from an action—something that somebody does. Good weather is not an example of an externality. Nor is an earthquake. The action could be taken by an individual (say, smoking a cigarette) or a firm (dumping toxic waste into a river). In most cases, the action is associated with production by a firm or consumption by a household.
In addition, the action must directly affect another individual’s well-being or a firm’s profits. It could be something that affects the health or happiness of an individual. It could be something that affects the profits of a firm. (“Directly” here means that the effect doesn’t come about because of an induced change in behavior. Suppose, for example, that a firm offers you a job, but to get to that job you now must spend a longer time commuting. The extra commute is not an externality imposed on you by the firm.)
Finally, the effect must not operate through prices. Whenever we take part in market transactions, we have effects (usually tiny effects but effects nonetheless) on market prices. These changes in prices make others in the market better or worse off. But they are not externalities.
In our earlier example of driving, the marginal social cost was larger than the marginal private cost. The gap between the two is a measure of the size of the externality. Because the action of driving imposes a cost, we call this a negative externalities. Pollution is the classic example of a negative externality, but there are others. Congestion of public roads or public parks is another instance of a negative externality.
By contrast, there are also occasions when an action bestows an external benefit on third parties. We call this a positive externalities. For example, writers of open-source software create a social benefit that is in excess of the private benefit that they personally obtain. As another example, suppose that a firm engages in research and development and creates new knowledge. If others are also able to benefit from that knowledge without paying for it (for example, after the expiry of a patent), they are beneficiaries of a positive externality.
Toolkit: Section 31.19 "Externalities and Public Goods"
• A positive externality arises when one person’s or firm’s action bestows benefits on others. When there is a positive externality, too little of the action is undertaken.
• A negative externality arises when one person’s or firm’s action imposes costs on others. When there is a negative externality, too much of the action is undertaken.
Although negative externalities sound bad and positive externalities sound good, positive externalities are also a source of inefficiency. The logic exactly parallels the case of negative externalities. Suppose a firm is deciding how much output to produce. To maximize its profits, it sets marginal cost equals to marginal private benefit (that is, marginal revenue). But if the firm’s production generates a positive externality, the marginal social benefit exceeds its marginal private benefit. The firm produces insufficient output from a social point of view, as illustrated in Figure 14.3.1 "A Divergence between Marginal Private Benefit and Marginal Social Benefit". The principle for socially efficient production is for the firm to produce up to the point where marginal cost equals marginal social benefit.
Figure \(1\): A Divergence between Marginal Private Benefit and Marginal Social Benefit
From a social point of view, however, the firm should produce up to the point where marginal social benefit equals marginal cost.
Solutions to Externality Problems
The definition of an externality makes it clear that the fundamental problem is one of behavior—actions by a firm or a household. The behavior reflects a difference between private costs or benefits and social costs or benefits. These observations also point us to a solution. We need to change incentives so as to align private costs or benefits and social costs or benefits. For example, if the private marginal cost of pollution to a firm were somehow equal to the social marginal cost, then a firm acting in its own self-interest would produce the socially optimal amount of pollution. The challenge for policymakers is to find a way to adjust the incentives so that the firm takes into account social marginal costs in addition to private marginal costs.
From this perspective, inefficiency arises because there are no market signals that force the polluter to take into account how its actions are affecting others. The goal of government policy in the presence of externalities is to provide incentives for firms and households to internalize their effects on others. These policies include direct restrictions on what people can do (for example, banning smoking in public buildings), taxes and subsidies that affect prices in an economy, and the introduction of markets that force polluters to pay for the right to pollute. Because externalities involve a divergence between private costs and social costs (or private benefits and social benefits), the goal in all cases is to adjust the incentives so that the actor internalizes the externality.
Creating Markets
We said that externalities are a source of inefficiency, but we should be more precise: externalities are a source of inefficiency unless they are compensated for. Think back to the smoker and nonsmoker who shared an office. The smoker’s actions impose a negative externality on the nonsmoker. Without any compensating payments, we end up with an inefficient outcome. But when the smoker pays the nonsmoker for the right to use up the clean air, we end up with an efficient outcome. Negotiation between the smoker and the nonsmoker in effect creates a market for the clean air. Once this market is in place, the inefficiency disappears.
Building on this insight, governments can actively try to create markets to solve pollution and other externality problems. A good example of this is the 1990 Amendments to the Clean Air Act in the United States. Much of the air pollution in the United States is caused by utility companies (think of power stations), particularly those that generate electricity from coal. Such power stations pump sulfur dioxide into the atmosphere, which causes acid rain and other environmental problems. The amendments to the Clean Air Act created tradable emission permits that were allocated to utility companies.
Such permits are licenses to emit a specified amount of pollution. A firm must own or purchase a permit if it wishes to emit pollutants into the atmosphere. These permits can be traded in a market. A firm that wishes to emit more pollution than allowed by its existing permits can purchase permits from others. A firm with more permits than it needs can sell them to other firms.
The first response of many people to a policy such as this is moral outrage. At first hearing, it may seem odd that the government is granting a license to pollute. In fact, this can be a very effective way to control pollution. To see how such a system works, suppose that there are two power stations.
1. GreenPower has installed pollution reduction measures and is emitting 100,000 tons of sulfur dioxide per year. Because it is already an environmentally friendly power station, it is very costly for it to reduce emissions further. To be concrete, suppose it will cost \$20 per ton to reduce its emissions.
2. Atmosfear has no pollution control devices in place and is currently emitting 300,000 tons of sulfur dioxide per year. Because it has not yet installed any pollution reduction devices, it is able to reduce its emissions relatively cheaply, at a cost of \$10 per ton.
Suppose the government decides that it wants to restrict the amount of pollution to a total of 200,000 tons per year, down from the current 400,000. It doesn’t matter which power station emits the pollution; either way, the sulfur dioxide ends up in the atmosphere.
One approach is for the government to simply instruct each power station to cut its emissions by 50 percent. The trouble with this is that GreenPower already has an environmentally friendly system in place. It will cost \$1 million (\(= 50,000\ tons × \$20\ per\ ton\)) to reduce its emissions from 100,000 tons to 50,000 tons. Atmosfear has to reduce its emissions by 150,000 tons, which costs \$1.5 million (\(= 150,000\ tons × \$10\ per\ ton\)). The total cost of reducing emissions to meet the target is \$2.5 million.
There is a better alternative. Suppose the government gives each power station a license to emit a certain quantity of pollution. For example, suppose it gives GreenPower a license to emit 50,000 tons and Atmosfear a license to emit 150,000 tons. So far, this is identical to the previous situation. Crucially, though, the government also allows the power stations to trade these licenses. If GreenPower can buy the right to emit sulfur dioxide for less than \$20 per ton, it will prefer to do this rather than reduce its own emissions.
Because it costs Atmosfear only \$10 per ton to reduce its emissions, the cheapest way to achieve a 200,000-ton reduction is for Atmosfear to carry out the entire reduction in emissions, down to 100,000 tons. If it does so, then it will have 50,000 unused permits that it can sell to GreenPower. The total cost of emissions reduction in this scenario is only \$2 million. For example, suppose they agree on a price of \$15 per permit. Then the cost to GreenPower is \(\$50,000 × \$15 = \$0.75\ million\) (instead of \$1 million). The cost to Atmosfear is \$1.25 million: \$200,000 × \$10 = \$2 minus the \$0.75 million it collects from GreenPower.
In some ways, this is like our smoking example. The power stations are able to trade, so they can both be better off. Emissions are reduced to the required level of 200,000 tons, and this reduction is achieved in the most cost-effective manner. Notice also that the government gets to decide on the total amount of acceptable pollution; the approach is consistent with very tight or very lax environmental standards. However, once the government has determined its desired level of pollution, the trading of permits allows the necessary reductions in pollution to be achieved at the lowest possible cost to society.
With tradable permits, pollution is controlled in the most efficient way, without regulators’ needing detailed knowledge on different power stations. The trading system has some other advantages as well. Firms have an incentive to pollute less because they can sell excess permits for a profit if they do not need to use them. Environmental groups can even purchase emissions permits and take them out of circulation to reduce pollution below the level mandated by the government.
A more contentious question has to do with how the permits are allocated in the first place. One approach is to do what we did in our example: the government can simply allocate permits based on the existing level of emissions. A problem with this policy is that it effectively punishes firms that have already engaged in environmentally responsible changes. It also creates an incentive for lobbying by firms: because permits are valuable, firms will invest resources in trying to persuade policymakers to give the permits to them rather than to their competitors. Instead of giving away the permits, the government can instead auction them. This increases costs for the firms but has the advantage that it generates funds for the government. See Chapter 6 "eBay and craigslist" for a discussion on auction mechanisms.
Taxes and Subsidies
Remember that the problem with externalities is that private incentives do not reflect social costs and benefits. Another approach to fixing these incentives is through taxes and subsidies.
Consider first the case of a negative externality. The problem in this case is that the marginal social cost exceeds the marginal private cost. As we saw in Figure 14.2.1 "A Divergence between Marginal Private Cost and Marginal Social Cost", this leads to overconsumption of a good. One way to fix the problem is to impose a tax that equals the difference between the marginal private cost and the marginal social cost. In effect, this converts the condition for private optimality (consume until marginal benefit equals marginal private cost) into the condition for social optimality (consume until marginal benefit equals marginal social cost).
The case of a positive externality is entirely analogous. The problem is that the marginal social benefit exceeds the marginal private benefit. As we saw in Figure 14.2.2 "A Divergence between Marginal Private Benefit and Marginal Social Benefit", this leads to underproduction of a good. One way to fix the problem is to impose a subsidy that equals the exact difference between the marginal private benefit and the marginal social benefit. This converts the condition for private optimality (consume until marginal private benefit equals marginal private cost) into the condition for social optimality (consume until marginal social benefit equals marginal cost).
We see such policies in practice. Taxes on gasoline exist in part to compensate for externalities such as the pollution caused by automobiles and the wear and tear on roads. Subsidies to universities and think tanks exist in part to encourage the production of knowledge, which is a good with positive externalities.
Command and Control
There are also other kinds of environmental policies. The government can simply mandate that certain levels of pollution must not be exceeded. In some cases, such command and control regulation may be easier to implement and monitor.
Under most circumstances, economists favor either taxes or the creation of a permit market to command and control. The reason is that command and control is relatively inflexible and requires a lot of knowledge of how much pollution is generated by each individual firm. Taxes, subsidies, or permit markets are more flexible and do a better job of changing the incentives faced by polluting firms.
Encouraging Altruism
A rather different approach to externalities is to appeal to people’s altruism. In economics, we typically assume that people consider only their own self-interest when making decisions. Moreover, we usually think of this self-interest in fairly narrow terms. This may seem a rather embittered view of human nature. People often do things that are directed toward others’ happiness rather than their own—that is, people are sometimes altruistic rather than selfish. In the environmental context, people sometimes purchase products from environmentally responsible firms even if those products are more expensive. People sometimes purchase carbon offsets to compensate for the carbon generated by their driving or air travel. Companies often find it worthwhile to advertise the fact that they are environmentally responsible.
Governments also provide environmental information. The European Union has recently proposed measures requiring that new cars display their impact on global climate change, just like health warnings on cigarettes.See Ian Traynor and David Adam, “It’s Lean and Mean, but Is It Green? EU Plans Clampdown on Car Ads,” Guardian, June 5, 2008, accessed February 28, 2011, http://www.guardian.co.uk/environment/2008/jun/05/carbonemissions.carbonfootprints. Unlike health warnings on cigarettes, this labeling does not help people live healthier lives. And unlike efficiency ratings on appliances, this labeling does not help people make better decisions that will save them money. Climate change labels appeal purely to people who want to act in a way that will lessen their environmental impact. As we saw earlier in the chapter, purchases of hybrid cars seem to be primarily motivated by people’s desire to be more environmentally responsible.
Psychologists and economists have studied why people sometimes behave in such ways. Perhaps it is because they are genuinely altruistic—they care about the well-being of others as well as themselves. Perhaps it is because of persuasion and peer pressure—if your friends behave in an environmentally conscious way, then there is pressure for you to do the same thing. Perhaps it is because of the feeling of satisfaction (sometimes called a “warm glow”) associated with such behavior. For our purposes in this chapter, however, the exact reasons why people behave this way are less important than the behavior itself. There are several ways of thinking about altruistic behavior, but in the environmental context, altruism really amounts to people deciding to internalize some of the externalities that they impose. They incorporate some of the social cost into their own private costs. Governments, through advertising campaigns, can encourage such altruistic behavior.
Difficulties with Environmental Policy
Our discussion of externalities makes it seem that it is straightforward for policymakers to design effective environmental regulation. Government regulators simply need to calculate the difference between marginal private costs and marginal social costs and between marginal private benefits and marginal social benefits. Then they can put in place the appropriate taxes, subsidies, or both.
In practice, a major difficulty is knowing how to place values on externalities. Environmental policies to combat air or water pollution require the government to monitor the amount of emissions effectively and accurately. If emissions cannot be monitored, then tax or permit schemes are impossible to implement. Effective environmental policies also require the government to measure the damage incurred by the victims of the pollution.
As with many economic policies, questions also arise concerning the distribution of resources. In an environmental context, the key point of debate is often whether compensation should and will be paid. If a factory pollutes the river running through a town, imposing negative externalities on the town’s residents, then is it enough to adjust the incentives so that there is the “right” amount of pollution—that is, so that the marginal benefit to the firm equals the marginal social cost? Or should the firm also be required to compensate the residents of the town? This is again a question of property rights, for we are really asking who has the initial right to the clean water in the river. It is also closely related to the question of whether pollution permits should be given away (implying that firms have the property rights) or sold at auction.
Whenever government steps in and enacts policies to affect behavior, it also must worry about whether there will be perverse responses to those incentives. As an example, the disposal of solid waste is a significant environmental problem in many countries. It is in part an economic problem: people do not usually pay directly for the removal of their garbage, so they do not have an incentive to recycle or avoid waste in other ways. A solution—favored by many economists and adopted by some municipalities—is to charge people a fee per bag for garbage removal. A study by Don Fullerton and Tom Kinneman revealed that this policy can bring its own problems.Don Fullerton and Thomas Kinneman, “Household Responses to Pricing Garbage by the Bag,” American Economic Review 86, no. 4 (1996): 971–84. When such a scheme was introduced in Charlottesville, Virginia, citizens responded by putting much more garbage in each bag than they used to (Fullerton and Kinneman called this the “Charlottesville stomp”), so the reduction in the waste stream was lower than the authorities had anticipated. More seriously, some people also responded by dumping their trash illegally.
Valuing the Environment
The measurement of environmental harm is complicated. Suppose, for example, that pollution brings with it increased risk of disease or death. How do we place a cost on these risks? We can perhaps attempt to value health in terms of the costs of treatment and lost working hours, but it is much harder to place a value on the distress and suffering caused by ill health. Economists, lawyers, and others have even come up with varying ways to place a dollar value on human life, but—as you can surely imagine—these techniques are contentious. One reason is that all such approaches tend to rely, at least in part, on estimates of lost earnings. This means that the lives of skilled and high-paid individuals may end up being valued more than the lives of unskilled, lower-paid individuals.
A second set of issues has to do with how we value damage to the natural environment. Take, for example, the oil leak in the Gulf of Mexico in 2010, which caused substantial harm to birds, fish, and ocean ecosystems. Most of us are upset by the sight of seabirds with their feathers clogged with oil. But how should we assess the value of such damage? Similarly, what is it worth to ensure the survival of a particular endangered species?
Where possible, economists look to market prices to provide some indication of the value that society places on goods and services. In the case of environmental goods, though, we typically cannot look to markets. In such cases, we may need to use surveys and other methods for inferring household valuations. This is known as contingent valuation.
For several reasons, it is very difficult to carry out reliable contingent valuation surveys. In such a study, a household might be asked, “What would you be willing to pay to ensure that the whooping crane (for example) does not go extinct?” Such surveys often give implausible answers. For example, following an oil spill, people in Washington state and the province of British Columbia were supposedly willing to pay over \$11,000 for each seabird that was saved—even though the seabird population would recover naturally in a decade or so.
The main problem, as you can perhaps guess, is that people do not face a real budget constraint when asked such questions, so they have no particular incentive to give a truthful answer. A related issue is that people are typically presented with an issue in isolation. A household that claims to be willing to spend \$50 to save one species from extinction might not be willing to spend \$10,000 to save 200 species at a cost of \$50 each. A third issue is that people may not have the information they need to make good decisions. We are not used to making purchases of environmental quality, so it is harder for us to give our valuation of a clean river than it is for us to give our valuation of, say, a bar of soap.
Yet, for all these objections, we do need some way of placing a value on environmental resources. The fact that we find it difficult to measure such things does not mean that they have no value. Contingent valuation studies are now very sophisticated, and researchers are very active in the search to make such studies better and more accurate.
Whose Welfare Should Be Included?
Another difficulty with environmental policymaking is that it is not always clear whose opinions should be taken into account when making environmental policy. For example, suppose there were a proposal to allow a major resort development at the Grand Canyon. Should that be the concern of residents of the area, the state of Arizona, or the entire United States? For that matter, should residents of other countries be entitled to a voice? After all, the Grand Canyon is one of the most spectacular sites in the world, visited by thousands of foreign tourists every year.
Perhaps you think it self-evident that foreigners should have no say in US environmental policy. Yet environmentalists in the United States and Europe have often voiced their opinion on the environmental consequences of policies in other countries, such as the construction of the Three Gorges Dam in China. Similarly, much of the world was outraged when, in 2001, the Taliban in Afghanistan destroyed two giant Buddhas that had been carved in the sixth century.
An even bigger problem has to do with the treatment of future generations. When you drive your car today, you are imposing costs not only on the living but also on those as yet unborn. The people most likely to be adversely affected by global climate change are not yet alive. How should we take into account their welfare and well-being? Scientists are largely in agreement that carbon emissions from the burning of fossil fuels will have an effect on global climate. Most environmental economists are convinced by this evidence, yet there continues to be disagreement among economists about the appropriate policy response. Most of that disagreement in the end comes down to different views about how to account for the welfare of future generations.
Uncertainty
One of the biggest difficulties with designing environmental policy is uncertainty. Global climate change is the clearest example. Although there is widespread agreement that we face some risk of climate change from carbon emissions, there is debate about the size of the effect. It is possible that we are facing only a small change in global climate, in which case it might not be worth spending a lot of resources now on reducing emissions. It is also possible that there could be catastrophic effects on global climate, in which case we should spend a lot of resources right now on reducing carbon emissions. And it is probable that we are facing something in between these extremes. Policymakers must try to get good estimates of how likely these scenarios are and then must decide how risk-averse they want to be when setting policy.
International Cooperation
Because environmental problems are often not confined to a single country, international agreements are sometimes needed for effective environmental policy. The Montreal Protocol on Substances That Deplete the Ozone LayerUnited Nations Environment Programme, “Section 1,” Handbook for the Montreal Protocol on Substances that Deplete the Ozone Layer—7th Edition (2006), accessed March 14, 2011, ozone.unep.org/Publications/MP_Handbook/Section_1.1_The_Montreal_Protocol. is an example of successful international cooperation on environmental policy. In the 1970s, scientists recognized that certain chemicals known as chlorofluorocarbons (CFCs) were leading to a reduction in the atmospheric ozone layer. The ozone layer filters out dangerous radiation, so its destruction was linked to increases in skin cancer and other problems. The Montreal Protocol came into force in 1989 and has been signed by almost every country in the world. It mandated a gradual phaseout of CFCs, and current research shows that the atmospheric concentrations of CFCs have decreased as a result.
To date, however, there has been much less progress on the even bigger problem of global climate change. Although there has been much negotiation, there is still no international agreement on climate change that is comparable to the Montreal Protocol. In 1997, countries signed the Kyoto Protocol,United Nations Framework Convention on Climate Change, Kyoto Protocol to the United Nations Framework Convention on Climate Change, 1998, accessed March 14, 2011, http://unfccc.int/resource/docs/convkp/kpeng.pdf. which was the first major international agreement to address the accumulation of greenhouse gases in the atmosphere. Some countries—notably Canada, Australia, New Zealand, and most of Europe—committed to specific targets, while others made more general commitments. However, the United States did not ratify the agreement. Meanwhile, several of the largest emitters of greenhouse gases, such as China, India, and Indonesia, did not have any specific commitment to greenhouse gas reductions. As a result, the impact of the protocol is greatly limited. One interesting feature of the Kyoto Protocol is that it included provisions for emissions trading.
In 1999, the United Nations held another summit in Copenhagen, in an attempt to make more progress on this topic. The outcome of the summit was the Copenhagen Accord:United Nations Framework Convention on Climate Change, “Copenhagen Accord, Draft decision -/CP.15,” Copenhagen, December 7–18, 2009, accessed March 14, 2011, http://unfccc.int/resource/docs/2009/cop15/eng/l07.pdf. a declaration that climate change was a problem. However, no binding commitments on greenhouse gas emissions resulted. A follow-up meeting in Cancún, Mexico, in 2010, delivered the Cancún Agreement,United Nations Framework Convention on Climate Change, “Outcome of the work of the Ad Hoc Working Group on long-term Cooperative Action under the Convention, Draft decision -/CP.16,” accessed March 14, 2011, http://unfccc.int/files/meetings/cop_16/application/pdf/cop16_lca.pdf. which—although still not a binding treaty—was judged by many observers to represent significant progress over the Copenhagen Accord. Still, despite many meetings and fine-sounding commitments, the world is a long way from having an agreement on greenhouse gas emissions to match the Montreal Protocol.
Other Kinds of Externalities
Our discussion here has been about externalities arising from either the production or the consumption of goods and services. However, the idea of externality is used much more broadly in economics because it is a very helpful way of diagnosing inefficiencies.
One example comes from the working of labor markets. In general, both firms and workers spend time and resources trying to make a good “match.” Firms have human resource departments that spend resources advertising jobs, going through résumés, interviewing job applicants, and so on. Workers spend time preparing their résumés, interviewing at different firms, and so on. Both are willing to do this because a good match can be very beneficial: the firm gets a highly productive worker for which it is willing to pay a good wage. Chapter 9 "Growing Jobs" discusses search and matching in the labor market in more detail.
Now, the more effort the worker and the firm expend, the more likely they are to come up with a good match. And though each benefits individually from this effort, some of the benefit also flows to the other side of the market. In other words, if a worker tries harder to make a good match, this bestows a positive externality on a firm, and if a worker tries harder to make a good match, this bestows a positive externality on the worker.
As another example, is it a good thing if a new fast-food restaurant opens in your town? To answer this, we can think about the externalities that arise because of the decision to enter. When a new restaurant opens, it is providing a product that is similar but not identical to some of the offerings already in the market. It thus steals business from existing restaurants and reduces their profits. We can think of the entry of a new restaurant as imposing a negative externality on existing restaurants. Conversely, the entry of a new restaurant bestows a positive externality on consumers because they benefit from the increased choice. Thus the entry of a new restaurant leads to both positive and negative externalities.
We said previously that if an action has positive externalities, then there will be too little of that action from a social point of view. If an action imposes negative externalities, there will be too much of that action. In this example, the action is the entry of a new firm or product. If the positive externalities are more important, then there is too little entry, from a social point of view. If the negative externalities are more important, then there is too much entry. In general, we cannot draw any conclusions about whether there are too many firms (or products) or too few.
Key Takeaways
• An externality arises when an action taken by one person directly affects another’s welfare. These operate outside of markets.
• One solution to an externality problem is to create a market so that the effects of one person’s actions on others will be reflected in the market price of taking that action. Another solution is to put in place taxes or subsidies so that private incentives are aligned with social goals.
• One challenge for policy design is that the valuation of environmental goods is difficult to measure. Moreover, external effects do not respect borders, so international agreements are often required.
Exercises
1. If someone living nearby you is playing loud music, is that a positive or negative externality?
2. In a system with tradable permits, how is the total quantity of permits determined?
3. Suppose you invent a new product. After the patent expires, others can freely copy your design. Is your act of invention an example of an externality? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/14%3A_Cleaning_Up_the_Air_and_Using_Up_the_Oil/14.03%3A_Externalities.txt |
Learning Objectives
1. What is the Hotelling rule for the use of resources?
2. What is a nonexcludable good?
3. What is an accumulable resource?
Some individuals take deliberate actions to limit or reduce their environmental impact. For some people, the choice of a greener lifestyle can affect almost all aspects of their consumption, including housing, transportation, and the food that they eat. There are, of course, many different ways in which our actions affect the environment. Our choices affect the amounts of pollutants that are emitted into the air and the water. They affect the amount of greenhouse gases that enter the atmosphere, which in turn has an impact on climate change. And they affect the rate at which we use up natural resources such as oil.
We explained that air pollution from automobiles is an example of an externality, which means that there is a divergence between marginal private costs and marginal social costs. Because of this externality, decisions to drive in a city can generate a social dilemma. It is not obvious, though, that consumption of gasoline generates an analogous problem. Some people argue that, if you are willing to pay for gasoline, you have the right to buy as much or as little as you please. If you want to drive a gas-guzzling Hummer or sport utility vehicle (SUV) rather than a fuel-efficient Prius, then—in their view—that is your right. Others make a different claim. They argue that because oil is a scarce resource, we ought to be conservative with its use. Driving a gas guzzler—in their view—wastes the earth’s limited natural resources and thus is environmentally irresponsible. We now evaluate these two views.
Nonrenewable Resources and the Hotelling Rule
Oil is a nonrenewable (exhaustible) resource—that is, a resource that does not regenerate over time. Obviously, if we keep using up a nonrenewable resource, we will eventually run out of it, which is why it is called exhaustible. We most often hear this concern voiced about oil. For example, as oil prices increased to record levels in 2008, there was a great deal of discussion in the media about “peak oil”—the point at which world oil production is at its maximum.
Given that total oil resources are limited, we will eventually go beyond the peak oil point. Many commentators believe that we are at or close to this point already and have expressed concern about the implications of this for the world’s economy. Consider, for example, the following quotation from a 2005 report:
World oil demand is expected to grow 50 percent by 2025. To meet that demand, ever-larger volumes of oil will have to be produced. Since oil production from individual reservoirs grows to a peak and then declines, new reservoirs must be continually discovered and brought into production to compensate for the depletion of older reservoirs. If large quantities of new oil are not discovered and brought into production somewhere in the world, then world oil production will no longer satisfy demand. That point is called the peaking of world conventional oil production.Robert L. Hirsch, Roger Bezdek, and Robert Wendling, “Peaking of World Oil Production: Impacts, Mitigation, & Risk Management, ” Minnesotans for Stability, February 2005, accessed January 31, 2011, http://www.mnforsustain.org/oil_peaking_of_world_oil_production_study_hirsch.htm; also quoted in James Hamilton, Limitations of the Hirsch Report on Peak Oil, Econbrowser, August 9, 2005, accessed January 31, 2011, www.econbrowser.com/archives/2005/08/limitations_of.html.
When economists read a quotation like this, however, they typically think that something is missing. The quotation says that, at some point “world oil production will no longer satisfy demand.” Economists respond that this does not make sense: the price of oil will adjust to ensure that supply equals demand. Similarly, they would say that it is very unclear what “oil demand is expected to grow 50 percent” means. Does this mean a shift in demand (a 50 percent increase in the quantity demanded at every price) or an increase in the equilibrium quantity (the quantity purchased will be 50 percent higher than it is now)? Fundamentally, economists would say that we cannot talk sensibly about the oil market without discussing what will happen to the price of oil. We turn to this question next.
The Hotelling Rule
Suppose you own 1,000 barrels of oil. You want to decide when you should sell them. You could sell them now or hold onto them in the hope that the price of oil will increase. This is a difficult problem, so we begin by making some simplifications. First, imagine you already have the oil in storage, so we can ignore the costs of extracting it from the ground. Second, suppose you can store it for free. Third, suppose you can buy and sell oil in a competitive market.
Even with these simplifying assumptions, it seems as if you are facing a hard decision. In fact, this problem is easier than it looks. If you sell one barrel this year, you get this year’s price. You can invest this at the market rate of interest and get (price this year × interest factor). Alternatively, you can store your oil for a year and then sell it next year at next year’s price. If this year’s price multiplied by the interest rate is greater than next year’s price, then you should sell all of your oil this year. If next year’s price is higher, you should store all of your oil for sale in the future. By following this rule, you can determine how to make the most money from your stock of oil.
Of course, this decision looks the same to anyone else who is in the same position as you. So if this year’s price multiplied by the interest rate is greater than next year’s price, then everyone would try to sell their oil this year. There would be a huge supply of oil to the market, which would tend to reduce the price this year. If next year’s price is higher, then there will be little to no oil supplied to the market this year, which would tend to increase the current price. The only way the oil market will be in equilibrium is if a condition known as the Hotelling rule holds. This is an arbitrage condition for the use of resource stocks. In the case of a nonrenewable resource sold in a competitive market, with no costs of extraction, no costs of storage, and no uncertainty, the rule states that
The Hotelling rule tells us that the price of the resource increases at the rate of interest. For example, if the nominal interest rate is 6 percent (the nominal interest factor is 1.06), then the Hotelling rule says that the price of oil will increase 6 percent per year. The rule has a remarkable implication: it does not matter whether you sell your oil or hold onto it. If you sell your oil, you can earn the market rate of interest on your savings. If you hold onto your oil, it as an asset that yields a rate of return equal to the market rate of interest. Either way, you should expect to get the same return.Oil can be thought of as an asset. In Chapter 10 "Making and Losing Money on Wall Street", we discuss how the prices of different kinds of assets are determined. The discussion in that chapter also explains how we can take into account the fact that you don’t know the future price of your asset—in this case, next year’s price of oil—with certainty.
Complications
The basic Hotelling relationship underlies the pricing of all renewable and nonrenewable resources, but there are many other factors that also come into play. We can in principle build all these other complications into our equation, but this would require mathematics and analysis that go beyond the level of this book. Still, we can give a brief idea of how to incorporate these other factors.
Costs of storage. If it is costly to store the resource from one year to the next, then the price must increase at a rate fast enough to cover the cost of storage as well as the rate of interest.
Costs of extraction. We have ignored the costs of extracting oil from the ground. This cost is not constant in either the short run or the long run. In the short run (say, in a given year), the marginal cost of extracting oil increases when we pump more oil from the ground. (One implication is that the supply of oil at any given time is not perfectly elastic.) As we start to run out of oil, it is likely that the marginal cost of extracting oil from the ground will increase substantially. This, too, must be factored into the arbitrage condition. Marginal extraction costs that increase over time are an additional factor causing prices to increase.
Discovery of new oil fields. If new oil fields are discovered, then the overall supply of oil in the world increases. This increase in supply leads to a decrease in the price. As soon as there is a discovery of a new field, the price of oil jumps to a new Hotelling path. What matters for the pricing of oil is new information about existing resources. If the oil companies discover a new oilfield—or come up with a better technique for extracting existing reserves—there will be a decrease in the price of oil as soon as this information becomes known to the market. This is why the price of oil is so sensitive to political changes in the Middle East.
Shifts in the demand curve. The price of oil is also affected by shifts in the demand curve. For example, the increasing prosperity of countries such as China and India is causing the demand for fossil fuels to shift outward. Technological developments are one source of changes in demand. If scientists were to come up with a cheaper source of energy, the demand for oil would decrease.
Market power. The supply of oil is heavily influenced by the decisions of oil-rich countries such as Saudi Arabia and Kuwait. Producers with market power tend to restrict supply to force prices up. The effect of this is to increase prices at all times, which in turn means that existing stocks of oil will last longer. Market power, in and of itself, does not affect the basic conclusion from the Hotelling rule unless the degree of market power changes over time.
Uncertainty. Finally, we took the stock of oil, the demand curve, and the rate of interest as known with certainty. In reality, of course, all of these are unknown. Changes in the information with regard to any of these variables will lead to changes in the price of oil.
Does the Hotelling Rule Work in Practice?
The Hotelling rule is based on a very simple arbitrage idea, so it is highly compelling. Yet it is sometimes difficult to observe the rule in operation in the data for oil or for any other nonrenewable resource. Figure 14.4.1 "The Price of Oil (in 2008 Dollars)" shows what has happened to the price of oil in the last 60 years or so. The prices are in 2008 dollars. Oil prices were reasonably steady in the 1950s and the 1960s. The 1970s are sometimes called the “oil shock decade,” and from the graph you can see why. The price of oil jumped to a level that is equivalent to over \$100 a barrel in 2008 dollars. Then oil prices fell again and were relatively low in the 1980s and 1990s. The early years of the 21st century saw another big increase in oil prices, with the price reaching record levels in 2008.
Oil prices were relatively stable in the 1950s and 1960s, rose rapidly in the 1970s, were low from the mid 1980s until about 2002, and have since increased rapidly.
Source: Federal Reserve Bank of St. Louis FRED database: Spot price of West Texas crude oil ( http://research.stlouisfed.org/fred2/data/OILPRICE.txt) deflated by the Consumer Price Index ( http://research.stlouisfed.org/fred2/data/CPIAUCSL.txt).
It is not easy to reconcile this figure with the Hotelling rule. We do not see the price of oil increase steadily, as the Hotelling rule seems to suggest. The problem is that the complications that we mentioned in Section "Complications" are quite significant in practice. Over the last several decades, we have seen technological improvements, the discovery of new oil fields, political instability in the Middle East and other oil producing regions of the world, price-fixing by the oil-producing countries, and so on. Most of the time, it seems as if these variables are swamping the pattern we expect from the Hotelling rule.
If we look at other nonrenewable resources, it is likewise difficult to see Hotelling effects. In large part this is because technological improvements have often made resources less valuable, even as they became scarcer. For example, copper became significantly less valuable when scientists developed techniques for transmitting information along fiber-optic cables rather than along copper wire.
For all of these reasons, you should not think of the Hotelling rule as literally describing what will happen to the price of nonrenewable resources in the real world. Instead, you should think of it as explaining one component of the price. If the exhaustion point of the resource is a long way in the future, the Hotelling rule may not play a big role in explaining the price. Other factors that shift the demand and supply curves may explain most of the price variation. Nevertheless, most economists are confident that the Hotelling rule does contribute to resource price changes, and as a resource gets closer to exhaustion, the Hotelling rule will play a bigger and bigger role. James Hamilton, an economist who is an expert on oil, put it as follows in late 2006:
My own view is that, for most of the past century … the resource exhaustion was judged to be sufficiently far off as to be ignored.…I do not infer that the next decade will necessarily be like the previous century. Certainly declining production from U.S. oil reservoirs set in long ago.…
I am not at all prepared to dismiss the hypothesis that [the Hotelling rule has] indeed started to make a contribution to oil prices over the last five years, and will become more apparent over the next five. For example, the announced intention of OPEC producers to cut back production as the price goes below \$60 might be most naturally interpreted from that perspective—producers don’t see it as being in their interests to sell for less, given what the oil will be worth in the future.See James Hamilton, “Is Peak Oil Irrelevant?,” Econbrowser, October 24, 2006, accessed January 31, 2011, www.econbrowser.com/archives/2006/10/is_peak_oil_irr.html.
Excludable and Nonexcludable Resources
The Hotelling rule tells us that we expect the price of a nonrenewable resource to rise as we use it up. As its price increases, households and firms have an incentive to substitute other goods for the resource. As the price of oil increases, people switch to other forms of transportation and more fuel-efficient vehicles. More generally, an increase in the price of oil makes other forms of energy—such as wind, solar, or nuclear power—more attractive.
Nothing in this description suggests any failure of the market mechanism. Although we have explained what will happen as we start to run out of a resource, we have not given any reason to suggest that we will use up the resource too quickly. In fact, we have even pointed to one reason we might be using up oil too slowly: if oil producers have market power, they have an incentive to limit the supply to the market and increase the price. The mere fact of using up a nonrenewable resource does not mean that the market is not efficient. To understand the difference between using oil and polluting the atmosphere, we need a new distinction.
Toolkit: Section 31.19 "Externalities and Public Goods"
A nonexcludable good (or resource) is one for which it is impossible to selectively deny access. In other words, it is not possible to let some people consume the good while preventing others from consuming it. An excludable good (or resource) is one to which we can selectively allow or deny access.
Go back once more to our example of a smoker in an office. The smoker actually consumes two things: she consumes cigarettes and she consumes the clean air in the office by turning it into dirty air (economists call this “joint consumption”). Clean air, like a cigarette, is a “good.” But it is a good with a special property. Under most circumstances, we cannot allow some people access to clean air while denying others access to clean air. Clean air is nonexcludable.
Drivers in Mexico City likewise consume clean air: driving leads to less clean air and more dirty air. Like the smoker in the office building and the car drivers in Mexico City, polluting firms consume clean air as well. In this instance, we can think of clean air as being another input into the production process. Air pollution is a process by which the nonexcludable resource that we call “clean air” is consumed by households and firms. This is a somewhat unfamiliar way to talk about environmental pollution, but it makes sense once you think about it. At the end of the production process, there is less clean air than before because the firm has made some air dirty. The polluting firm uses clean air in its production process.
Partially Excludable Goods
Other examples of nonexcludable goods are fireworks displays, lighthouses, fish in the ocean, concerts in a public space, and broadcast television. These examples prompt the following observations.
• Whether or not something is excludable can change with advances in technology. Early television and radio signals were nonexcludable because they could be accessed by anyone with a suitable receiver. But cable television and Internet radio are excludable because it is technologically possible to restrict access to certain users.
• Excludability is not a hard-and-fast line. Think about roads, for example. Toll roads are excludable; it is possible to control access to toll roads because there are relatively few entrances and exits. By contrast, roads in a neighborhood or in the middle of a city are nonexcludable; it is almost impossible to imagine allowing selective access to different city blocks. The more different entrances there are to a road, the harder it is as a practical matter to make the road excludable. Similarly, fish in the ocean are neither fully excludable nor completely nonexcludable. Fish in international waters can be fished by anyone, but coastal waters are under the jurisdiction of individual nations that may restrict fishing rights.
Going back to our smoking example, we cannot make the air in a single office excludable, but we can perhaps do the next best thing: within a single building, we could certainly imagine permitting smoking in some offices and not in others. In other words, we could define property rights differently in different offices and in this way make clean air partially excludable. In some cases at least, this might be a practical way to accommodate both smokers and nonsmokers. We see something to this effect in airports and other public spaces. Very often you will find that most of an airport is designated as nonsmoking (meaning that the property rights to clean air have been allocated to nonsmokers), but there are designated rooms or areas where smokers have the right to consume—that is, use up—the clean air.
Externalities and Nonexcludable Goods
There is a connection between nonexcludability and externalities. As our clean air example suggests, goods—like clean air—that are nonexcludable will tend to be overconsumed. When a good is nonexcludable, its marginal private cost is zero. If its marginal social cost is positive, then there is a negative externality from the consumption of a good. As these observations suggest, there are typically negative externalities associated with nonexcludable (or partially excludable) goods.
The flipside is that nonexcludable goods will be underproduced. To see why, think about whether a private firm will want to produce nonexcludable goods. For goods that are completely nonexcludable, the answer is no. There is no return from producing such goods because they cannot be sold for profit. Anyone can consume these goods without paying for them. Goods that are partially nonexcludable may be produced, but they will be produced in insufficient quantities.
Should We Worry about Running Out of Resources?
Because clean air is a nonexcludable resource, there are externalities associated with its use, and we know that this implies inefficiency. Economics provides a clear argument for why we end up overconsuming clean air. Similarly, many people take it as self-evident that we are overconsuming oil and other natural resources. The arguments we made with respect to clean air, however, do not translate to the case of oil. It is true, of course, that consumption of oil may have negative externalities because it leads to pollution. But the problem in this case has nothing to do with the fact that oil is a nonrenewable resource.
It is difficult to buy and sell nonexcludable goods—after all, why would anyone buy something that is free? This makes clean air unlike most of the other goods we study in economics. Excludable goods and services, by contrast, are those that we can prevent someone else from enjoying. Excludable goods—like oil—are easily traded in markets.
When people worry about running out of resources, they are speaking, for the most part, about excludable resources: those that are mined from the ground or grown on farms and privately owned forests. Economic analysis suggests that this worry may be largely misplaced. Unless we have specific reasons to think that markets are misallocating these resources, there is no particular cause for concern or government intervention.
There are some exceptions to this principle. Oil is sometimes drilled from pools that are not uniquely owned. Different companies may be able to access the same oil pool. In this case, the oil in the pool is partially nonexcludable—any company with access to the pool is able to drill it. It follows that there is a negative externality associated with the drilling of the oil in this case, so we expect there to be too much drilling.
Renewable Resources
Oil is a nonrenewable resource. New oil reserves are not going to be created (at least over any period of time relevant to human beings). Over time, the stock of a nonrenewable resource can only decrease, never increase. By contrast, a renewable resource is one that regenerates over time.
Whether the stock of a renewable resource grows, shrinks, or stays constant depends on the balance between how fast we use up the resource and how quickly it regenerates. If a resource is depleted at a rate faster than it regenerates, the stock will decrease. If a resource regenerates faster than it is depleted, the stock will increase. Examples of renewable resources are stocks of fish in the ocean and forests. Clean air and water are also examples of renewable resources: if the source of pollution disappears, then a polluted river or polluted air will tend to improve naturally over time. Of course, this process can take quite a while.
In some cases resources may be renewable only above a certain threshold. For example, we can overfish a particular species of fish to the point of extinction. So although a renewable resource will normally naturally regenerate over time, it can turn into a nonrenewable resource if the stock falls below a critical level.
As with nonrenewable resources, what matters most for efficiency is whether a resource is excludable or nonexcludable. If a renewable resource is excludable, then a modified version of the Hotelling rule applies. The arbitrage condition in this case takes into account the fact that the resource stock gets larger as time goes by. If the resource is nonexcludable, however, then all the problems we saw earlier in the chapter come into play. The marginal social cost of using the resource will typically exceed the marginal private cost, leading to overconsumption of the resource.
Accumulable Resources
Nonrenewable environmental resources get used up over time. With good stewardship, which usually requires well-established property rights, the stocks of renewable resources can stay constant or even increase. Environmental resources, however, typically cannot grow without limit. There is a limit to how many fish there can be in the ocean or how clean the air can be.
Economists also identify a third class of resources, called accumulable resources. Such resources can increase (more or less) without limit. The most important examples are physical capital (factories, machines, etc.), human capital (the skills and know-how of workers), and general human knowledge.
Even though there is no reason to think that the depletion of a nonrenewable resource is necessarily a source of economic inefficiency, it does not follow that the depletion of natural resources is without cost for an economy. For example, as oil becomes more expensive, it costs more to produce other goods and services that use energy as an input. From an economic perspective, this is a lot like a worsening of technology.
Crucially, though, we are accumulating resources such as physical capital, human capital, and knowledge at the same time that we are running down our stocks of oil, coal, and other natural resources. In the last couple of centuries, the economy of the world has grown substantially because we have been able to accumulate resources at a rate that far outpaced our depletion of the natural environment. For much of that time, we had natural resources in abundance, so their price stayed low. At the same time, we increased our technological know-how at unprecedented rates.
There is no guarantee, from economics or anywhere else, that this state of affairs will continue. We will continue to run down our stocks of nonrenewable resources. If technological advance (and other accumulation) fails to keep pace, then we might well see the prices of these goods increase. More generally, the fact that we have seen our economies growing in the past is no guarantee that they will continue to grow in the future.
Technological optimists point to the rapid growth of our knowledge and expect this to continue. If they are right, then technological advance will keep our living standards growing even though we are depleting our stocks of resources. Technological pessimists observe that the last two centuries are an anomaly if we look at the broad sweep of human history. If the rate at which we accumulate knowledge, human capital, and other accumulable resources were to decrease significantly, then the drag on the economy from declining resources would begin to seem substantial. Economics does not allow us to predict the future, and we do not know who is right.
Key Takeaways
• According to the Hotelling rule, a resource should be extracted so that the rate of price increase in the resource should be the same as the interest rate.
• A good is nonexcludable if it is impossible to deny access to it.
• An accumulable resource is one that can be increased over time with investment. Leading examples include physical capital and human capital.
Exercises
1. If the price of oil is decreasing while the interest rate is positive, is the Hotelling rule violated?
2. Is the Internet a nonexcludable good?
3. Will technological advance necessarily offset the depletion of the stocks of natural resources? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/14%3A_Cleaning_Up_the_Air_and_Using_Up_the_Oil/14.04%3A_Renewable_Nonrenewable_and_Accumulable_Resources.txt |
In Conclusion
Economists and environmentalists sometimes do not see eye to eye. Economists think environmentalists often focus on the wrong problems, and environmentalists think economists place too much faith in markets. Yet economics is the science that helps us understand why some environmental problems are among the most important and difficult that we face.
When economists look at excludable resources, for which property rights are well defined, they tend to be less concerned. It is certainly possible that we will run out of oil and other nonrenewable resources. But that in itself does not signal a problem. What matters is whether we are using our resources efficiently or inefficiently. Perhaps the best thing for us as a society to do is to use up our resources quickly. More important, as oil becomes scarce, we know that market prices will force users to economize on oil and look for substitutes instead.
We are assuredly not saying that an economy is better off with fewer resources. We would always like to have more of an exhaustible resource. The most important question, though, is how to best use the resources we have. Markets can sometimes provide a good answer to this question. If markets work properly, sending the correct signals to producers and consumers, then market allocation will be efficient.
Economists worry a great deal more about environmental problems where resources are nonexcludable. Pollution of the air, pollution of rivers and oceans, biodiversity loss, overfishing, and climate change are all examples of environmental problems for which we cannot rely on markets. To an economist, it is not surprising that markets fail in these cases. All of these resources are nonexcludable. When resources are nonexcludable, market allocations will not typically be efficient, and there may be a role for government to try to solve these problems.
Key Link
exercises
1. In the example about second-hand smoking in the office discussed in 14.1 Section "Smokers, Nonsmokers, and the Coase Theorem", how would you use the Coase theorem to determine how much smoking should occur if there are many people in the office? What difficulties do you see in trying to apply this theorem?
2. (Advanced) Consider Table 14.2.1 "The Payoffs in a Social Dilemma Game". Suppose your payoff from taking public transportation when everyone else is taking public transportation is \$3 rather than \$1. Why is it harder to predict what will happen in this situation? See the toolkit. [Hint: Look at what decision you make when others take public transportation and when they don’t.]
3. Consider some situations that might arise in your college or university. Which of the following is an example of an externality?
1. In a class that is graded on a curve, you study harder and get a better grade, so others get a worse grade.
2. At examination time, lots of people want to study, so it is difficult to find space in the library.
3. You find it difficult to understand your professor’s accent.
4. Your favorite television show is on the night before you have a big test, and you can’t decide whether to watch or study.
5. Other people ask good questions in class, which makes the class more interesting for you.
6. Everyone is selling his or her used chemistry textbook, so you can buy one at a cheap price.
7. Late-night parties in neighboring dorm rooms are preventing you from sleeping.
4. Give three reasons why the marginal social cost of driving is greater than the marginal private cost of driving.
5. There are many endangered species in the world, such as the white tiger and the sea otter. Why are these species endangered whereas cows and sheep are not?
6. Suppose you meet some friends at a pizza restaurant. You are all very hungry, and you know the wait for the pizza may be long. At the next table, you see some people who have just finished one pizza, and another is about to be delivered to their table. Explain how you could conceivably create a market that would make both your table and the other table better off. What is the nature of the transaction costs that prevent such trades from happening in restaurants in real life?
7. One reason people choose to buy large vehicles, such as SUVs, is because they are safer if you are involved in an accident. Explain how this could give rise to a social dilemma game.
8. Copy Figure 14.3.1 "A Divergence between Marginal Private Benefit and Marginal Social Benefit". Indicate on that diagram how large a subsidy would be required to induce the socially optimal quantity.
9. If you were to graph a measure of pollution on one axis and a level of economic activity (such as the real gross domestic product per person) on the other, what type of relationship do you think you would find? How would you explain this relationship?
10. Think of an externality that arises in a college dorm. What market can you think of that would (or could) eliminate any inefficiencies from that externality?
11. Using Table 14.2.1 "The Payoffs in a Social Dilemma Game", think of another example of a social dilemma game. What are the choices of the people, the payoffs, and the outcomes?
12. Explain why tradable permits for the right to dump garbage into a river would be more efficient than telling producers how much they are allowed to dump in the river. How is the total quantity of tradable permits determined?
13. Suppose you had a system of tradable permits that allocated permits to those who needed them (that is, the firms that polluted a lot). Would that be a good system to provide an incentive for firms to undertake investment in clean technologies?
Economics Detective
1. In recent years, the European Union has discussed requiring airlines to obtain permits to emit pollution in order to operate. What is the status of this proposal? How might it work?
2. Pick a nonrenewable resource and try to find out what has happened to its price over the last few decades. Do you see any evidence of the Hotelling rule? If not, try to find out what have been the main factors affecting the price of this resource.
3. If you live in the United States, try to find the Superfund site nearest to where you live. What kind of pollution is at the site? (If you live somewhere else, pick a US city of your choice.)
4. What is a “carbon tax”? What is the economic rationale for such a tax? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/14%3A_Cleaning_Up_the_Air_and_Using_Up_the_Oil/14.05%3A_End-of-Chapter_Material.txt |
The Hotelling rule states that the nominal price of oil will increase at the nominal rate of interest. This seems a little bit mysterious. After all, we also think that the price of oil is determined by demand and supply in a market. In fact, these two approaches to the price of oil are completely consistent.
To see how, imagine that the worldwide demand curve for oil each year is as follows:
$price = 1000 − 0.000001 \times quantity,$
where we measure the price in dollars and the quantity in barrels. Individual suppliers are willing to sell oil at the price determined by the Hotelling rule. At higher prices, they will supply a lot of extra oil to the market; at lower prices, they supply no oil to the market. In other words, the supply of oil will be perfectly elastic at the market price.
But this is not enough to determine the market price. We know the market price this year only if we know the price next year. And we know the price next year only if we know the price the year after that, and so on. Unless we know the price at some future date, we cannot calculate the price today. But here is the trick: we do know that the price will eventually increase to the choke price (which is $1,000 per barrel in our example). Over time, the price increases at the rate of interest, as implied by the Hotelling rule. If the demand curve is unchanged from year to year, the quantity demanded gets smaller. This makes sense: the increasing price reflects the increasing scarcity of the resource. The price increases until it eventually reaches the choke price, where the quantity demanded decreases to zero. But when will that happen? It has to happen when the last barrel of oil is being sold. If there is oil left over at that time, the price would decrease below the choke price. And if we ran out of oil before then, the price would have to hit the choke price earlier. Anything else would cause a mismatch between demand and supply. Thus the price today needs to be just right so that when the last barrel of oil is being sold, the price increases to exactly the choke price. Figure 14.6.1 "An Example of Oil Depletion According to the Hotelling Rule" shows an example based on this demand curve. Suppose that the total amount of oil available in the world at the end of 2010 is 29.2 billion barrels, which is owned by many competitive suppliers. How will this oil get released to the market? In 2011, 900 million barrels of oil are sold, so the market price is therefore$100. The price then increases at the rate of interest, which is 5 percent per year in our example. By the year 2044, less than 4 billion barrels remain, and the price of oil has increased to $500 per barrel. In this particular illustration, we run out of oil in slightly under half a century: the last 9 million barrels of oil are sold in the year 2058, at$991 per barrel.
Figure $1$: An Example of Oil Depletion According to the Hotelling Rule
These figures show an example of resource depletion according to the Hotelling rule. (a) The price and quantity of oil traded each year trace out the demand curve. (b) The stock of oil over time represents the supply curve. Initially, there are slightly under 30 billion barrels of oil available. In the first year, 90 million barrels of oil are sold in the market, at \$10 per barrel. The price then increases at the rate of interest. In the year when the price reaches the choke price (2059), the stock of the resource is fully used up. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/14%3A_Cleaning_Up_the_Air_and_Using_Up_the_Oil/14.06%3A_Appendix-_An_Example_of_the_Hotelling_Rule_in_Operation.txt |
You have probably never considered working for the Department of Justice, yet here is a job opportunity open to everyone.
If you have information about a possible antitrust violation or potential anticompetitive activity, use the following questions as a guideline to describe your complaint:
• What are the names of companies, individuals, or organizations that are involved?
• How do you believe they have violated the federal antitrust laws?
• Can you give examples of the conduct that you believe violates the antitrust laws? If so, please provide as much detail as possible.
• What is the product or service affected by this conduct? Where is the product manufactured or sold, or where is the service provided?
• Who are the major competitors that sell the product or provide the service?
• What is your role in the situation in question?
• Who is harmed by the alleged violations? How are they harmed?See US Department of Justice, “Reporting Antitrust Concerns,” accessed March 14, 2011, http://www.justice.gov/atr/contact/newcase.html.
You may never have heard about antitrust laws. You may have only a vague idea of what antitrust is. Yet these laws have a direct impact on your day-to-day life because they can have a significant impact on the prices you pay for goods and services. As the Department of Justice explains,
Most states have antitrust laws, and so does the federal government. Essentially, these laws prohibit business practices that unreasonably deprive consumers of the benefits of competition, resulting in higher prices for inferior products and services…
When competitors agree to fix prices, rig bids, or allocate customers, consumers lose the benefits of competition. The prices that result when competitors agree in these ways are artificially high; such prices do not accurately reflect cost and therefore distort the allocation of society’s resources. The result is a loss not only to U.S. consumers and taxpayers, but also the U.S. economy.US Department of Justice, “Antitrust Enforcement and the Consumer,” accessed March 14, 2011, www.justice.gov/atr/public/div_stats/211491.
Antitrust laws in the United States are principally codified in three acts of Congress—the Sherman Antitrust Act, the Clayton Act, and the Federal Trade Commission Act—and the Federal Trade Commission and the Department of Justice enforce each act. In other countries, similar government agencies perform these same tasks.
How might you become involved in pursuing antitrust violations? Without knowing the provisions of these laws, it is hard to see how you could ever detect and report violations. Fortunately, the Department of Justice provides some further guidance: look for situations where the price of a good is in excess of the marginal cost of producing that good. Remember that marginal cost is the cost of producing one additional unit of output. In a competitive market, firms set prices equal to marginal cost, but when they have market power, firms set prices in excess of marginal cost. Chapter 7 "Where Do Prices Come From?" contains more information. The Department of Justice’s suggestion reflects this conclusion: price in excess of marginal cost is a likely indicator of market power.
In practice, it is more complicated. For example, the cost of producing one more compact disc (CD) is the cost of the material it is made from, the cost of burning the CD, and the cost of the jewel case in which it is packed. These costs are very small: no more than a few cents. Yet, if you have bought a CD recently, you probably paid between \$10 and \$20 for it. Should you be reporting your local CD retailer to the Department of Justice?
In fact, the government sometimes actively protects and creates market power, despite the fact that it has entire divisions devoted to encouraging competition. It creates market power through patent and copyright laws, which prevent people from copying inventions and created works (like music or books). In the case of CDs, the government grants copyright protection because the creation of the very first copy of a CD is very costly. When a CD is produced, there are enormous music creation costs incurred by the musicians and the company recording and producing the music. These costs are much more sizable than the actual cost of producing the CD you purchased. From this perspective, the high prices are needed to make it worthwhile for the artist to incur the creation costs.
You can perhaps sense the tension. The costs of producing the very first CD are high, but the cost of producing the thousands (or millions if the artist is successful) of copies of the first CD are relatively small. Should the price reflect the marginal cost of that last CD or should it be higher to cover the creation costs as well? This argument was vividly illustrated in 2001 when music file sharing first became popular. A firm called Napster ( http://music.napster.com) supplied a technology that facilitated the sharing of music through the Internet. Napster essentially reduced the marginal cost and the price of a song all the way down to zero. Napster’s technology was in direct competition with the record companies, and a legal battle ensued. The final ruling forced Napster to block its file sharing and effectively ended its ability to share music. Other peer-to-peer networks have replaced it, however, and a lot of music is still available for free on the Internet.
In this chapter, we investigate these varied aspects of competition policy. This might seem like an arcane topic, but it has a huge impact on the prices you pay for goods and services. It is competition policy that keeps the price of CDs high and the price of airline tickets low. In this chapter, we evaluate the impact of competition policy on the economy and answer the following questions.
• What happens in markets when there are only a few producers?
• What are the different kinds of competition policy carried out by the government?
Road Map
To make sense of competition policy, we need to first understand what firms would do if there were no antitrust laws constraining them. We therefore begin by looking at economic outcomes in the absence of government protection. We first contrast a market in which there is a single seller with a market that is serviced by many sellers—that is, a competitive market. From this comparison, we can understand the basis of antitrust laws.
Next, we look at why the government sometimes actively promotes market power through patents and copyright. Specifically, we show how such laws can encourage innovation and creation of intellectual property. Finally, we look at situations where there are only a few competing firms. We explain how the outcome is different depending on whether firms choose to set prices or to set the quantity that they produce, and we again look at the role of government policy. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/15%3A_Busting_Up_Monopolies/15.01%3A_Working_for_Antitrust.txt |
Learning Objectives
1. What is a monopoly?
2. What is the outcome when there is a monopoly?
3. What are the policies taken to deal with monopolists?
When there are many buyers and sellers of a homogeneous product, we have a competitive market ( Figure 15.2.1 "The Competitive Market Outcome"). Equilibrium is at the intersection of supply and demand. At the equilibrium level of output, households enjoy buyer surplus, given by the marked area below the demand curve and above the equilibrium price. The surplus arises from the fact that some buyers are willing to pay more than the equilibrium price for the good.
Figure \(1\): The Competitive Market Outcome
At the equilibrium quantity in a competitive market, all gains from trade are exhausted.
Surplus also flows to firms. Remember that a competitive firm’s individual supply curve is equal to its marginal cost curve. In Figure 15.2.1 "The Competitive Market Outcome", the supply curve slopes upward because marginal cost is increasing. Firms obtain surplus because they can produce output at a marginal cost that is less than the equilibrium price of the good. This is shown as seller surplus in the figure.
At the equilibrium quantity, there are no further gains from trade. Producing more output would not increase the total surplus. In fact, producing more output would reduce the surplus: the marginal cost of producing more output would exceed the marginal valuation of extra output. Producing less output would likewise lower total surplus because the buyers and the sellers would lose some of their surplus.
The competitive market provides a benchmark because it leads to an efficient outcome. But very few markets are truly competitive. In most markets, firms possess some market power. This means, in particular, that they are able to set a price above marginal cost without losing all of their sales. In a competitive market, the demand curve facing a firm is perfectly elastic at the market price, whereas when a firm has market power, its demand curve slopes downward.
Toolkit: Section 31.10 "Buyer Surplus and Seller Surplus"
You can review the concepts of buyer surplus, seller surplus, and the gains from trade, in the toolkit.
The Definition of a Market
At the other extreme to the competitive market is the case of monopoly. A monopoly arises when there is a single producer in a market. The demand curve facing a firm is, in this case, the same as the market demand curve.
The definition of a monopoly seems easy, yet it is hard to decide exactly what we mean by “a market.” Think about diamonds. It is often said that the De Beers Corporation is a monopolist in the market for diamonds because this company controls most of the world’s diamond supply. Yet, depending on how broadly or narrowly we define the market, De Beers has either a lot of competitors or only a few. We could define the market very narrowly as “De Beers-branded diamonds” (De Beers is able to brand its diamonds by using certificates of authenticity). De Beers would then be a monopolist by definition. We could define the market more broadly as “all diamonds,” in which case De Beers has substantial market power but does not have a total monopoly. This is perhaps the most natural definition to use, yet it misses the fact that other precious stones, such as emeralds, rubies, or opals, are also possible substitutes for diamonds. An even broader market definition is “the market for precious stones.” We could go even further still and consider De Beers as part of the market for luxury goods, competing with, say, Louis Vuitton bags and Ferrari sports cars. We illustrate this in Figure 15.2.2 "The Extent of Competition Depends on the Definition of the Market".
There is no hard-and-fast definition of a market, but goods that are highly substitutable for each other are generally taken to be in the same market.
Figure 15.2.2 "The Extent of Competition Depends on the Definition of the Market" also gives an illustration for the case of music. By definition, a given indie band has monopoly power over its own music. So again, with a very narrow definition of the market, we would say that the band is a monopolist for its own songs. But that band also competes with other indie bands for consumers’ dollars, so another definition of the market would be “CDs by all indie bands.” Again, we could define the market still more broadly as “all music” or even “all forms of entertainment.”
One of the difficult tasks of antitrust authorities is deciding what definition to use for a market. There is no single correct way to define a market, and the extent of market power depends on where we choose to draw the line. For this reason, the term monopoly is somewhat misleading. Almost all firms are monopolists if we adopt a sufficiently narrow definition of the market. The decision about how to set prices in the presence of market power, which is sometimes called the monopoly pricing problem, actually applies to nearly every firm in the economy. What matters in practice is determined by the extent of a firm’s market power.
The extent of a firm’s market power depends on two things: (1) the number of firms that potentially compete with it and (2) the extent to which those other companies produce close substitutes for a firm’s product. A strip mall at the edge of town might contain several different fast-food restaurants. Each restaurant enjoys some market power because the food it has available is slightly different from that at the other establishments. But many consumers are likely to be willing to substitute reasonably freely among the different restaurants, so the market power of each restaurant is limited. Contrast that with a fancy French restaurant with a famous chef. That restaurant enjoys much more market power because there are almost certainly fewer comparable restaurants nearby and the meals at other high-end restaurants are not such close substitutes.
Market power can stem from many different sources. A firm has market power if it is selling a unique product or service. A firm can also derive market power from its superior or exceptional service. If a firm creates customer loyalty, either through exceptional service or by loyalty programs (such as frequent flyer miles), this is also a source of market power. Retail firms can derive market power from their location: your local corner store has some market power because you would prefer to walk there rather than drive to a more distant supermarket.
Firms devote a lot of resources to establishing, protecting, and increasing their market power through advertising and other forms of marketing. Many firms spend a great deal of money on developing their brand image and brand awareness. Sporting goods companies such as Nike and Adidas are classic examples. When customers are loyal to brands, firms have market power.
Pricing with Market Power and the Monopoly Outcome
The managers of a monopoly firm must pick the point on the demand curve that will maximize the firm’s profits—the total revenues of the firm minus its costs of producing its output. We can think about the firm choosing either its level of output or its price. If a firm chooses how much to produce, then the price of its product is determined from its demand curve. (Remember that the demand curve facing the firm and the market demand curve are the same thing for a monopolist.) If a firm chooses a price for its product, then the quantity produced is determined by the demand curve. For now, we tell the monopoly story assuming it chooses the quantity of output.
When a firm is maximizing its profit, producing a little more or a little less output will not increase the firm’s profit. This means that the extra revenue from producing one more unit of output is exactly equal to the cost of producing one more unit of output: marginal revenue equals marginal cost. We call this level of output the profit-maximizing quantity and illustrate it in Figure 15.2.3 "The Monopoly Outcome". The price the monopolist sets, termed the profit-maximizing price, can then be read from the demand curve. Once a monopolist determines how much to produce, the price of its output is determined by the maximum amount that consumers are willing to pay for the good.
A monopolist produces a quantity such that marginal revenue equals marginal cost. The price is determined by the demand curve.
Toolkit: Section 31.15 "Pricing with Market Power"
The principles of pricing with market power are explained in more detail in the toolkit.
Distortions Due to Market Power
We have competition policies in market economies because market power often leads to an outcome that is not efficient. To understand this distortion, compare the monopoly outcome with the competitive market outcome we saw earlier. Figure 15.2.4 "Distortions Due to Market Power" is Figure 15.2.1 "The Competitive Market Outcome" with some areas of the figure labeled.
• We indicate the buyer surplus—the area between the price set by the monopolist and the demand curve. Even though there is a monopolist in this market, buyers can still enjoy some surplus if their marginal valuation of the good exceeds the price they pay. So while the price may be too high in the monopoly case, there still remains some surplus flowing to buyers.
• There is an area labeled variable cost—the total area under the marginal cost curve.
• There is an area labeled seller surplus (monopoly profit)—the difference between revenues at the monopoly price and variable costs. The total revenue received by the monopolist is the price times the quantity sold. This is a rectangle. Monopoly profit, as shown in the figure, equals this rectangular area minus variable costs.
• The difference between the competitive and monopoly outcomes creates a social loss—the triangular area labeled deadweight loss in Figure 15.2.4 "Distortions Due to Market Power". The demand curve reflects consumers’ marginal valuation of the good. Below the competitive quantity, this marginal valuation is greater than the marginal cost of producing the good. This means that there are potential gains from trade that are not being realized.
Toolkit: Section 31.1 "Individual Demand", Section 31.11 "Efficiency and Deadweight Loss" and Section 31.14 "Costs of Production"
You can review in the toolkit (1) the correspondence between demand and marginal valuation, (2) the meaning of efficiency and deadweight loss, and (3) the definitions of variable cost and marginal cost (and the relationship between them).
Figure \(4\): Distortions Due to Market Power
A monopolist produces a quantity that is less than socially optimal: there is a deadweight loss.
Comparing Figure 15.2.1 "The Competitive Market Outcome" with Figure 15.2.4 "Distortions Due to Market Power", we see that—relative to the competitive outcome—the monopolist charges a higher price and produces a lower quantity. Since the competitive outcome was efficient, the monopoly outcome is inefficient. Households in the economy would be better off if the monopolist produced at the competitive level of output and sold at the competitive price.
Competition Policy toward Monopolies
When a firm has market power, there is a distortion in the market: prices are too high, and output is too low. Antitrust laws are designed to address precisely this situation.
Antitrust
By virtue of the Sherman Antitrust Act of 1890, the US government can take legal action to break up a monopoly. In 1902, President Theodore Roosevelt used the Sherman Antitrust Act as a basis for trying to break up the monopolization of railway service in the United States. The resulting legal case, known as Northern Securities Co. v. United States, involved two key elements: restraint of trade and interstate commerce.
Multiple providers of rail service had joined together in the Northern Securities Company, resulting in a restraint of trade. The Supreme Court decisionCornell University Law School, Legal Information Institute, “Northern Securities Co. v. United States (No. 277),” accessed March 14, 2011, http://www.law.cornell.edu/supct/html/historics/USSC_CR_0193_0197_ZS.html. provides direct discussion of the anticompetitive nature of the creation of this company, noting that the company had been set up to eliminate competition among the different providers. Further, this restraint of trade had interstate implications because the railway lines themselves were not contained within any one state. This was a key point of jurisdiction: the Sherman Antitrust Act spoke directly about the effects of market power on interstate trade. Under the US Constitution, interstate commerce is part of the responsibility of the federal government.
Another famous antitrust case decided by the Supreme Court ( http://supreme.justia.com/us/221/1/case.html) centered around the breakup of the Standard Oil Trust in 1911.Justia.com, US Supreme Court Center, “Standard Oil Co. of New Jersey v. United States, 221 U. S. 1 (1911),” accessed March 14, 2011, http://supreme.justia.com/us/221/1/case.html. John D. Rockefeller founded Standard Oil in 1870 soon after the discovery of oil in Ohio. By the late 1870s, the company controlled nearly 90 percent of the refineries in the United States. Shortly thereafter, the Standard Oil Trust was formed with the idea that the individual shareholders in a group of companies would come together to create a single company. This company would then jointly manage all the companies that joined the trust. In doing so, a monopoly was created. (This, by the way, is where the term antitrust comes from.)
Once again, the issue of jurisdiction played a role. Standard Oil was originally deemed a monopoly by the Ohio Supreme Court, which ordered it to be broken up. Instead, the company was simply reorganized as a New Jersey–based corporation. Because the company had moved to another state, the Ohio ruling became irrelevant, and the federal government had to step in to prevent unlawful interstate trade. The court ruled that the trust be dismantled. In the modern era, similar concerns arise across national borders: if two companies merge in Europe, for example, US antitrust authorities still take an interest, and vice versa.
These cases may seem like ancient history. Yet they remain very relevant today for at least two reasons. First, the legal system relies heavily on precedent, meaning that cases decided today depend on past rulings in similar cases. The actions of the Supreme Court in these two cases created a significant precedent for the present-day antitrust actions of the federal government. Second, antitrust actions continue to this day. A recent case again alleging a violation of the Sherman Antitrust Act was brought against Microsoft Corporation by the US government in 1998. Microsoft was charged with monopolizing the software market through its Windows operating system. As stated in the case, “Virtually all major PC manufacturers find it necessary to offer Microsoft operating systems on most of their PCs. Microsoft’s monopoly power allows it to induce these manufacturers to enter into anticompetitive, long-term licenses under which they must pay royalties to Microsoft not only when they sell PCs containing Microsoft’s operating systems, but also when they sell PCs containing non-Microsoft operating systems.”A full description of this aspect of the case is contained in John Kwoka and Lawrence White, eds., The Antitrust Revolution (New York: Oxford University Press, 2004).
One noteworthy element of the case concerned the definition of the market. After all, there are competing operating systems to Microsoft, most notably Apple Computer’s operating system. If the court viewed these products as substitutes for Microsoft’s operating system, then the claim that Microsoft was a monopolist would be less clear. Interestingly, the court ruled that Apple was not in the same market as Microsoft.
Price Discrimination
Because there are people willing to pay more than the marginal cost, it seems as if the monopolist in our earlier example is leaving some money on the table. Is there a way for the monopolist to make higher profits? The answer to this question hinges on an assumption that was implicit in our analysis: we suppose that the monopolist has to sell every unit of the good at the same price. In many cases, however, firms sell different units of their product at different prices. This is known as price discrimination, and it can arise either because (1) a firm sells to different customers at different prices or because (2) a firm sells different units at different prices to the same customer. There are numerous examples of both kinds of price discrimination. An example of the first is discounts offered to senior citizens or students. An example of the second is quantity discounts such as “buy two, get one free.”
Firms have developed many creative forms of price discrimination, and we could easily fill a whole chapter with them. Our main focus here, however, is to understand how price discrimination operates in a monopoly market. Let us think about a case where the monopolist faces a unit demand curve: each buyer either purchases a unit of the good or does not buy the good at all. The downward-sloping demand curve comes from the fact that different individuals have different valuations of the good.
Toolkit: Section 31.1 "Individual Demand"
You can review unit demand in the toolkit.
Now imagine what the monopolist would do if she knew everyone’s individual valuations and was also able to charge a different price to different buyers. In this case, we obtain a remarkable result. If the monopolist could sell each unit at any price she wanted, then she would charge each individual his valuation of the good, with striking consequences.
• The monopolist captures the entire buyer surplus. Compared to the competitive case, there is a redistribution of surplus from buyers to the monopolist.
• The deadweight loss from the monopoly is eliminated. The monopolist produces the same level of output as in a competitive market because it is worthwhile to sell to anyone whose valuation exceeds marginal cost.
Buyers obtain no surplus because each buyer surplus equals his valuation minus the price he pays—which we have just said is equal to his valuation. Each buyer is actually indifferent about buying or not buying the good. (If this seems odd, then you can imagine that the monopolist charges a price slightly below individuals’ valuations, so buyers obtain only a tiny amount of surplus. The conclusion is the same.) So where does their surplus go? It shows up as monopoly profits. By price discriminating, the monopolist captures all the gains from trade in this market. And where do these monopoly profits eventually go? They flow to the owners of the monopoly. The buyer surplus that is taken away by the price-discriminating monopolist is eventually returned to the household sector as dividends from the firm. However, it is not the same households who gain and lose surplus. Not everyone is a shareholder in the monopoly. Monopoly power causes a redistribution from the monopolists’ customers to its shareholders.
A situation like the one we have described, where a monopolist knows the valuations of all her customers, may seem a bit farfetched. Still, in situations where a monopolist negotiates individual prices with buyers, she will do her best to guess their valuations. For example, think of a used car dealer. When a prospective customer arrives on the lot, the dealer will typically engage the customer in conversation in an attempt to learn where he lives, what kind of job he has, and so on. Such information helps the dealer guess the buyer’s valuation.
Other Kinds of Price Discrimination
There are many kinds of price discrimination.
• Explicit segmentation. The monopolist may be able to divide the market into identifiable segments and charge different prices to different segments. For example, movie theaters often offer student and senior citizen discounts. As another example, businesses often charge different prices in different countries. The idea is that the monopolist can charge higher prices to segments that are less price sensitive.
• Self-selection. If a firm cannot explicitly identify different segments, it can set a menu of prices and allow customers to sort themselves into different groups. When Apple introduced the iPhone, it originally charged a high price, knowing that impatient customers would buy immediately. It then dropped the price to capture the more patient, more price-sensitive customers. Discount coupons are another example. Individuals with more time to spare will clip and redeem coupons—and these individuals will typically also be more sensitive to price.
From the perspective of a firm, the biggest danger of price discrimination is the possibility of arbitrage. If you are selling your product more cheaply to some than to others, you don’t want someone to buy at the cheap price and then resell to your higher-value customers. This is a particular issue for pharmaceutical companies that charge different prices in different countries. If you need proof of this, look at the spam in your e-mail. The chances are very good that you have recently received an e-mail offering you pharmaceuticals at Canadian prices.
Competition Policy on Price Discrimination
The Robinson-Patman Act of 1936 directly forbids certain forms of price discrimination. The following is from the act, with our emphasis added: “It shall be unlawful for any person engaged in commerce…to discriminate in price between different purchasers of commodities of like grade and quality, where either or any of the purchases involved in such discrimination are in commerce…and where the effect of such discrimination may be substantially to lessen competition or tend to create a monopoly in any line of commerce.”Cornell University Law School, Legal Information Institute, “§ 13. Discrimination in price, services, or facilities,” accessed March 14, 2011, http://www.law.cornell.edu/uscode/15/13.html.
The type of price discrimination we have discussed certainly involves discrimination among different purchasers. What is less clear is whether such actions would “lessen competition or tend to create a monopoly.” In our earlier example, price discrimination actually makes the market more efficient, and in general, price discrimination can increase or decrease efficiency. There are no simple guidelines, and each case must be examined on an individual basis.
Price discrimination also occurs in business-to-business transactions between firms. In a recent price-discrimination case involving Volvo, a car dealer charged that other dealers had obtained deeper discounts (price concessions) that permitted them to be more competitive.See Cornell University Law School, Legal Information Institute, “Volvo Trucks North America, Inc. v. Reeder-Simco GMC, Inc. (04-905) 546 U.S. 164 (2006) 374 F.3d 701, reversed and remanded,” accessed March 14, 2011, http://www.law.cornell.edu/supct/html/04-905.ZS.html. This seems to fit the requirements of the Robinson-Patman Act because Volvo trucks are a homogeneous good (Volvo trucks in this case), and the practice allows one dealer to undercut another.
A jury trial led to an award of \$4.1 million to the injured company. Not surprisingly, Volvo appealed the decision, partly because, so it claimed, the other dealers were not in direct competition with the dealer filing the suit. Once again, you can see the critical significance of defining the market. The Supreme Court eventually decided the case in January 2006 in favor of Volvo.
Key Takeaways
• A monopoly occurs when there is a single seller, called the monopolist, in a market.
• A monopolist produces the quantity such that marginal revenue equals marginal cost. This is a lower level of output than the competitive market outcome.
• The government has the legal authority to break up monopolies and forbids price discrimination.
Exercises
1. Think of two goods or services you have bought recently. Were close substitutes available? Do you think the producer and the retailer of those products had a lot of market power?
2. Looking at Figure 15.2.4 "Distortions Due to Market Power", why do buyers have any surplus? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/15%3A_Busting_Up_Monopolies/15.02%3A_Market_Power_and_Monopoly.txt |
Learning Objectives
1. What is the role of the patent and copyright systems?
2. What factors determine how long patent protection should last?
3. What is the commitment problem associated with the patent system?
In the introduction to this chapter, we mentioned the breakup of Napster, a company that facilitated the sharing of music. Napster provided file-sharing software that allowed computer users to share music files over the Internet. A music file, like any other computer file, is simply information: a collection of bits and bytes. It costs nothing to make a copy of a music file. What Napster did, in other words, was to make it easier for music files to be distributed at marginal cost. You might think that the antitrust authorities would have been delighted. But the argument in this case was that there was an infringement of the rights of the music producers. The courts held in their favor: the law came down on the side of the monopolists. We now consider why governments sometimes actively support and promote monopolies.
To understand the Napster case, we begin by recognizing that creating, producing, and recording a new song is a very costly process. First of all, there is the time spent by the band in writing and arranging the song. Professional recordings also need the services of a producer and an expensive recording studio. A great deal of time and resources must also be expended to create an MP3 file of the song. Economists say that the first-copy costs are large. As the name suggests, these are the costs involved in creating the initial version of a good. They are a particular type of entry cost. Goods that involve a large amount of research and development or other intellectual input, such as books, computer software, and pharmaceutical products, have large first-copy costs.
As we just pointed out, though, once a song is produced, it can be reproduced at zero cost. The fixed costs of producing a song are very large, whereas the variable costs are zero. Perhaps you can now see the problem. If songs were sold in a competitive market, their price would be zero. Producers of the music would earn no revenues. Composers would earn no money. In this world, no one would have an incentive to produce music unless they were doing it purely for their own pleasure.
Similar tensions can be found in many other industries. Nearly anything that can be stored as a computer file has high first-copy costs accompanied by low variable costs. A newspaper article takes time to research and write but can be copied at zero marginal cost. Computer software can be very expensive to develop but—once created—can be copied at no additional cost. Pharmaceutical compounds are very expensive to develop: they first involve the work of highly trained research scientists in expensive laboratories and then require years of testing on animals and humans. Once a drug has been developed, however, it is often quite cheap to produce.
If the antitrust authorities forced newspapers, software developers, and pharmaceutical companies to sell at marginal cost, these firms would not earn enough revenues to justify their initial investment. Instead, such firms are permitted to sell at above marginal cost. More than that, the government actively bestows monopoly power. It does so through legal protections for inventions and created works, known as patents and copyrights.
The Decision Problem of an Innovating Firm
To understand how patents and copyrights work, we think about a firm contemplating an innovation—the introduction of a new product or a new means of production into a market. The firm’s decision involves several stages, as shown in Figure 15.3.1 "The Stages of Innovation":
1. Do we innovate or not? A decision to innovate is a decision to incur certain costs: the costs of research and development and the costs of entering a market.
2. How much should we produce during the years of patent protection?
3. What do we do once the patent protection ends?
Our ultimate goal is to evaluate the innovation decision at the first stage, but to do so, we must start at the end and work backward.
Figure \(1\): The Stages of Innovation
The Final Stage: Competition
Once a firm’s patent expires, other firms can produce a similar or an identical product. The firm will then be operating in a competitive market and can no longer expect to gain any particular advantage from its innovation. When the patent for a pharmaceutical product expires, for example, other companies can step in and produce chemically identical copies of the product, known as generics.
In a competitive market, we expect the price of the product will decrease until it equals marginal cost. For this reason, the innovating firm cannot anticipate making very much profit at this stage. For simplicity, we can think of the firm making no profits. Although there may be some advantage in being the original producer of a product, any excess profits that remain after the patent expires are unlikely to be substantial. More precisely, the firm would earn no more than a “normal” level of profit—the same as it could earn in any other activity. Such normal profits would not provide any benefit to justify the initial innovation, so we can ignore them.
The Middle Stage: Patent Protection
If the innovating firm is going to make profits to justify the costs of developing its product, these profits must come in the middle stage when the firm has patent protection. During this period, the firm has monopoly power by virtue of the patent. We know how the firm behaves in this situation.
• It will produce a level of output such that marginal revenue equals marginal cost.
• It will set the price equal to the market’s willingness to pay for this output level.
This is exactly what we saw earlier in Figure 15.2.4 "Distortions Due to Market Power". The monopolist produces less output than is efficient and earns monopoly profits.
Notice that a firm’s decision about how much to produce and about what price to set does not depend on the costs that it paid for researching and developing its product. After the firm gets to this second stage of its decision, those costs are in the past. They are sunk costs. They have no influence on the marginal cost of production and the price/output decision of the monopolist.
To calculate the total profit that a firm earns in this monopoly stage, we must do two things: (1) calculate the firm’s profit in each year and (2) add these profits over the entire time that the firm has patent protection. The firm’s profits in any given year are given by
profits = revenues − total cost = revenues − variable cost − fixed operating cost.
The area shown as “monopoly profit” in Figure 15.2.4 "Distortions Due to Market Power" corresponds to revenues minus variable costs. (Businesspeople and accountants call this a firm’s profit contribution.) In any given year, the monopoly will also typically incur some costs of operation in any given year that are constant, irrespective of how much output it produces. Examples include rent on a building and other long-term contracts. These are the firm’s fixed operating costs, which also must be subtracted from the firm’s revenues to calculate its profits.
Because the monopolist earns profit in each year of its patent protection, we add these profits together. We do so using the tool of discounted present value. This calculation takes into account that money earned in the future is less valuable than money today whenever the rate of interest is positive. Thus the proper measure of the profits at this stage is the discounted present value of the sum of the profits made during the period of patent protection. Factors that would increase the discounted value of a firm’s profits include the following:
• Lower marginal costs
• More inelastic demand
• More years of patent protection
• Lower interest rates
Toolkit: Section 31.5 "Discounted Present Value"
You can review discounted present value in the toolkit.
The First Stage: Innovation
We are finally in a position to evaluate whether or not a firm should innovate. The gains from innovation are measured by the present discounted value of the flow of profits. A firm must compare these gains to the costs of innovation to determine whether or not the innovation is worthwhile. These innovation costs are determined by the costs of the research and development (R&D) process together with any other costs of market entry. For example, a firm must pay scientists and engineers, fund research laboratories and R&D departments, and so on. Having done the hard work of analyzing stage two, the decision for stage one is straightforward. The firm should follow this rule: “innovate if the discounted present value of profits is greater than the costs of innovation.” The firm should innovate as long as the monopoly profits it will earn in the second stage (appropriately discounted) are greater than the costs of innovation in the first stage.
Think again about a pharmaceutical firm. Such firms spend an enormous amount of money on the research and development phases of new pharmaceutical compounds. This occurs in stage one. Once the product goes to market, however, the costs of development are sunk and have no effect on the firm’s profits during stage two. The same point applies to the production of a music CD. The costs of producing, marketing, and distributing a typical CD are estimated to be around \$500,000. Of this, at least \$100,000 represents the costs of production.
One thing that we have neglected in our discussion is that the payoff from research and development efforts is typically uncertain. Many promising pharmaceutical compounds turn out, on further testing, to be ineffective or have unacceptable side effects. A band recording a new song cannot know for sure if it will sell hundreds of copies, thousands of copies, or millions of copies. The decision about whether or not to innovate must be based on a firm’s best estimates of the expected value of its profits.
An Example
Table 15.3.1 "Calculating the Discounted Present Value of Expected Profits" provides a numerical example of the innovation decision. The first year is the innovation stage: we suppose the cost of innovation is \$150. The firm earns no revenues in that year and incurs no costs, so its first year profits are −\$150. In the second year, the firm finds out if its innovation was successful. We suppose there is a 50 percent chance that it is successful, in which case the firm has monopoly power for the second and third years. It earns the revenues and incurs the costs listed in the third and fourth columns of the table. If the innovation is unsuccessful, it earns no profits. After the third year, the firm earns no profits. Suppose finally that the interest rate is 10 percent.
Year Innovation Cost (\$) Total Revenues (\$) Total Operating Costs (\$) Profit If Successful (\$) Profit If Not Successful (\$) Expected Value of Profits (\$) Discounted Present Value of Expected Profits (\$)
1 150 0 0 −150 −150 −150 −150
2 0 200 68 132 0 66 60
3 0 400 158 242 0 121 100
Table \(1\): Calculating the Discounted Present Value of Expected Profits
The profits in the second year if the innovation is successful are \$132. The expected value of profits in that year is therefore given by \((0.5 × \$132) + (0.5 × 0) = \$66.\) These must be discounted back one year using the 10 percent interest rate. In other words, we divide the second-year profits by 1.1. The discounted value of the second-year profits in the first year is therefore \$60. The expected value of the third-year profits, by a similar calculation, is \$121. These must be discounted back two years, all the way to the first year. To do so, we first divide by 1.1 to get the value of expected third-year profits in the second year \((\$121/1.1 = \$110)\). We then discount this back another year by dividing by 1.1 again. The discounted value of expected third-year profits in the first year is therefore \(110/1.1 = \$100\).
We can now legitimately add together the numbers in the last column, and we find that the discounted present value of the firm’s stream of profits is \$160. This exceeds the cost of innovation (\$150), so the firm should go ahead with the project. It expects to earn \$10 from the project.
The Role of Patents
Imagine for a moment that we went through the same analysis in the previous section but without patent protection—that is, suppose that as soon as a firm innovates and introduces a new product into a market, it can immediately be copied and produced and marketed by any other firm. This means that the second stage is completely eliminated: the market goes straight from innovation to competition.
This has an apparent benefit. There is no longer a monopoly in the second stage. We know that monopoly causes inefficiency: the firm sets its price above marginal cost to earn monopoly profits. But there is a problem: the innovation will not occur. The firm innovates only if the discounted present value of profits exceeds the cost of innovation. If we eliminate stage two, then we eliminate the profit flows that justified the innovation in the first place. Without the profits, there will be no innovation. It is the patent protection that provides the incentive for innovation.
The trade-off should be clear. Patents
• provide incentives for innovation, but
• create monopoly power and hence distortions.
The gain from patent protection is that it provides the basis for the second stage of the innovation process. Without this protection, the gains from innovation would not exist. Looking back at Figure 15.2.4 "Distortions Due to Market Power", this gain comes at the cost of an inefficiently low level of output and a consequent loss of gains from trade.
Lawmakers must trade off this cost and this gain. Under current US law ( http://www.uspto.gov), patent protection for most products lasts for 20 years. The optimal length of patents remains an active area of research in economics and an active area of policy concern. It is very hard to maintain the right balance between incentives for innovation and eliminating market distortion.
Commitment
Perhaps the government could both encourage innovation and avoid the monopoly distortion. Suppose that, after an innovation had been introduced, the government removed the patent protection. As an example, many individuals in the world suffer from HIV/AIDS but cannot afford medication at current prices. This problem is especially severe in much of sub-Saharan Africa. As a matter of social policy, one would like to have the drug companies first develop HIV/AIDS treatments and then sell those products at marginal cost.
Currently, some pharmaceutical companies have developed treatments that are still protected by patents. Eliminating these patents seems like it might be good social policy, given that the lives of millions of people are at stake, but it would come with a significant cost. If the government ignores patent protection for a particular product today, innovators will suspect that the government can no longer be relied on to provide patent protection in the future, which would have a huge impact on innovative activity. Thus by failing to provide patent protection for one product, the government risks destroying its reputation for patent protection in general. This is an example of a commitment problem. Prior to stage one of the innovation process, the government promises patent protection to provide an incentive for innovation. After stage one is finished and the product is introduced in the market, the government’s incentives change: it wants to remove the market distortions. Because the innovation stage is over, the government could potentially renege on its promise of patent protection.
Pharmaceutical companies like GlaxoSmithKline, which produce the antiretroviral drugs used for treating HIV, have in fact offered to make their products available more cheaply. However, pharmaceutical companies have strongly opposed suggestions that their patents not be honored. A better policy proposed by economists and others is a patent buyout. This would work as follows. The government would pay the pharmaceutical company a reasonable market price for its patent and then allow other companies to come into the market and produce generics. A related idea is that governments could offer to buy future patents if drug companies came up with treatments for particular maladies. For example, even though malaria is a major killer in the world, pharmaceutical companies have little interest in researching its treatment. The reason is one of harsh market economics: most sufferers from malaria are poor, so a malaria drug would not be very lucrative. If governments offered a substantial patent buyout for a malaria drug, however, firms might find it worth investing in this disease area after all.
International Dimension of Patents
If you have a US patent for a good that you have invented—for example, a new kind of printer—then you are protected in the United States. However, US patent law does not protect you if you are selling in other countries. A firm in another country could take your printer apart, analyze how it works (this is called reverse engineering), and then produce the good itself. If the firm tried to sell the good in the United States, you could take it to court, but if it is selling elsewhere in the world, you have very little protection.
Other countries (such as Japan) and regions (such as the European Union) have patent laws that are similar to those in the United States. (Indeed, one of the earliest biotech patents went to the famous biologist Louis Pasteur in 1873 for his method of producing yeast.) These laws are structured, as are those in the United States, to balance the gains from innovation against the costs of monopolization of the market. Thus producers who sell across the world will typically seek patent protection in many different countries.
Still, to the extent that the benefits of innovation flow to purchasers around the world, the innovation-monopoly trade-off is potentially altered. If we think about the stage two monopoly as “the price we pay for the benefits of innovation,” then residents in countries with strong patent laws are paying in part for benefits that flow to individuals and households in other economies. In some countries—China is a leading example—patents and copyrights are not very well protected. This is good news if you want to buy some cheap DVDs in China, but if you are the owner of the rights to these pirated movies, you surely wish that copyright laws were more thoroughly enforced around the world.
Key Takeaways
• Patents and copyrights provide innovators with protection from competition so that there is a return to innovation.
• Although a patent system provides protection, it also creates market distortions by granting monopoly power. A patent system should be designed to balance the incentive to innovate against the losses from these distortions.
• After innovation has taken place, the government may be tempted to take away patent protection to avoid market distortions. This is the commitment problem faced by a government. Governments are aware that if they take away patent protection from firms that have already innovated, they will greatly damage the incentives for future innovation.
Exercises
1. Draw the diagram for a competitive market where marginal cost is zero. What does the supply curve look like? Who gets the surplus in the market? Use this diagram to explain the tension between innovation and competition.
2. The subsection on patent protection ended with a list of factors that would increase a firm’s profits. Explain why each of these would cause the present discounted value of the firm’s profit flow to increase. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/15%3A_Busting_Up_Monopolies/15.03%3A_Patents_and_Copyright.txt |
Learning Objectives
1. How do we predict the market outcome in a market with a few sellers?
2. How does the outcome depend on whether firms set prices or quantities?
3. What are the main tools of competition policy in markets with a few sellers?
So far we have looked at monopolies: markets with a single seller. But as we pointed out earlier, the extent to which a firm is a monopolist really comes down to how we choose to define the market. The market power of all firms is limited, to a greater or lesser degree, by the presence of firms selling competing products. In this section, we examine how the presence of competitors affects the distortions due to market power.
If there are enough competitors to give us perfect competition, then there is no distortion. But what about intermediate cases, where there are a small number of sellers? The market power of Microsoft Corporation is muted by the presence of competitors producing products that are substitutes for Microsoft software. If Microsoft were to triple the price of its Windows operating system, many buyers would switch to Macintosh computers or even start running the free operating system Linux. To the extent that substitute products are available to well-informed consumers, market power is decreased.
Once firms have to start worrying about the strategies of their competitors, decision making can become surprisingly complex. Each choice that a firm makes concerning what goods and services to produce, how to produce them, how to market them, how to price them, and so on, is now complicated by the fact that all of its competitors are making similar choices. This contrasts with a competitive market, where a single firm does not need to consider the behavior of its competitors at all; it only needs to know the market price for its output.
The task of a firm with market power is to choose the point on the demand curve that maximizes its profit. From the firm’s perspective, it doesn’t matter whether it (1) sets a price and then lets the quantity demanded come from the demand curve or (2) chooses a quantity and then lets the price be whatever the market will bear. Oddly enough, though, the interaction among firms is very different in a world where firms are setting prices compared to one where they choose their level of output. As we go through this section, we shall see why.
Market Outcomes When Firms Set Prices
We start by thinking about the case where firms set prices, beginning with two firms selling exactly the same product. An example is two gas stations at the same intersection, each of which has to choose what price to set for the gasoline that it sells. We first look at the choice of one of these firms and then study what happens when the two firms interact. We make a simplifying assumption, which is reasonable for gasoline retailers, that marginal cost is constant.
The Pricing Decision of a Single Firm
The first thing we need to know is the shape of the demand curve facing a firm. Let us look at the decision of one gas station (firm A). The owner of this gas station can look across the street and see the price set by its competitor (firm B) across the street. Suppose, for example, that firm B is selling gas at \$2 per gallon. What does the demand curve for firm A’s gas look like?
• If firm A charges a price greater than \$2 per gallon, all its potential customers will go across the street to firm B. The quantity demanded will be zero.
• If firm A charges a price less than \$2 per gallon, it can capture the entire market. The demand curve faced by firm A is the same as the market demand curve.
• If firm A sets a price of exactly \$2 per gallon, then the two firms will divide up the market. The simplest assumption is to suppose that they will each get half the market.
We illustrate this demand curve in Figure 15.4.1 "The Demand Curve Facing a Firm, Taking as Given the Price Set by a Competitor".
Figure \(1\): The Demand Curve Facing a Firm, Taking as Given the Price Set by a Competitor
This figure shows the monthly demand curve facing firm A in a market where two gas stations are setting their price per gallon.
If firm B sets a price of \$2, what should firm A do? As long as \$2 is greater than the marginal cost, firm A makes the most profit if it undercuts firm B a little bit. If it sets a price of \$1.99, it can capture the entire market, whereas if it sets a price of \$2 it gets only half the market. But exactly the same is true of firm B. For any given price that firm A sets, firm B would do better to undercut it by a penny. Competition provides a strong incentive for firms to cut their prices.
Nash Equilibrium
The discussion so far tells us how one firm will respond to the price of the other, but we don’t yet know where the firms will end up. We do not yet know what the equilibrium will look like. Previously, we used the term equilibrium in the context of supply and demand, denoting the point where the supply and demand curves intersect. The idea of equilibrium goes beyond this, however: it denotes a situation of balance in which no one has any desire to change.
When we think about strategic situations with a small number of firms, we maintain the idea of an equilibrium where no one wants to change their decision. We use an idea of equilibrium invented by John Nash (a mathematician who won a Nobel Prize in Economics for this and other contributions). The concept of the Nash equilibrium also expresses a sense of balance, but it is applied to strategic situations rather than markets. The key feature of the Nash equilibrium is that no one has any desire to change what is being done.
Toolkit: Section 31.18 "Nash Equilibrium"
The Nash equilibrium is used to predict outcomes in strategic situations, often referred to as “games.” In a game, a small number of players (such as firms) interact. Each player chooses an action, and each player receives a payoff (for example, profit). The payoff of a player depends on his chosen action and the actions chosen by all the other players. In the Nash equilibrium, two things are true:
1. Each player chooses the action that gives him or her the highest payoff, based on his or her predictions of the other players.
2. Each player’s predictions of the actions of the other players are correct.
Nash Equilibrium When Firms Choose Prices (Bertrand Competition)
To see the Nash equilibrium in action, go back to our gas stations. So far, we have seen that—taking firm B’s price as given—firm A will want to set a lower price. For example, if firm B sets a price of \$2, firm A will set a price of \$1.99. But this is not a Nash equilibrium because firm B would then like to do something different. If firm A sets a price of \$1.99, firm B will want to set a price of \$1.98, and so on. This process will stop only when the firms’ prices equal marginal cost. Thus we can make an educated guess: in the Nash equilibrium, each firm sets its price equal to the marginal cost of production. In this equilibrium, both firms earn no profits.
To see that this is indeed an equilibrium, we suppose firm B sets its price equal to marginal cost and then ask if firm A would like to change its price away from marginal cost. Were firm A to set its price greater than firm B, it would get no sales and no profits. This does not make firm A better off. If firm A were to set its price below marginal cost, then it would capture the entire market, but it would make a loss on each sale. It would be selling below the costs of production and thus make negative profit. This certainly does not make it better off. So firm A has no incentive to do anything different. Obviously, the same arguments apply to firm B. If both firms set the price at the marginal cost, neither can change its price and make higher profit.
The game played between two firms producing an identical product and setting prices is called Bertrand competition. The remarkable implication of Bertrand competition is that the predicted outcome (price) will equal marginal cost. With only two firms, in other words, we get the same outcome as with a competitive market. Even with two firms, the market can be very competitive, and there may be no need for antitrust authorities to intervene.
The Prisoners’ Dilemma
Households certainly like Bertrand competition because they can purchase goods at marginal cost. The firms, however, clearly do not like the outcome. Both firms understand that they would both be better off if they could only charge more for a good. If they could meet together and collude, then they would want to behave like a monopoly and share the profit between them. But charging the monopoly price is not a Nash equilibrium. If one firm were to set the monopoly price, the other would have an incentive to undercut its rival by charging a slightly lower price.
Here is another way of looking at this problem. Let us again consider a situation where two firms are choosing their prices. To keep things simple, suppose now that the firms must choose between two prices: the (high) monopoly price and the (low) competitive price. We will no longer assume constant marginal cost, so the firms still earn some profit when the price equals marginal cost. There are thus four possibilities: (1) both firms set a high price, (2) both firms set a low price, (3) firm A sets a high price and firm B sets a low price, and (4) firm A sets a low price and firm B sets a high price.
Suppose that Figure 15.4.2 "The Payoffs (Profits) from Different Pricing Choices" shows us the profits that firm A earns in each case. (There is a similar figure for firm B.) When both firms set high prices, firm A earns profits of \$100 (think of this as monopoly profits of \$200 that they share.) However, if firm B sets a high price, firm A is better off setting a low price. In this case, firm A gets profits of \$120. So if firm B sets a high price, firm A does best by setting a low price. What about if firm B sets a low price? Then firm A gets nothing if it sets a high price and profits of \$60 if it sets a low price. Firm A is clearly better off setting a low price in this case as well. No matter what firm B does, firm A should set a low price. The same is true for firm B, so the Nash equilibrium is for both to set a low price. If they could collude, they would both agree to set a high price and earn higher profits. But collusion is not a Nash equilibrium because both firms have an incentive to cheat. This is an example of a prisoners’ dilemma game.
Figure \(2\): The Payoffs (Profits) from Different Pricing Choices
Firm A and firm B are each choosing to sell at either a high price or a low price. No matter what firm B chooses to do, firm A is better off setting a low price.
Is there any way that the firms might be able to change the incentives so that they can collude? Each firm would like some means of punishing the other if it cheats. If they get to set their prices only once, there is no obvious punishment. But if these firms are competing over a long period of time—as happens in the real world—then more possibilities open up.
Think again about our two gas stations. They might both agree to set a high price for their gas. Then they keep a careful eye on each other. As long as firm B keeps its prices high, firm A is content to do the same. But if firm B ever drops its prices, then firm A can punish it by retaliating. More specifically, suppose the firms adopt the following rules:
• We both set the monopoly price (cooperation).
• However, if one of us ever fails to set the monopoly price (defection), then the other firm will set the competitive price forever after.
Figure 15.4.3 "The Payoffs (Profits) from Cooperating and Defecting" shows an example of firm A’s profits in this case. (This should now be understood as a discounted present value of profits because we are imagining the firms competing for months or years.)
Defecting means setting the low price every month. Cooperating means setting the high price as long as the other firm has set the high price in all previous months but switching to the low price every month if the other firm ever sets the low price.
Will the firms have an incentive to follow these rules? Put yourself in the shoes of firm A. If firm B is charging the monopoly price, then you can make a quick profit by undercutting firm B’s price. This will generate a gain in that period. But there is a cost: in future periods, firm B will charge the competitive price, and your profit will be driven to \$0. For the numbers in the table, it is better for firm A to cooperate if firm B also cooperates. Thus if two firms compete with each other over and over again, they may be able to sustain collusive high prices.
There is something else striking about Figure 15.4.3 "The Payoffs (Profits) from Cooperating and Defecting". It is a Nash equilibrium for both to cooperate, but it is still also a Nash equilibrium for both to defect. Look at the profits of firm A if firm B defects. Firm A earns \$300 if it defects but only \$180 if it cooperates. If you thought the other firm was going to renege on the agreement, then you would want to do the same thing. Economists say that this game has multiple equilibria. Expectations are critical: if each firm expects the other firm to cooperate, then they will indeed both cooperate; if each firm expects the other firm to defect, then they will indeed both defect. This is called a coordination game.
Toolkit: Section 31.18 "Nash Equilibrium"
The prisoners’ dilemma game, the coordination game, and other games are discussed in more detail in the toolkit.
One final note: we are showing how firms can (and often do) sustain high prices even in the face of competitive pressures. We are not suggesting that this is what you should do if you are ever responsible for setting prices! Conspiring to set high prices is very often a violation of antitrust laws.
Price Competition with Imperfect Substitutes
Up to this point, we supposed that the two firms were producing an identical product. If we think of two firms producing goods that are close—but not perfect—substitutes, we still reach very similar conclusions. For example, suppose there are two pizza restaurants on the same street. If one restaurant undercuts the other’s price, it would no longer expect to immediately capture the entire market, but it would still expect to gain a lot of business. In this situation, the arguments that we have just made still apply. Each restaurant would have an incentive in the short run to undercut the other’s price. If they compete repeatedly, however, they may be able to sustain high prices.
Market Outcomes When Firms Set Quantities
Look again at Figure 15.4.1 "The Demand Curve Facing a Firm, Taking as Given the Price Set by a Competitor". The demand curve in that figure is based on the idea that if firm A sets its price a little below firm B’s price, firm A will capture the entire market. This presumes, though, that firm A can produce enough to supply the entire market. Suppose instead that firm A is unable to supply more than 25,000 gallons of gas per month. Now, if firm B has set a price of \$2, then the best that firm A can do is to also set a price of \$2. Firm A no longer sees any benefit from cutting its price because it cannot supply any more gas to the market. Similarly, think of the two pizza restaurants. If both restaurants are typically full most evenings, then neither would see a benefit from cutting its price. There is no point in trying to attract your competitors’ customers if you cannot then supply them with the goods or services that they want.
This suggests another way in which firms can keep prices high. They can deliberately limit their capacity to change their own incentives about price-setting. In effect, this is another way of “changing the game” of Figure 15.4.2 "The Payoffs (Profits) from Different Pricing Choices". To analyze this kind of behavior by firms, we suppose that they choose their level of output rather than the price they set.
The Capacity Decision of a Firm
We again consider a situation where two firms are competing in the same market. As before, the first step is to determine the demand curve facing an individual firm. Figure 15.4.4 "The Demand Curve Facing One Firm Shifts to the Left as the Other Firm Increases Its Output" shows our gas station example again. In contrast to our previous analysis, firm B is choosing how much to produce (that is, how much gas to sell) rather than what price to set. As firm B increases its output, the demand curve faced by firm A shifts to the left. If firm B produces nothing, firm A faces the entire market demand curve. If firm B produces (sells) 30,000 gallons, firm A’s demand curve is shifted to the left by that amount. You can see that the demand curve faced by firm A has a familiar shape, unlike the odd demand curve in Figure 15.4.1 "The Demand Curve Facing a Firm, Taking as Given the Price Set by a Competitor".
As firm B produces more output, the demand curve faced by firm A shifts to the left.
When its demand curve shifts to the left, firm A’s marginal revenue curve also shifts to the left. Figure 15.4.5 "Firm A’s Profit-Maximizing Choice of Output as Firm B Changes Its Level of Output" shows what happens. Note that the downward-sloping curves here are now marginal revenue curves, not demand curves. We omitted the demand curves to keep the diagram from being too cluttered.
Part (a) of Figure 15.4.5 "Firm A’s Profit-Maximizing Choice of Output as Firm B Changes Its Level of Output" shows two marginal revenue curves for firm A associated with different levels of output for firm B. An increase in firm B’s output causes the marginal revenue curve facing firm A to shift to the left. How will firm A respond? As always, we know it will produce a level of output such that marginal revenue equals marginal cost. So as the marginal revenue curve shifts inward, firm A will produce less output. If firm B produces more output, firm A will produce less. This response of firm A to firm B is shown in part (b) of Figure 15.4.5 "Firm A’s Profit-Maximizing Choice of Output as Firm B Changes Its Level of Output". Here the output of firm B is on the horizontal axis, and the output of firm A is on the vertical axis. The downward sloping curve, sometimes called a reaction curve, shows us the output of firm A for every level of output of firm B.
Figure \(5\): Firm A’s Profit-Maximizing Choice of Output as Firm B Changes Its Level of Output
As firm B produces more output, firm A’s marginal revenue curve shifts to the left (a), and firm A responds by producing less output (b).
Toolkit: Section 31.18 "Nash Equilibrium"
A reaction curve is used to help find the equilibrium in a strategic situation. It shows what happens to one player’s best strategy when the other player’s (or players’) strategy changes.
Nash Equilibrium Revisited
We can now predict what will happen in this market. To simplify matters, we assume that the two firms are identical. This will make it easier to find a Nash equilibrium. In a Nash equilibrium, the following things are true.
• Firm A is choosing the level of output that maximizes its profits, which is based on its prediction of how much output firm B is producing.
• Firm A’s prediction about firm B’s level of output is correct.
• Firm B is choosing the level of output that maximizes its profits, which is based on its prediction of how much output firm A is producing.
• Firm B’s prediction about firm A’s level of output is correct.
If the two firms are identical, they will produce the same levels of output in the Nash equilibrium. Then, as shown in Figure 15.4.6 "Nash Equilibrium for Quantity Game", the equilibrium level of output corresponds to the intersection of the reaction curve and the 45-degree line. It is at this point, and only at this point, that all four conditions that we have listed hold. To understand this, put yourself in the position of firm A. You make a forecast about how much firm B will produce. Suppose you correctly forecast firm B’s profit-maximizing quantity. Then you will respond with your own profit-maximizing quantity. This is the point labeled as the Nash equilibrium in the figure. But why should you predict that quantity for firm B? That quantity is in fact its profit-maximizing choice, given what you are doing. The beliefs that each firm has about the other’s actions are consistent, and indeed they are self-enforcing.
Figure \(6\): Nash Equilibrium for Quantity Game
The Nash equilibrium when both firms are identical occurs at the level of output where the reaction curve crosses the 45-degree line.
Determining Prices
Now that we know how firms choose capacity (quantity), how are prices determined? The answer is easy: prices come from the demand curve. If the two firms are producing identical products, the price comes from the market demand curve, given the total output of the two firms. This is similar to what we did in the monopoly case: given the output level, we turned to the demand curve to find the price. If the two firms are producing products that are not perfect substitutes, then the analysis is similar. However, there is not one demand curve in this case; there are two. Each firm faces a demand curve that depends on the output of the other firm, as shown in Figure 15.4.7 "The Markets for Both Firms".
Figure \(7\): The Markets for Both Firms
Firm A correctly predicts firm B’s profit-maximizing level of output, and firm B correctly predicts firm A’s profit-maximizing level of output.
Inefficiency
When firms are choosing the price to set, it is possible for competition between two firms to drive prices all the way down to marginal cost and eliminate all monopoly inefficiency. This is what we see with Bertrand competition. When firms choose quantity rather than price, the effects of competition are much weaker. Look again at Figure 15.4.7 "The Markets for Both Firms". You can see that both firms are setting price in excess of marginal cost: there is still a distortion due to market power.
Competition between the firms does matter, however. Increases in firm B’s output, for example, shift firm A’s demand curve to the left. As a consequence, firm A ends up choosing a lower price than it would otherwise. Competition from firm B helps keep firm A’s prices low. By similar reasoning, competition from firm A helps keep firm B’s prices low.
In an ideal world (from their point of view), these firms would both limit their output further to get closer to the monopoly outcome. Exactly the same kind of strategies that we discussed earlier could come into play: firms that compete repeatedly over a long period of time might tacitly agree to reduce output further, punishing any defection by increasing output and cutting prices.
Competition Policy with a Small Number of Firms
In the United States, there are two aspects of policy when there are a small number of firms. First, a small number of firms in a market may be able to collude to set high prices. Antitrust laws can be used to punish such collusive behavior. Second, if there are a small number of firms, they may want to merge and become one large firm. Such mergers must be approved by the US government.
Collusive Behavior
The Sherman Antitrust Act is not only used against existing monopolies but is also more generally applied to groups of firms that act to jointly monopolize a market. If multiple firms act collusively to exert market power, they may fall foul of the act. Indeed, in the Standard Oil case, the key issue was the way the Standard Oil Trust brought multiple firms together into a single decision-making unit.
One form of collusive behavior occurs when firms come together to jointly decide on output levels and/or the price of the goods and services they sell. Occasionally, managers of firms are foolish enough to get caught on record making such proposals. In a famous incident a couple of decades ago, the CEO of American Airlines, Robert Crandall, proposed a 20 percent price increase to his counterpart at Braniff Airlines. Unfortunately for Crandall, the conversation was taped. (Interestingly, Crandall was not actually guilty of a violation of the Sherman Antitrust Act because no actual price-fixing took place.) More often, such agreements are likely to be tacit. One firm may try raising its prices, to see if others will follow. It can be very hard for the antitrust authorities to determine if price-fixing is actually occurring.
Other countries also have laws and agencies that seek to prevent collusion by firms. For example, in April 2008, the Office of Fair Trading in Britain charged two tobacco companies of colluding with supermarkets to set high prices for cigarettes. Specifically, the Office of Fair Trading said that the companies had set up arrangements “linking the retail price of a manufacturer’s brand to the retail price of a competing brand of another manufacturer.”Quoted in G. Wearden, “OFT Accuses Tobacco Firms and Retailers of Cigarette Price Fixing,” Guardian, April 25, 2008, accessed January 31, 2011, http://www.guardian.co.uk/business/2008/apr/25/regulators.retail.
Another form of collusive behavior occurs under the heading of “bid rigging.” Suppose only a few dairies provide milk to all schools in a region of the country. The schools set up auctions to decide which dairies will supply milk to different school districts. There is one auction for each district, and several dairies compete to provide milk to the different districts. The situation seems at first glance to be very competitive. We might expect the dairies to compete with each other in all the auctions, with this competition driving down milk prices for the schools. But imagine instead that the dairies agree ahead of time to divide up the districts. So for example, if there are three districts and three dairies, the dairies might agree that dairy 1 would win the auction in one district, dairy 2 in another, and dairy 3 in the third. They do this by each putting in very high bids (meaning they would charge a lot for a service), in the districts where they do not want to win the auction, allowing one dairy to win the auction and still charge a high price. Exactly such a scheme occurred in Texas, and an individual was charged with a felony.
Mergers and Acquisitions
Suppose you heard that Apple Computer and Microsoft Corporation were proposing a merger. You can perhaps imagine Steve Jobs and Bill Gates telling us how much we as consumers would benefit from this merger. They would say that Apple and Microsoft could combine the best features of their operating systems. The two companies could avoid costly duplication of research, so they would be able to provide goods more cheaply. They would no longer need to spend so much on advertising, again providing savings that could be passed onto the consumer, and so on. In a nutshell, Jobs and Gates might claim, the merger would bring new exciting products with lower costs of distribution and marketing.
You can be sure, however, that the Department of Justice, European antitrust authorities, and other similar bodies throughout the world would look on a proposed Microsoft-Apple merger with a highly skeptical eye. They would carry out their own studies of the costs and benefits of the merger. Even if the merger were to bring all the advertised benefits, it would also make the computer operating system market much less competitive. If there are originally two firms in a market and they then merge, they become a monopoly. The analysis in this chapter allows us to predict that output would decrease and prices would increase. Because a market with only two firms may still be very competitive, the loss in buyer surplus going from a competitive market to a monopoly can be sizable.
Stemming from the Clayton Act, the Department of Justice and the Federal Trade Commission must approve mergers and acquisitions of larger companies. The guidelines used for those decisionsUS Department of Justice, “Horizontal Merger Guidelines,” accessed March 14, 2011, http://www.usdoj.gov/atr/public/guidelines/hmg.htm. emphasize two general points: (1) the effect of the merger on efficiency and (2) the effect of the merger on market power. Efficiency here refers to cost efficiency—the extent to which a merged company will be able to reduce its costs of production. The Department of Justice puts it as follows in its merger guidelines: “Efficiencies generated through merger can enhance the merged firm’s ability and incentive to compete, which may result in lower prices, improved quality, enhanced service, or new products.”US Department of Justice and Federal Trade Commission, Revised Section 4 Horizontal Merger Guidelines, April 8, 1997, accessed March 1, 2011, http://www.ftc.gov/bc/docs/horizmer.shtm.
Efficiency may also relate to the quality of the good being produced. If a merger enables a better product to be produced at the same price as before, then the merger increases market efficiency. Put differently, if the merger increases the surplus of buyers, either because the product is improved or because the reduced costs of production lead to a lower price, then the merger has had a positive impact on efficiency. For example, one benefit from airline mergers might be the more efficient use of the information systems that handle travel reservations. Another might be more efficient use of airport landing rights.
With these guidelines in mind, how would the Department of Justice respond to a proposed merger of Microsoft and Apple? They would study the proposed merger with the goal of determining if the merger would create a more efficient market or if it would increase the market power of the sellers. Department of Justice economists would use frameworks like the ones we have presented in this chapter to help them predict the outcome of the merger.
The Department of Justice would almost certainly decide not to approve an Apple-Microsoft merger. However, it does not block most proposed mergers. There is debate among economists about whether the antitrust authorities are too lenient or too stringent. A recent study by economists Orley Ashenfelter and Daniel Hosken looked at five mergers that they suspected of being anticompetitive.Orley Ashenfelter and Daniel Hosken, “The Effect of Mergers on Consumer Prices: Evidence from Five Selected Case Studies” (National Bureau of Economic Research Working Paper 13859), February 2008. They compared prices of the goods produced by the merged firms with prices of goods that were not close substitutes yet had similar costs. They concluded that, in four of the five cases, prices increased between 3 percent and 7 percent, and “given the large amount of commerce in these industries, the implied transfer from consumers to manufacturers is substantial.” The evidence from this study thus suggests that the antitrust authorities are too permissive in allowing mergers.
The European Union also watches mergers closely, likewise balancing cost-efficiency and competitiveness considerations. Here is a statement of its policy on mergers: “If the annual turnover of the combined businesses exceeds specified thresholds in terms of global and European sales, the proposed merger must be notified to the European Commission.… These rules apply to all mergers no matter where in the world the merging companies have their registered office, headquarters, activities or production facilities. This is so because even mergers between companies based outside the European Union may affect markets in the EU. ”See European Commission, “Mergers: Overview,” accessed March 14, 2011, ec.europa.eu/comm/competition/mergers/overview_en.html.
Key Takeaways
• The market outcome with a few sellers is the Nash equilibrium of the game they play. In the Nash equilibrium, none of the firms has an incentive to change what is being done.
• The market outcome depends on the strategy variable of the firms. If each firm is choosing the price of its output, then the outcome with many firms is the competitive outcome. If each firm is choosing the quantity of its output, then there is a distortion in the output market as price exceeds marginal cost.
• Governments act to regulate markets with a small number of sellers by making sure that firms do not make decisions jointly and evaluating the efficiency gains and market distortions from proposed mergers.
Exercises
1. Show that one firm setting its price at marginal cost and the other one setting a price above marginal cost is not the Nash equilibrium.
2. Explain how the interest rate will influence the choice of a firm to cooperate with another one in setting the monopoly price. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/15%3A_Busting_Up_Monopolies/15.04%3A_Markets_with_a_Small_Number_of_Sellers.txt |
In Conclusion
There are very few examples of truly competitive markets. Most firms in the economy possess a certain amount of market power because their product, service, or location is distinctive. This means that most prices in the economy are in excess of marginal cost.
That said, the degree of market power of most firms is relatively small. Canon has some market power for its cameras because Canon cameras are not identical to Nikon, Olympus, or Sony cameras. But the presence of these other manufacturers severely limits Canon’s ability to charge high prices. Your local Thai restaurant has some market power because its food is different from that of other restaurants in the neighborhood. Again, though, this does not mean it can charge very high prices because customers can easily eat at other restaurants instead.
Occasionally, however, firms are so large relative to their markets that they have substantial market power. This distorts prices and output in the economy. Firms with such market power can make a lot of money by restricting their output and charging very high prices. This is where the antitrust authorities come into play. Their task is to identify firms that are abusing their market power in this way. In effect, their job is to try to bring the economy closer to the economists’ ideal world, where markets are competitive, there are no distortions, and all possible gains from trade are realized.
In some cases, though, governments have reasons to create and support market power through patents and copyrights. They do so because the benefits from innovation outweigh the distortions associated with monopoly. Policy in this area is highly contentious because the right balance between encouraging innovation and fostering competition is unclear. Economists and policymakers continue to struggle with this and are likely to do so for years to come.
Key Links
exercises
1. Suppose you have two types of beverages: a cola and a beer. Are these products in the same market?
2. The table in Question 3 shows data for a monopolist who sells a good to four households, each of which buys at most one unit and each of which has a different valuation for the good. The monopolist can produce the good at a marginal cost of \$4. The monopolist can discriminate perfectly in its pricing, charging each household its valuation. Fill in the missing elements in the table. How many units should the monopolist produce? How does your answer change if marginal cost is \$6?
3. (Advanced) Looking again at the following table (with marginal cost equal to \$4), calculate the marginal revenue. What is its relationship to price? Explain your findings.
Household Quantity Household Valuation Price Total Revenue Marginal Cost Total Cost Profit
A 1 12 12 12 4 4 8
B 2 6 6 18 4 8 10
C 3 4 4 4
D 4 3 3 4
TABLE \(1\): PRICE DISCRIMINATION BY A MONOPOLIST
1. Write an explanation of the monopoly pricing problem assuming the monopolist sets the price rather than chooses quantity. Why is the outcome the same either way?
2. Looking at the table in Question 3, if the interest rate increased to 15 percent, would the firm still have an incentive to innovate?
3. Explain why there is a greater incentive to innovate if the final stage of competition is with a small number of quantity-setting firms rather than price-setting firms.
4. Why might a merger lead to a price reduction? Why might a merger lead to a price increase?
5. Suppose that a firm (the incumbent) produces with constant marginal cost at \$10 and has a constant (minus) elasticity of demand of 2. What is its profit-maximizing price? Now suppose that a new firm enters the market. The demand curve facing the incumbent firm shifts inward, but suppose that the elasticity of demand does not change. Should the incumbent firm change its price? What happens to the quantity that it sells? Draw a diagram to illustrate this market.
6. Imagine there is a motorcycle dealer in your neighborhood. You know both the price of the motorcycle set by the dealer and the amount of money the dealer paid for that motorcycle. It turns out that your valuation of the motorcycle is less than the posted price but greater than the cost of the motorcycle to the dealer. Are there gains to trade? Do you think you could convince the dealer to sell the motorcycle to you? If so, is there a deadweight loss? Why might the dealer be unwilling to sell the motorcycle to you?
7. Plane tickets are often sold at different prices to different people. Is this a form of price discrimination?
8. Writers of textbooks sometimes make their products available at a price of near zero. Does this mean they are altruists, or are they earning revenue some other way?
9. If interest rates increase, what needs to happen to patent lengths to maintain incentives for innovation?
10. In 15.4 Section "Market Outcomes When Firms Set Quantities", we looked at the situation when two firms chose quantity simultaneously. Describe the game and the outcome if one firm chose its quantity first and the other one followed. Would the outcome be the same as that discussed?
11. If you were a judge looking at a prospective merger between Coke and Pepsi, would you be more inclined to support the merger on efficiency grounds or argue against the merger as being anticompetitive?
Economics Detective
1. If a company invents, patents, and produces a product in the United States and sells the product in China, what type of protection does the company have in China?
2. If a US company operates in Europe, is it subject to European competition policy?
3. What legal authority does the European Union have over US firms?
Spreadsheet Exercise
1. (Advanced) Build a version of Table 15.3.1 "Calculating the Discounted Present Value of Expected Profits" starting with entries on demand and costs. To do so, use the examples in Chapter 7 "Where Do Prices Come From?" to create demand, revenue, and then marginal revenue. Also use the examples there to create variable cost and marginal cost. Then find the profit-maximizing quantity and price. Using this information, calculate the profit for each year and then calculate the discounted present value of these profits. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/15%3A_Busting_Up_Monopolies/15.05%3A_End-of-Chapter_Material.txt |
What do you do when you are ill? You might first go to a drugstore, browse the shelves a bit, and find an over-the-counter medication that you think will make you feel better. Your choice of product could be influenced by many things, including past experience, the advice of friends, or perhaps an advertisement you saw on television.
If the trip to the drugstore doesn’t solve the problem, a visit to a doctor usually comes next. The first doctor you visit is likely to be a general practitioner, or GP for short. Even if insurance is picking up some of the cost, a trip to the doctor is often not cheap. Nor is it usually fun: it may involve long waits and unpleasant tests. We go to the doctor not because we enjoy the experience in itself but because of a deeper demand—a desire to be healthy.
A trip to the doctor typically ends with a bill, a prescription, and perhaps a smile along with a “see you again soon.” (That last bit, of course, is not quite what you want to hear.) Then you go to the pharmacy to fill the prescription. If you look at the piece of paper the doctor gave you, you might notice a couple of things. First, the doctor’s handwriting is often illegible; penmanship is evidently not high on the list of topics taught at a medical school. Second, even if you can read what is written, it probably means nothing to you. The chances are that it probably names some medication you have never heard of—and even if you have heard of it, you probably have no idea what the medication does or how it works.
In other words, though you are the purchaser and the patient, your treatment is largely out of your hands. Health-care purchases do not directly reflect individual choices the way most other spending decisions do. You did not choose to be sick, and you do not choose your treatment either.
Occasionally, your GP might recommend that you visit another doctor, called a specialist. Your GP might try to explain the basis of this recommendation, but you probably lack the expertise and the knowledge to evaluate the decision. Once again, you must trust your doctor to make a good decision for you: the decision to visit the specialist is largely your doctor’s rather than your own. You typically follow the doctor’s advice for two reasons: (1) you trust the doctor to make decisions in your best interest, and (2) if you have medical insurance, you do not have to pay most of the costs.
We have described this as though you have no control at all over your own health care and treatment. This is an exaggeration. If you are somewhat informed or knowledgeable about what is wrong with you, then you can discuss different treatment options with your doctors. You can become at least somewhat informed by reading articles on the Internet. You can seek out second and third opinions if you do not trust your doctor’s diagnosis. If you are having serious treatments, such as a surgical procedure, you will have to sign forms consenting to the treatment. There is a trend these days for people to become more involved and empowered about decisions involving their own health. Yet, unless you have medical training yourself, you will have to rely to some degree, and probably a very large degree, on the advice of your doctors.
If you are seriously ill, you may have to go to the hospital. There you have access to many more specialists as well as a lot of specialized equipment. Whatever autonomy you had about your treatment largely disappears once you enter the hospital. At this point—at least if you are living in the United States—you certainly should hope you have insurance coverage. Hospital costs can be astounding.
If you look back in history, health care was not always provided the way it is today. One difference is that doctors used to visit patients at home. They would traditionally arrive with a small black bag containing their basic tools. (This type of service is still provided in some communities and in some countries, but it is now rare in the United States.) For the most part, that was where your medical treatment ended.
In part, this reflected the state of medical knowledge at the time. It is hard to comprehend how much medical science has advanced in the last century. One hundred years ago, our knowledge about the workings of the human body was rudimentary. There were few treatments available. Antibiotics had not yet been discovered, which meant that the simplest injury—even a scratch—could become infected and be fatal. If you had appendicitis, it would very likely kill you. There were few means of diagnosis and no treatments for cancer.
Today, the story is very different. We visit specialists who have highly advanced (and expensive) training. We have access to advanced diagnostic tools, such as magnetic resonance imaging (MRI) scans, blood tests that identify markers for cancer, and genetic testing. We also have access to expensive treatments, such as kidney dialysis and radiation therapy. Perhaps most strikingly, we have access to a range of pharmaceutical products that have been developed—sometimes at great expense—by scientists and researchers. These products can treat medical conditions from asthma to apnea to acne.
With all these visits to doctors and all these medications, we spend a great deal on health care. Spending as a fraction of gross domestic product (GDP; a measure of the total output of the economy) has been increasing since 1960 ( Figure 16.1.1 "US Health-Care Expenses as a Percentage of GDP"). Figure 16.1.2 "Global Health-Care Spending" shows total spending on health services per person around the world.World Health Organization, “Total Expenditure on Health per Capita, 2007 (in US\$),” accessed March 1, 2011, http://www.who.int/nha/use/the_pc_2007.png. The shaded areas indicate the level of spending on health-care services. The United States spends the most on health care per person, with Norway and Switzerland also being high-spending countries. Other rich countries, such as Japan, Australia, New Zealand, South Korea, and countries in Western Europe, likewise spend relatively large amounts on health care. The poorer countries in the world, not surprisingly, spend much less per person on health care. Across countries in the world, as within a country, health-care purchases are related to income.
Figure \(1\): US Health-Care Expenses as a Percentage of GDP
Figure \(2\): Global Health-Care Spending
One reason that we spend so much on health care in the United States is that high-quality care, such as is available in rich countries, is at least in part a luxury good—that is, something that we spend relatively more on as our income increases. Yet even across relatively affluent countries, health care takes very different forms.A comparison of programs is provided by Ed Cooper and Liz Taylor, “Comparing Health Care Systems: What Makes Sense for the US?” In Context, accessed March 14, 2011, www.context.org/ICLIB/IC39/CoopTalr.htm. Compare, for example, the United States and Canada. Canada has a system in which the government pays for health care. The program is financed by the payment of taxes to the government. Doctors’ fees are set by the government, which limits competition within the health industry. Furthermore, other developed countries spend much less on health care than the United States but have health outcomes that are as good or even better.
Differences in both the quality and cost of health care mean that, perhaps surprisingly, health care is traded across national boundaries. In some cases, people travel across the globe to obtain care in other countries. Sometimes, people travel to obtain treatments that are unavailable in their home countries. For example, US residents sometimes travel to other countries to obtain stem-cell treatments that are banned in the United States. Or people may seek health care in other countries simply because it is cheaper: people from around the world travel to Thailand, for example, to obtain cheap and reliable dentistry services. There are even tour operators that arrange such “health tourism” trips. National Public Radio had a March 18, 2008, story of a husband and wife going to China for get stem-cell treatment for their seven-month-old daughter ( http://www.npr.org/templates/story/story.php?storyId=88123868). There is also a company that organizes trips to Canada ( http://www.findprivateclinics.ca/resources/general/medical-tourism.php). Given all these differences in health care costs around the world, we address the following question in this chapter:
What determines the cost of health care?
Road Map
Because we want to talk about the price of health care, supply and demand is a natural starting point. As we use this framework, though, it will rapidly become clear that there are many things that are unique about the market for health care. One indication of this is that there is a whole subfield of economics called “health economics.” There is no subfield called “chocolate bar economics,” “tax advice economics,” or “lightbulb economics.” Evidently, there is something different about health care. Another indication is the fact that governments around the world pay an enormous amount of attention to this market. Governments intervene extensively in this market through taxes, through subsidies, and sometimes by being the direct provider of health-care services.
We first study the demand for health care by households. Then we look at the supply of health care, after which we turn to the determination of prices. As we proceed, we will see that health care includes all sorts of different products and services. We will also see that there are many reasons why it is difficult to analyze health care with a simple supply-and-demand framework.
One key reason why health care is such a complicated topic has to do with the fact that, frequently, we do not pay for health care ourselves. Rather, we (or our employers) purchase health insurance, and then the insurance company pays the health-care providers. We therefore discuss health insurance in some detail. The chapter ends with a discussion of the government’s role in the health sector, in which we talk about market failures and a variety of proposed government solutions. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/16%3A_A_Healthy_Economy/16.01%3A_The_Cost_of_Health_Care.txt |
Learning Objectives
1. What factors determine the price and quantity of health care?
2. In what sense is spending on health an investment?
3. What factors determine the demand for health-care services?
4. What is the production function for health?
Suppose we want to explain why health care is more expensive in the United States than in Europe. Then supply and demand seems like a natural starting point. If we imagine a market for health care drawn in the usual way, with the quantity demanded on the horizontal axis and the price on the vertical axis, then the question becomes, “Why is the price of health care higher in the United States than in Europe?”
Supply and demand offers two possible answers ( Figure 16.2.1 "Two Explanations for Why Health Care in the United States Is More Expensive Than in Europe"). The prices can be high because demand is high. For example, if the demand curve is further to the right in the United States compared to Europe (part [a] of Figure 16.2.1 "Two Explanations for Why Health Care in the United States Is More Expensive Than in Europe"), this implies—all else being equal—higher prices in the United States. The other reason for high prices is because supply is limited. If the supply curve in the United States lies further to the left than the supply curve in Europe (part [b] of Figure 16.2.1 "Two Explanations for Why Health Care in the United States Is More Expensive Than in Europe"), then this also would imply—all else being equal—higher prices for health care in the United States. Neither argument seems that compelling, which naturally leads us to wonder if the supply-and-demand framework is really the best framework for analyzing health care. In fact, there are good reasons to think that the supply-and-demand framework is not the best approach to this market.
Supply and demand offers two possible explanations of high health-care costs in the United States: demand in the United States is high (a), or supply in the United States is limited (b). Neither is a very compelling explanation.
Let us think about the demand side first. Our standard approach to demand is based on the idea that each individual will consume a good or a service up to the point where the marginal valuation from one more unit equals the price of that additional unit. Chapter 4 "Everyday Decisions" explains this idea in more detail. Unfortunately, the health-care consumer often has very little idea of the value—let alone the marginal valuation—of the particular treatment being received. The consumer is very often not paying the full price for that treatment because the cost is frequently covered, at least in part, by insurance. Together, these mean that our traditional approach to demand does not work very well for health-care services.
The supply side is also problematic. First of all, some health-care suppliers have significant market power. This does not mean that we can get no insights from supply-and-demand reasoning. But it is trickier to compare the price of health care across countries because we have to consider differences in market power as well. A bigger problem is that some health-care suppliers, such as hospitals, are either government-controlled or not-for-profit institutions. The standard economic approach presumes that firms seek to make as much profit as possible, but government or not-for-profit hospitals may not have profit maximization as their goal.
In addition, health-care prices are not necessarily determined by supply and demand. Again, the government has a significant influence on prices: for example, the governments in some countries set prices for pharmaceutical products. Even if they are not set by the government, prices may be determined by bargaining between, say, hospitals and drug companies rather than by supply and demand. Furthermore, if people need health-care services, then their demand is likely to be very inelastic (the quantity demanded does not respond much to price changes). Inelastic demand is not, in and of itself, a problem for a competitive market. It just means that the equilibrium price could be very high. But if we couple inelastic demand with consumers who lack information and add in some market power by suppliers, then matters become more complicated. Perhaps you already have a sense of why: we have a large group of consumers with very inelastic demand who are relatively uninformed. This sounds like a gold mine for the supplier.
We have so far ignored the issue of what exactly is being traded in this market. “Health-care services” can mean many very different things:
• Labor time of various trained professionals, such as GPs, specialists, nurses, medical technicians, pharmacists, and many others
• Procedures and testing, such as magnetic resonance imaging (MRI) scans and laboratory analyses of blood samples
• Hospital and nursing care services
• Emergency services such as ambulances
• Pharmaceutical products (which itself covers a huge range, from bandages to chemotherapy drugs)
You can probably think of other components as well. So it is more than a little misleading to treat health care as something homogeneous that is bought and sold in a single market.
We hope that by now we have completely muddled your view of the health-care market. Our main point is that the simple framework of supply and demand is not sufficient for understanding health care. There are too many different markets, each with its own peculiarities and unusual features. And those features mean that there are several reasons why we might expect inefficiency. One, as we have already noted, is the presence of market power. Another is the various information problems we have mentioned. A third is that some aspects of health care have the characteristics of a public good.
The Demand for Health Care
Now let us dig a little deeper into the demand side of health care.
Response to Price
The law of demand applies to health care as in other markets: as the price of health care increases, you demand less of it. But we must be careful. What matters is the price of health care to you. If you have health insurance, this price may be much lower than the actual cost of providing you with care. Under most health-insurance contracts, the marginal private cost of care to a household is less than the marginal social cost of providing that care. The household has an incentive to purchase a lot of health-care services because its purchases are, in effect, being subsidized by insurance companies. We take up the topic of health insurance later in this chapter.
Toolkit: Section 31.19 "Externalities and Public Goods"
You can review the distinction between marginal private cost and marginal social cost in the toolkit.
Another key characteristic of health care is that demand is relatively inelastic. If you are sick and require care, you will purchase health-care services at almost any price. Of course, your ability to purchase health care is ultimately limited by your income, but you are likely to trade off spending on many other products to purchase the medical care you need. This is why we often read stories about people without insurance being bankrupted by medical expenses.
Health as Investment
Everyone prefers being healthy to being sick. The demand for health care is in part an expression of this preference. One thing that makes health care different from most other goods and services, though, is that it is simultaneously an investment. Money you spend on being healthy today will also benefit you in the future. There are several different ways in which spending on health care represents an investment.
Mortality. One clear impact of our health-care choices can be seen in terms of mortality rates. Mortality rates measure how likely we are to die at different ages. In 2004, the mortality rate in the United States for people ages 15–24 was about 80 out of 100,000, or 0.08 percent. In contrast, the mortality rate for those over the age of 85 was 13,823 out of 100,000, or 13.8 percent.Mortality rates can be found at the National Center for Health Statistics, National Vital Statistics System, “Mortality Tables,” accessed March 14, 2011, http://www.cdc.gov/nchs/nvss/mortality_tables.htm. In other words, the typical young person has about a 1 in 10,000 chance of dying in a given year, whereas the typical old person has more than a 1 in 10 chance of dying.
It is not surprising that the mortality rate increases with age—that is, that young people have a lower probability of dying than older people. (Infants are an exception: a 6-month-old child is more likely to die than an 18-month-old child because very young children are particularly susceptible to certain diseases.) But these average mortality rates disguise a lot of variation, much of which is under our control. There are many behaviors that have predictable effects on our likelihood of dying. Smokers have a higher probability of dying than nonsmokers. Those who are obese have a higher probability of dying than those who are not. Diet, exercise, and risky behaviors (which includes everything from unprotected sex to skydiving) affect mortality rates as well.
Cigarette smoking is linked to lung cancer and thus to mortality. If you compare two similar individuals of the same age, one who is a smoker and the other a nonsmoker, then the mortality rate is significantly higher for the smoker. This does not mean that the smoker will necessarily die before the nonsmoker. It means that all else being the same, smoking increases the probability of death. Refraining from smoking is a type of investment in your future.
Our diet also affects our probability of becoming ill and of dying. As with cigarettes, there are often trade-offs between eating and drinking things we enjoy and the effects of such consumption on our long-term health. Making these types of choices is an economic decision. Each of us makes different choices because we value the taste of particular foods differently, and we value our overall health differently as well. If a thirty-year-old discovers he has elevated cholesterol levels that pose a long-term risk of heart disease, he may decide to adjust his diet, perhaps consuming less red meat. If an eighty-year-old learns the same news, he may not think the long-term benefit is worth giving up his steaks for.
Productivity. Being healthy also means that you can work and earn wages. One of the costs of poor health is lost days at work. This is a cost not only to the individual but also to society as a whole: the economy’s population is producing less output. If you are in poor health, then you risk losing wages for the days when you cannot come to work. Many employers provide insurance for these lost wages through the provision of sick days: if you are sick, you are not expected to work but you will still be compensated up to a contracted number of days per year. In addition, there is disability insurance as part of the social security system in the United States.The government program is summarized at http://www.ssa.gov/disability. Private employers sometimes also offer disability insurance as part of their compensation packages, and you can also purchase insurance directly from an insurance company.
Information Problems
Health care is an example of a good for which the typical individual is unable to determine the quality of what is being purchased. You can think of other examples, such as legal services and used cars. In such situations, how can we make good decisions? Generally we do so by relying on the advice of experts. In the case of health, these are the doctors, dentists, and other health professionals who are trained to analyze our health situation and make suggestions to us. We listen, try to understand, and, using their advice, make an informed choice.
Suppose you get a phone call from someone telling you they know of a stock, trading on Wall Street, that will double in price the following day. You might be very skeptical, suspecting that they have other reasons for wanting you to buy. Compare this to a conversation with a medical expert. Generally you are going to believe that the expert is acting in your best interests. Although you might get a second (or third) opinion, you do so because health problems are complex and the first expert may have missed something, not because you are afraid the doctor is misleading you in order to profit from your visit. But why do we trust medical experts so much more than the provider of stock tips? We generally do so because we trust that their incentives are aligned with our goals; that is, we hope that they are motivated to act in our best interests.
The Supply of Health Care
We now turn to the supply side of health care. Economists often talk of output being produced using a production function that uses labor, capital, and intermediate inputs. What is the production function of a hospital?
• The labor in a hospital includes doctors, surgeons, orderlies, technicians, nurses, administrative staff, janitors, and many others.
• The hospital buildings are part of the hospital’s capital stock. In addition, hospitals contain an immense quantity of other capital goods, such as hospital beds and diagnostic tools—everything from stethoscopes to x-ray machines.
• Intermediate inputs in a hospital include dressings for wounds, and pharmaceutical products, such as anesthetics used for operations.
Other sectors of the health-care industry likewise employ labor, capital, and intermediate inputs.
Toolkit: Section 31.17 "Production Function"
You can review the meaning and definition of a production function in the toolkit.
Doctors
If you look at the wall in your doctor’s office, you will typically see a large number of framed degrees and other qualifications. To become a doctor, you must first succeed as an undergraduate and then go through multiple years in medical school. After this comes an internship and then you finally graduate and can practice on your own. In most countries, you must have a license to practice medicine. This makes sense: you would not want anyone to advertise as a doctor regardless of their skill level. Most of us would be unable to tell whether a particular individual was a qualified professional or a quack. When buyers cannot easily evaluate the quality of the good or the service they are purchasing, it is useful to have external validations of quality.
Licensing provides more than a guarantee of quality, however. It also limits entry into the profession. Suppose you learned that a small group of lobbyists in your hometown wanted gas station owners to be licensed in the same way as physicians. You would quite rightly suspect that their goal was not to guarantee high-quality gasoline. More likely, they would be trying to limit the number of gas stations to increase their market power. Your suspicions would not be allayed if these lobbyists argued that gas was potentially a very harmful commodity, so by licensing the sellers of gas, they were protecting the community. In the case of doctors, the underlying reason for licensing is not so nefarious. But it still creates a barrier to entry that limits competition and increases market power, just as it would with gas stations.
Doctors differ from gas station owners in many other ways. Typically, we suppose that gas stations and other firms in an economy have profit maximization as a goal. It is this presumption that allows us to develop our theory of supply. Doctors not only think about profits but also take an oath of office, called the Hippocratic Oath, which is as follows:
I swear by Apollo, the healer, Asclepius, Hygieia, and Panacea, and I take to witness all the gods, all the goddesses, to keep according to my ability and my judgment, the following Oath and agreement:
I will prescribe regimens for the good of my patients according to my ability and my judgment and never do harm to anyone…
I will not give a lethal drug to anyone if I am asked,…Wikipedia, s.v. “Hippocratic_Oath,” accessed March 14, 2011, http://en.Wikipedia.org/wiki/Hippocratic_Oath.
This oath is administered to nearly everyone obtaining a medical degree.
Other Health-Care Workers
In addition to doctors and specialists, there are many other kinds of workers in the health care industry, including nurses, dental hygienists, administrative staff, technicians, staff in care facilities such as hospices and nursing homes, and many others. The health-care industry employs almost 10 percent of all civilian workers in the United States.
Table 16.2.1 "Employment in Health Services (in Millions)" shows the breakdown of employment by health-service site for three years: 2000, 2003, and 2006. We list some (not all) of the types of health sites. From the table, we see that the number of workers in this industry has increased from 12.2 million in 2000 to about 14.4 million in 2006. This increase is typical of many service industries and contrasts with manufacturing, where the number of workers employed is declining.
Type of Health Service Site 2000 2003 2006
Physicians (offices and clinics) 1.4 1.7 1.8
Hospitals 5.2 5.6 5.7
Nursing care facilities 1.6 1.9 1.8
Total 12.2 13.6 14.4
Table \(1\): Employment in Health Services (in Millions)
Source: National Center for Health Statistics, Health, United States, 2007 with Chartbook on Trends in the Health of Americans (Hyattsville, MD: US Department of Health and Human Services, 2007), table 105, accessed February 1, 2011, http://www.cdc.gov/nchs/data/hus/hus07.pdf.
Hospitals are the most important type of employment site for health-care workers. In 2006, 40 percent of health-care workers were employed in hospitals. About three-fourths of the workers in the health-care sector are women. Women are particularly prevalent in nursing care facilities: of the 1.6 million workers in nursing care facilities in 2000, about 1.4 million were women.
There is a wide variety of occupations within health care: managers, professionals (doctors, dentists, pharmacists, etc.), service occupations (assistants, cooks, cleaners, etc.), and office workers. Professional groups account for about 44 percent of all workers, while about 32 percent of the jobs are in service occupations. There will typically be considerable variation of wages within a sector because of the different occupations of workers in that sector. For example, individuals working in diagnostic laboratories earn, on average, close to twice the wage of workers in nursing homes.
Health-Care Capital
When we look at an industry such as health care, one way of describing it is by counting the number of doctors’ offices, clinics, and so on. There are many different kinds of establishments that provide health services. Hospitals are only one example; others include doctors’ offices, clinics, nursing homes, and so on. According to the Bureau of Labor Statistics ( www.bls.gov/oco/cg/cgs035.htm), in 2008, there were 595,800 establishments in the health-care sector in the United States. Of these, doctors’ offices are 36 percent. Hospitals are only 1 percent.US Department of Labor, Bureau of Labor Statistics, “Career Guide to Industries, 2010–11 Edition: Healthcare,” accessed March 14, 2011, www.bls.gov/oco/cg/cgs035.htm. Another way to describe the industry is by detailing the number of workers employed in different activities, as in Table 16.2.1 "Employment in Health Services (in Millions)".
Taken together, these statistics paint an interesting picture. Hospitals are a small fraction of the total health-care establishments but employ 35 percent of the workers. This tells us that there are relatively few hospitals (compared to doctors’ offices), but they are big. About 70 percent of hospitals employ more than 1,000 workers. Such a pattern is not peculiar to the health-care sector. In US manufacturing, the majority of establishments are small, and a few large establishments employ the majority of workers.This is described in Steven J. Davis, John C. Haltiwanger, and Scott Schuh, Job Creation and Destruction (Boston, MA: MIT Press, 1998). We discuss this phenomenon in more detail in Chapter 9 "Growing Jobs".
The ownership of hospitals is also complicated. Some are private, while others are public, meaning that federal, state, or even county governments run them. In addition, not all private hospitals are in business for profit; some are classified as not-for-profit institutions. Table 16.2.2 "Hospital Activity, 2005" provides a breakdown of hospitals by type. From this table, you can see that most admissions are in not-for-profit hospitals that are not federally run. Their goal is largely to provide a public service. These hospitals have a length of patient stay averaging about 5.5 days.
Type of Hospital Admissions (Thousands) Average Length of Stay (Days)
All 37,006 6.5
Federal 952 11.6
Nonfederal, not-for-profit 25,881 5.5
Nonfederal, for-profit 4,618 5.3
Table \(2\): Hospital Activity, 2005
Source: National Center for Health Statistics, Health, United States, 2007 with Chartbook on Trends in the Health of Americans (Hyattsville, MD: US Department of Health and Human Services, 2007), table 105, accessed February 1, 2011, http://www.cdc.gov/nchs/data/hus/hus07.pdf.
There are other capital goods that enter the production function for the health sector. For example, pharmaceutical production facilities are part of this capital stock. So too is the capital stock of companies that produce the machines, such as MRIs, used in doctors’ offices and hospitals.
Technological Progress
Technological advances in health care are truly staggering. Technological progress in this sector, as in other sectors, comprises both product and process innovations. By product innovations, we mean increases in the types of goods and services available to households and doctors. A leading example is the vast array of drugs now available on the market, which is the outgrowth both of research and development at pharmaceutical companies and of publically funded research. Another example is the advanced machinery used in modern health-care facilities. A modern dentist’s office is filled with high-speed drills, x-ray machines, and other pieces of technology that would have been unthinkable in your grandparents’ day. MRI machines are another example: these are a significant advance over previous imaging techniques such as X-rays, but they are expensive—a new MRI machine will typically cost a hospital more than \$1 million.An article describes this technique at NOVA, “The Picture Becomes Clear for Magnetic Resonance Imaging,” accessed March 15, 2011, www.science.org.au/nova/062/062key.htm.
Process innovations refer to how techniques are implemented. For example, surgeons today can perform operations that surgeons of previous generations could not even imagine. The knowledge for these procedures was created by a few people and then taught to others in medical school and other training programs.
Process and product innovations come together when you compare how certain procedures are performed now relative to years ago. Consider surgery to repair a hernia. The first hernia (hiatal) surgery took place around 1919, and the procedure was risky and painful. Even relatively recently, a procedure like this involved hospital stays, many days lost from work, and a significant risk of medical complications.For the history of hiatal hernia surgery, see Nicholas Stylopoulos and David W. Rattner, “The History of Hiatal Hernia Surgery: From Bowditch to Laparoscopy,” Annals of Surgery 241, no. 1 (2005): 185–193, accessed March 14, 2011, http://www.pubmedcentral.nih.gov/articlerender.fcgi?artid=1356862. Today, the leading method for surgery uses a piece of capital called a laparoscope—a tube with light that allows a surgeon to see inside a patient’s abdominal cavity. Then, using another instrument, again inserted through a small incision, the surgeon can repair the hernia. Remarkably, this is an outpatient procedure. The patient emerges from the hospital with a few small wounds and can return to work and normal life within a few days.
Price Determination
If this chapter were like most others in this book, we would now turn to a discussion of how supply and demand interact in a competitive market to determine the price. Or, recognizing that firms with market power set prices, we might use the condition that marginal revenue equals marginal cost to talk about price determination. Unfortunately, when it comes to understanding the market for health care, these tools are not as useful.
To understand why, imagine you want to book a hotel room in New York City. You can call up any hotel and find the price of a room. Or you can go on the Internet and check prices either at the hotel’s website or at any number of other sites that provide booking services. You can find information about the hotel online, read reviews from previous guests, and talk to hotel staff members on the telephone if you need more information. If you are in the city, you can also walk into a hotel and find out the price and the hotel’s amenities.
Now compare this to a hospital. It is much harder to get information about prices, and you cannot simply walk in off the street and purchase an operation. You can in fact find out prices for hospital procedures if you look hard enough. For example, there is a website that allows you to find charges for different procedures in Wisconsin ( http://www.wipricepoint.org). Here you can “shop” for, say, different types of knee surgery. But these charges do not necessarily reveal the true price to you as a consumer because they may not include all the costs of doctors and other inputs. If you have insurance coverage, meanwhile, you need to find out what portion of any bill will be covered by your insurance. Figuring out the price of a procedure is quite complicated.
How, then, are prices determined? And, importantly, what price are we talking about: the price you pay or the money received by the hospital? Many of the most important prices are determined by the interaction of a few big players, including the government, insurance companies, and pharmaceutical companies. Figure 16.2.2 "Payments to Hospitals and Doctors" gives a sense of the sources of income for hospitals and doctors. Hospitals and doctors get paid by insurance companies, households, and the government.
• Medicare ( http://www.medicare.gov/default.aspx) is a federal program intended to provide health services to elderly (over 65) and disabled people. It covers nearly 40 million people. Under this program, the government sets fees for services provided by physicians. A listing of those fees is available through the Health and Human Services website.See Centers for Medicare and Medicaid Services, “Overview,” accessed March 14, 2011, www.cms.gov/apps/physician-fee-schedule/overview.aspx. A search engine at that site allows you to look for specific fees. These are the fees the government will pay physicians and hospitals for these services.
• Medicaid ( www.cms.gov/MedicaidGenInfo) is run by the US government in conjunction with state governments.The states design the programs subject to approval by the federal government. Thus there are differences across states. The federal government reimburses states according to a rule that depends on the average income per person in that state. This program provides health care to low-income households through payments made directly to a health-care service provider, such as a hospital.
Because of these programs, the government is a big player in the health-care market. Government decisions determine the demand for health-care services. Governments do not take prices as given. In some cases, the government sets rates for certain procedures, and health-care providers respond. In other cases, the government is involved in negotiations—with pharmaceutical companies, for example.
Insurance companies provide additional sources of revenues to the hospital and a doctor. If you are a policyholder and are admitted to a hospital, your insurance company will reimburse the hospital for part of the cost of your care. It also reimburses your doctor directly. How much of that cost is reimbursed depends on your insurance policy. If you enter a hospital, say, for an operation, the amount of money the insurance company will pay the hospital is set by an existing agreement. As a result, hospital administrators face a complex set of repayment schedules. Reimbursement rates for a given service depend on who is buying the service, as the following quotation illustrates: “Medicaid pays 80 percent of what Medicare pays and about 50 percent of what a commercial insurance carrier like Blue Cross/Blue Shield pays. For example, if Medicaid reimbursed \$500 for a gall bladder removal, Medicare would pay \$625 and the commercial carrier \$1,000 for the same procedure.”This quote comes from a hospital in Topeka, Kansas. See Jan Biles, “Medicare: Care versus Cost, cjonline.com, October 23, 2007, accessed February 1, 2011, www.cjonline.com/stories/102307/sta_211162036.shtml. Because of these differences in reimbursement rates, doctors and hospitals may sometimes decide not to provide services to certain patients. The same article notes that doctors sometimes turn down Medicaid patients because of these low rates.
And what will you pay if you walk into a hospital without health insurance? An April 28, 2008, article in the Wall Street Journal describes the plight of a cancer patient without adequate insurance. The patient was looking for treatment at a not-for-profit hospital in Texas. Her treatment required a payment of \$105,000 in advance. This practice of requiring prepayment is part of a trend in the industry.
Hospitals are adopting a policy to improve their finances: making medical care contingent on upfront payments. Typically, hospitals have billed people after they receive care. But now, pointing to their burgeoning bad-debt and charity-care costs, hospitals are asking patients for money before they get treated.
Hospitals say they have turned to the practice because of a spike in patients who don’t pay their bills. Uncompensated care cost the hospital industry \$31.2 billion in 2006, up 44 percent from \$21.6 billion in 2000, according to the American Hospital Association.Barbara Martinez, “Cash before Chemo: Hospitals Get Tough. Wall Street Journal, April 28, 2008, A1.
Key Takeaways
• Due to informational problems for households, market power by suppliers, and government intervention, the market for health care cannot be analyzed by using standard supply-and-demand curves.
• Spending on health care today has an effect on your health status in the future. In that sense, this spending is an investment.
• The demand for health services, like other goods, depends on your income and the price of the services. Unlike your demand for many other goods, your demand for health services is influenced by the costs of health insurance. Also, unlike the case for many other goods, consumers who demand health services are relatively uninformed about the service they are buying.
• The production function for health takes inputs, such as doctors, nurses, and machines, and produces health-care services.
Exercises
1. List three reasons why the conventional supply-and-demand model may not fit the market for health services well.
2. How is the demand for health services influenced by age?
3. Give an example of two intermediate inputs into the provision of health-care services. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/16%3A_A_Healthy_Economy/16.02%3A_Supply_and_Demand_in_Health-Care_Markets.txt |
Learning Objectives
1. What are the incentive issues associated with the demand for health insurance?
2. Why is health insurance linked to employment in the United States?
3. How does the law of demand apply to the demand for health services when there is health insurance?
Insurance is something that human beings have developed to help us deal with the risks we face in life. Here are some examples of risks that you might confront.
• Your car or other property will be stolen.
• You will lose some of your possessions due to a fire, flood, storm, or other natural disaster.
• Your car will be damaged in an accident.
• You will lose your job.
• You will be injured in an accident—for example, while working, driving, or playing sports.
• You will become ill.
You can easily add to this list. We always have to worry about bad things happening. One consolation is that, for all the risks listed, you can obtain insurance. This means that we pay a fee (the premium) to an insurer; in return, we receive payment from the insurer if the bad thing happens.
Insurance is based on the idea of the diversification of risk. Chapter 5 "Life Decisions" goes into much more detail about insurance and diversification. As an illustration, suppose you face a 1 in 5,000 chance of breaking your leg in a given year. If this happens, it will be very costly to you: between hospital bills and lost earnings, perhaps you would lose \$10,000. If you are like most people, you are risk-averse, meaning that you don’t like facing this risk. Suppose, however, you can get together in a group of 5,000 people and agree that if any one of you breaks a leg, you will all share in the bill. The most likely outcome is that only one person will suffer a broken leg, and your share of the costs will be \$2. There is still a bit of uncertainty: maybe no one will break a leg; maybe two, three, or four people will. But the likelihood that you will have to pay out more than a few dollars is very small.
Insurance companies are firms that carry out such diversification of risk by bringing together large groups of people. Insurance companies set a premium equal to the expected value of the loss (in the example, × \$10,000 = \$2), plus a fee to ensure the insurance company also profits from the deal.
Toolkit: Section 31.7 "Expected Value"
You can review the calculation of expected value in the toolkit.
Insurance, like other services, is traded in a market. You can choose to buy from a variety of sellers at a price that reflects the risk of the type of insurance you purchase. The gains from trade come from the fact that an insurance company is capable of pooling risk. The insurance company assumes your risk at a price you are willing to pay. Because people differ in terms of their attitudes toward risk, some people buy insurance against certain events, while others do not. If you are very cautious (more precisely, very risk-averse), then you are more likely to buy insurance.
What Makes Health Insurance Different?
Health insurance has the same basic structure as any other insurance: you pay a premium to an insurance company that then pays your medical bills if the need arises. Like other types of insurance, there are gains from the sharing of risk. However, health insurance differs from other kinds of insurance in a couple of ways:Melissa Thomasson, “The Importance of Group Coverage: How Tax Policy Shaped U.S. Health Insurance,” American Economic Review 93, no. 4 (2003): 1373–1384. See also the related discussion of the history of health insurance: Melissa Thomasson, “Health Insurance in the United States,” EH.net, February 1, 2010, accessed February 1, 2011, eh.net/encyclopedia/article/thomasson.insurance.health.us. (1) health insurance is largely provided by employers, and (2) informational problems are particularly acute.
Who Pays for Health Insurance?
In most European countries, health insurance is largely provided by the government. In some cases, the government is also a provider of health services. In the United States, the government provides some health insurance—to the very poor, the old, and military veterans. But for the most part, the provision of health insurance in the United States is very different. Table 16.3.1 "Sources of Health Insurance in the United States" shows the types of health insurance that households can obtain in the United States. The “Total” column indicates the fraction of households with insurance. Since 1999, this has averaged about 85 percent but has been falling somewhat. On the bright side, this tells us that most people are covered by insurance. It also tells us that about 50 million people in the United States have no health insurance. The table reveals in addition that by far the most important source of health insurance is through employers: about 60 percent of all individuals have insurance provided through a firm. The other forms of insurance are through the government (about 30 percent) and direct purchase (about 9 percent). These numbers add to more than 85 percent because many individuals have insurance from more than one source.
Year Total (%) Government (%) Employment (%) Direct (%)
2009 83.3 30.6 55.8 8.9
2007 84.7 27.8 59.3 8.9
2005 84.7 27.3 60.2 9.2
2003 84.9 26.6 61.0 9.3
2001 85.9 25.3 63.2 9.3
1999 86.0 24.5 63.9 10.0
Table \(1\): Sources of Health Insurance in the United States
Source: US Census Bureau, “Health Insurance Historical Tables,” accessed March 14, 2011, www.census.gov/hhes/www/hlthins/data/historical/files/hihistt1.xls.
It might seem odd that your health insurance is likely to be linked to your job. After all, your employer doesn’t pay for your car insurance or for insuring your bank deposits. Historically, this phenomenon has its roots in the Stabilization Act of 1942, which was signed into law by President Franklin Roosevelt. The idea of the legislation was to stabilize wages and prices during World War II. Although President Harry Truman repealed most of the provisions of the act in 1946, some of the effects of that act remain today.The end of the act by President Harry Truman is documented at the American Presidency Project, “Executive Order 9801: Removing Wage and Salary Controls Adopted Pursuant to the Stabilization Act of 1942,” accessed March 14, 2011, http://www.presidency.ucsb.edu/ws/index.php?pid=60709.
A key provision of the act established wage and price controls. This meant that wages were no longer determined by market forces but were instead set (in part) by the government. But when the government places restrictions on the way people trade, they will often try to find ways around those restrictions.This idea is at the heart of Chapter 12 "Barriers to Trade and the Underground Economy". The loophole in the Stabilization Act was that it exempted pensions and insurance from the calculation of wages. This meant that firms could vary the overall compensation they offered workers through the provision of pensions and health insurance. Even though wage and price controls are no longer in place, the practice of offering health insurance as part of a compensation package persisted.
An employment-based health insurance system was furthered by tax actions, such as the 1954 Internal Revenue Code, which made employer contributions to employee health insurance nontaxable. Individuals were also allowed to deduct medical expenses from taxable income. So if you are paid \$1,000 in extra income by your firm and you use these funds to buy health insurance, you are taxed on the \$1,000 of income. But if the firm buys the insurance for you, then you do not pay tax on the \$1,000 worth of benefits.
Being employed also changes the price you pay for insurance. If you contact an insurance company directly, the rates you will be quoted for health insurance are much higher than the rate (for you and your employer combined) if you buy a health policy through your job. One explanation for this is that it is cheaper to write an insurance policy for many people together than individually. A second explanation, which we explain in more detail later, is that, on average, employed people are likely to be a lower risk than those not working. A third factor is that a group of employees is already partly diversified, so the group is less risky than a single individual.
We saw in Table 16.2.1 "Sources of Health Insurance in the United States" that about 15 percent of individuals in the United States do not possess health insurance. But who are these individuals, and why are they uninsured? The “who” is easier to answer than the “why” because we have statistics on the uninsured. Table 16.2.2 "The Uninsured (in Millions)" reveals the following:This table comes from US Census Bureau, Income, Poverty and Health Insurance Coverage in the United States: 2009, table 8, page 23, accessed March 14, 2011, http://www.census.gov/prod/2010pubs/p60-238.pdf.
• Many of the uninsured are poor. Of the nearly 45 million uninsured in 2005, about 14.5 million had incomes less than \$25,000. (As a benchmark, according to the US Census Bureau, the 2006 poverty level for a family of four was \$19,350.) Only about 17.6 percent of the uninsured had incomes in excess of \$75,000. In 2009, of the 50.7 million uninsured, about 15.5 million had income less than \$25,000.
• Many of the uninsured are young. In 2005, there were 8.0 million uninsured people under the age of 18. This number was 7.5 million in 2009.
• Many of the uninsured are young and poor. About 2.5 million of the 8.5 million have family incomes below the poverty line. According to the US Census Bureau, 65.5 percent of the children in poverty were covered by the government Medicaid program.Medicaid ( www.cms.hhs.gov/MedicaidGenInfo) is a joint federal-state program providing funding for health care to qualifying low-income households (defined relative to the poverty level).
• Many of the uninsured are working. There were over 20 million individuals in 2005 who were working full time and yet did not have health insurance. In 2009, the number of full-time workers without health insurance was lower—14.6 million—while the number of part-time workers without health insurance was higher. We do not know from these data whether they were offered health insurance at work and declined or had jobs that did not offer this benefit.
2005 2009
Number of uninsured 44.8 50.7
Age
Under 18 8.0 7.5
18–24 8.2 8.9
Household income
Under \$25,000 14.4 15.5
\$75,000 or more 7.9 10.6
Work status
Full time 20.8 14.6
Part time 5.5 14.7
Table \(2\): The Uninsured (in Millions)
Source: US Census Bureau, Income, Poverty and Health Insurance Coverage in the United States: 2009, table 8, page 23, accessed March 14, 2011, http://www.census.gov/prod/2010pubs/p60-238.pdf.
Adverse Selection
One complication of health insurance markets is that those who demand insurance are the ones who are more likely to need insurance. This in itself might not be a problem, except that individuals also know more about their own health than do the companies that are insuring them.
Suppose that half the population carries a gene that gives them a 1 percent risk each year of contracting a particular kind of cancer. The other half does not carry this gene and has only a 0.1 percent risk of this cancer. If an individual becomes sick, suppose that the cost of treatment plus lost work time is \$100,000. Table 16.3.3 "Probabilities and Expected Losses" summarizes the situation. Group A has a 0.1 percent chance of contracting the cancer, so the expected loss for them is \$100 (= 0.001 × \$100,000). Group B has a 1 percent chance of contracting the cancer, so their expected loss is \$1,000 (= 0.01 × \$100,000).
Group Probability of Cancer (%) Expected Loss (\$)
A 0.1 100
B 1 1,000
Table \(3\): Probabilities and Expected Losses
Now let us think about an insurance company that wants to make money by selling insurance policies against this loss. Suppose these policies completely cover all losses in the event that the individual contracts the disease. If the insurance company were to set the price of a policy very high (say, \$5,000), then only very risk-averse people would buy the policy. If it were to set the price very low—say, \$50—then everyone in the population would want this policy, but the insurance company would make a loss on every individual.
However, suppose that the insurance company were to offer a policy for \$550. It might reason as follows: if everyone buys this policy, then we will lose \$450 on average from the group B individuals, but we will gain \$450 on average from the group A individuals. Because there are equal numbers of both groups in the population, we should expect to make no profits on average. For example, if there are 2,000 typical individuals (1,000 of each type), then on average one group A person will become sick (because their chance is 1 in 1,000) and 10 group B individuals will become sick. In total (reasons the firm), we expect to have to pay out for 11 people, implying payments of \$1.1 million (= 11 × \$100,000). We will get revenues of \$1.1 million (= 2,000 × \$550). At this price, our expected revenues and costs are the same. If we were to charge a slightly higher premium, then we could make profits from this contract.
As long as the individuals in the population do not know their own type, this works fine. Risk-averse individuals would find it worthwhile to buy this contract. The problem comes if individuals can make a good guess as to which group they are in—perhaps because they know the history of this cancer in their own families. Then the insurance company might be in for a shock. Group B people would definitely want to buy the contract. The premium is less than their expected loss. But group A people might reason that they are very unlikely to get this disease and might decide that an insurance policy that costs \$550 is much too expensive, given that their expected loss is only \$100. This means that group A people—unless they are very risk-averse—choose not to buy the contract. Now the insurance company will only sell 1,000 contracts, bringing in revenue of \$550,000, but it will have to pay out \$1 million (= 10 × \$100,000).
If the insurance company could distinguish members of group A from members of group B, then it could offer insurance at different rates to the two groups. It could offer insurance to group A at a premium of \$100. They would find it worthwhile to buy this insurance. Likewise, the insurance company could offer insurance to members of group B with a premium of \$1,000, and they would also find it worthwhile to buy insurance. In practice, insurance companies often cannot classify people into such precise risk groups nor offer such targeted policies. In this case, the only kind of contract that is profitable for the insurance company is one that is aimed at the group B people only, with a premium of \$1,000. Group A people are left with a choice of buying no insurance at all or buying a policy that is vastly overpriced given their actual risk of contracting the disease.
This is an example of what economists call adverse selection: a situation in which individuals of different risk types decide whether or not to buy insurance (this is the selection). Lower-risk individuals opt out of the insurance market, leaving only high-risk individuals in the market (this is the sense in which the selection is adverse). Adverse selection is an information problem that is a source of market failure: low-risk individuals also want insurance, but it is unavailable to them at a reasonable price.
How do insurance companies deal with their informational disadvantage? One thing they can do is look for other sources of information. For example, firms presumably want to hire healthy, responsible individuals and put some time and effort into making good hires. Insurance companies can use the fact that you work for a firm as a (highly imperfect) signal of your health risk. This is one of the reasons why it is usually cheaper to get insurance through your firm than directly from an insurance company.
A second form of information about you comes from your history. If you have a car accident, your car insurance premium will increase. After an accident, your car insurance company revises its view of your riskiness and resets the price of your insurance. The analogous situation in health care is called preexisting conditions, meaning some disease or disability you already possess when you apply for insurance. For example, someone who has previously suffered a heart attack will find that insurance coverage is more expensive because the insurance company knows that this person is at greater risk of another attack.
If you apply for insurance and have a preexisting condition, then the terms of the insurance will reflect the chance that the condition will recur. This is reasonable enough: insurance is meant to provide protection against things that might happen to you in the future, not those that happened in the past. But it raises a problem with employer-provided health insurance. Suppose an individual has health-care coverage on the job and then suffers a heart attack. His current policy covers him because the heart attack was not a preexisting condition when he obtained insurance. But if he wishes to change jobs, his heart attack becomes a preexisting condition for his new insurer. This can make it very costly to change jobs—in turn making the economy function less efficiently.
Moral Hazard
Another complicating element for insurance is the moral hazard: the idea that, after purchasing insurance, individuals may behave in riskier ways. For example, think about your likelihood of being in a car accident. The probability that you will have an accident depends on many things: road conditions, the actions of other drivers, luck, and many others. It also depends on the actions you take as a driver of the car. There are many things we do that influence our likelihood of having an accident, including (but not limited to) the following:
• Properly maintaining the car
• Paying attention when driving
• Driving when tired
• Driving after consuming alcohol
These items are influenced by decisions that we make. The link back to insurance is that, if we are insured, we may make different choices about the condition of our car, the way we drive, and our physical state when we drive. The analogous idea with health insurance is that we may choose to live a less healthy lifestyle or engage in riskier behavior if we know that we have health insurance to cover our expenses if we become sick or injured.
Insurance companies understand very well that their policies influence the choices that people make. Their response is to design insurance contracts that provide insurance without affecting individuals’ incentives too much. In the case of automobile insurance, you will not receive full coverage for your loss in case of an accident. Instead, insurance contracts typically include the following: (1) a deductible, which is the amount of a loss you have to cover before any insurance payment occurs, and (2) a copayment, which is the share of the loss for which you are responsible. The same applies to medical insurance. In the event you are ill, health insurance will typically cover a wide variety of medical costs, but there will usually be a deductible and often a copayment as well. As with property or automobile insurance, the deductible provides an incentive for you to take actions that make you less likely to claim against the policy.
There are two main moral hazard issues with health care. First, health care is an individual investment. Although no one wants to get sick, the more you pay for your own treatment, the more likely you will invest in your own health. Choices pertaining to exercise, diet, and preventive care can all depend on the insurance payments we anticipate if we need health care. The more insurance we have, the less incentive we have to take care of ourselves. And the less we take care, the more likely we are to present the insurance company with a sizable health bill.
Second, the size of the health bill also depends on your choices about treatment. When you are ill, you will meet with your doctor to jointly decide on treatments. Although your doctor will probably talk to you about various treatment options, their price will not be the focus of the discussion. Eventually you will meet with someone else in the office to discuss how your treatment will be paid for and, in particular, how much will be covered by your insurance. In the end, you have a menu of treatments and a menu of prices that you have to pay. You will then make a choice from this menu that is in your best interest.
The insurance company pays some of your bill, so the amount you pay is lower than the actual price of treatment. By the law of demand, you purchase more than you would if you had to pay the full price. For example, you might be much more inclined to get second and third opinions if you don’t have to pay the full price for these.
Even if you are not ill but are instead going to see your doctor for a checkup, incentives still come into play. Many insurance policies include funding for an annual checkup with a small copayment. We respond to those incentives by going for the annual checkups covered under the policy. We don’t go for checkups every month because such visits are not covered by most policies. The insurance company deliberately designs the incentives so you are likely to find it worthwhile to engage in basic preventive care.
Health Insurance and the Law of Demand
Now that we have a better understanding of health insurance contracts, we can say more about the demand for health care. We start with the cost of health care to us as households. We have just seen that if you have health insurance, the cost to you of a trip to the doctor is determined by your health insurance contract. Many of these contracts have a copayment provision—for example, you must pay \$20 for an office visit. Of course, the doctor charges the insurance company much more for the visit, but you don’t pay that cost. To you, a trip to the doctor costs \$20.
The economic approach to individual choice still applies. Your demand for visits to the doctor comes from comparing the marginal valuation of these visits against this cost of \$20. The law of demand works in the usual way: if your insurance company increased its copayment to, say, \$50, you would make fewer visits to the doctor. The extent to which the quantity demanded responds to the price depends, of course, on what exactly is wrong with you. If you are seriously ill, your demand is likely to be inelastic. If you have only a sore throat, you might wait a few days to see if you really think you need medical care.
There is another element of the health insurance contract that has a direct effect on your demand. Consider a dental contract. These contracts often provide insurance up to an annual limit. If you need dental work, your dentist may design a treatment plan spread out over several years so that you can obtain maximum insurance coverage for the plan of work. In this case, you and your dentist are responding to the incentives of the dental contract.
Key Takeaways
• Incentive problems of adverse selection (the health insurance provider not knowing your risk class) and moral hazard (actions you take to influence your probability of needing health care) are pervasive in the provision of health insurance. These incentive problems are present when the insurance is provided by private companies and the government.
• Health insurance in the United States is linked to your job as a consequence of legislation in 1942 that exempted the provision of insurance from controls on wages.
• When you have health insurance, your demand for health services will reflect the marginal cost to you of the service. This is usually through the copayment.
Exercises
1. Suppose the provision of health insurance at your firm induces you to stop exercising. Is this an example of a moral hazard or adverse selection?
2. If the copayment increases on your dental insurance, what will this do to the frequency of your visits to the dentist and the time you devote to taking care of your teeth?
3. What is the difference between a copayment and a deductible? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/16%3A_A_Healthy_Economy/16.03%3A_Health_Insurance.txt |
Learning Objectives
1. What is the basis for government intervention in the market for health-care services?
2. What forms does this intervention take?
In the United States and around the world, governments are involved in the provision of health care. Some form of national health insurance is commonplace in Europe and Canada. In the United States, bills promoting national health care and universal health insurance have been debated for many years.
Here is a quote from President Dwight Eisenhower’s 1954 State of Union Address: “I am flatly opposed to the socialization of medicine. The great need for hospital and medical services can best be met by the initiative of private plans. But it is unfortunately a fact that medical costs are rising and already impose severe hardships on many families. The Federal Government can do many helpful things and still carefully avoid the socialization of medicine.”AMDOCS: Documents for the Study of American History, “Dwight Eisenhower, ‘State of the Union, 1954,’" accessed March 14, 2011, http://www.vlib.us/amdocs/texts/dde1954.htm.
As we noted earlier, the federal tax code was modified in 1954 to provide incentives for employer-provided health insurance. We structure our discussion of government health policy by answering two questions: (1) why do governments intervene? and (2) how do they intervene?
Why Do Governments Intervene?
As usual, we analyze government involvement in the economy through the lens of market failure. When it comes to health care, there are several market failures to consider.
Externalities. One argument for public involvement in health care is the presence of externalities. If one individual is sick, then the likelihood that others around that person get sick increases. Individuals typically make decisions about their health care without thinking much about the effects of their decisions on the welfare of others. You may decide to go to work even though you are suffering from the flu because you need the money, and you may not think very much about your likelihood of infecting others. This is a classic example of an externality.
Commitment. Hospitals are often unwilling or unable to turn away individuals needing care but lack the resources to pay for that care. Through legislation passed in 1986, hospitals are required to treat patients in emergency situations, no matter what their insurance coverage.The regulation is called EMTALA ( http://www.emtala.com/history.htm). It literally applies only to those hospitals that accept Medicare, but this is almost universal. In many cases, this is an inefficient way to treat people. For example, one consequence is that the uninsured have an incentive to seek normal care in hospital emergency rooms, even though this is an expensive place to provide care.
If hospitals could commit not to serve people unless they had health insurance, then some of the uninsured might be induced to purchase health insurance, instead of relying on emergency wards. But hospitals are not able to make such a commitment; although this might be more efficient, it is also unacceptably callous and runs counter to the Hippocratic Oath.
Adverse selection and moral hazard. We explained earlier that when insurance companies are unable to observe the probability of illnesses, some individuals will obtain insurance while others do not. Although these choices may be optimal from the standpoint of an individual, the market outcome is not efficient.
Drug quality. The health-care market is filled with gaps in information. Patients and even their doctors cannot fully assess the safety and efficacy of pharmaceutical products. Although the drug companies test their own products, the government has a role in assessing this information and determining the safety and effectiveness of medications.
Doctor quality. Another informational problem in the health-care market is the inability of a patient to properly evaluate the quality of a doctor. You as a patient can look at some indications of your doctor’s ability, such as years of practice, school of graduation, and number of people in the waiting room. But it is not possible to make a fully informed judgment about the quality of your doctor. Again, the government plays a role by requiring that doctors obtain specialized training and pass a licensing examination before they are allowed to practice.
Patents. The research and development needed to create a new drug is substantial.We also discuss this in Chapter 15 "Busting Up Monopolies". For firms to earn a return on this investment, the patent system exists to provide them protection from other firms producing the same product and selling it at a lower price. Although this type of competition may be valued given that a product exists, it destroys the initial incentives that a firm has to undertake research and development. Governments provide patent protection to induce firms to undertake the necessary research and development.
Market power. Market outcomes are not efficient when there are relatively few sellers of a product. This may occur in various health-care markets because there may be relatively few doctors and few hospitals in a given location. Furthermore, pharmaceutical companies have market power based on exclusive knowledge of their specific product, as protected through patents. Finally, there are relatively few health insurance providers, and some are very large.
Equity and fairness. Even if health-care markets were efficient (and we have explained many ways in which they are not), they may not be equitable. One argument for government involvement is to provide for a more equitable allocation of goods and services. From this perspective, the fact that many Americans lack health insurance and adequate health care is also a basis for government involvement.
Article 25 of the Universal Declaration of Human Rights includes the right to health care: “Everyone has the right to a standard of living adequate for the health and well-being of himself and of his family, including food, clothing, housing and medical care and necessary social services, and the right to security in the event of unemployment, sickness, disability, widowhood, old age or other lack of livelihood in circumstances beyond his control” ( http://www.un.org/en/documents/udhr/index.shtml).United Nations, “Universal Declaration of Human Rights,” accessed March 14, 2011, http://www.un.org/en/documents/udhr/index.shtml. To the extent that basic health care is viewed as a basic human right, then the government ought to guarantee access to at least a minimal level of care.
Indeed, if the aim is to move toward equality of well-being, there is an even stronger equity argument for health care. Imagine for a moment that people could decide how to allocate health care and other resources before they knew anything about their own health or well-being. (Thought experiments of this kind are associated with the philosopher John Rawls. In Chapter 13 "Superstars", we discuss this kind of thought experiment in more detail.) People might well agree that those who became sick or disabled should be given extra resources to compensate them for their ill health.
How Do Governments Intervene?
Now that we have some understanding of the sources of market failure in the health-care market, we turn to a discussion of government policy.
Taxes and Subsidies
We have already mentioned one of the key ways in which the government subsidizes health care—by allowing employees tax-free health insurance benefits provided by an employer. In this way, the government reduces the cost of firm-provided health care. It is now common for employment contracts in the United States to include provision for health care.
One of the main issues surrounding employer-provided health insurance is the possibility of losing insurance when you change jobs (sometimes called the “portability problem”). In our economy, shifts in demand for goods and services and changes in productivity naturally lead to the creation of new jobs by some firms and the destruction of jobs by other (perhaps less profitable) firms. The efficient working of an economy therefore requires that workers leave old jobs for new ones. Unfortunately, insurance can get in the way of worker mobility. If you have a job with health insurance, then quitting your job to look for another may be costly for several reasons. First, you may lose insurance coverage during the period of job search. Second, an ailment that was covered by insurance by your existing firm could be viewed as a preexisting condition when you acquire insurance at a new firm. This can have an adverse effect on your insurance rates and the type of coverage you can obtain. In some cases, people choose not to change jobs purely because of the implications for health insurance.
Health care is also subsidized through income taxes. If you look carefully at your income tax forms, you will see that you can deduct medical expenses. If you itemize deductions on your tax form, and if your medical expenses are substantial enough, you can offset those payments against your taxes.
Regulation
Government regulations are common in the health industry. These regulations influence both demand and supply in this market.
On the demand side, households are required to obtain certain medical services. Some vaccinations are mandatory, for example. At the college level, there is ongoing concern about the spread of meningitis.See “Meningitis on Campus,” American College Health Association, April 27, 2005, accessed February 1, 2011, www.acha.org/projects_programs/meningitis/index.cfm. With concerns like this in mind, it is also common for colleges to require some vaccinations prior to admission. The argument for such interventions is that there are externalities from your health to the health of others.
The government licenses many of the actors on the supply side of the health-care market. This is another form of quality control. Doctors who practice in a state must pass exams called medical boards. Hospitals are certified for the types of activities they offer. Often the certification occurs at the state level.For details about accreditation in Texas, for example, see Texas Department of State Health Service, “General Hospitals—Health Facility Program,” accessed March 14, 2011, http://www.dshs.state.tx.us/HFP/hospital.shtm. Other providers of health care are also licensed. For example, a nursing home must be certified as a Medicare provider to receive reimbursements. The rationale for such interventions stems from the extensive information problems in the health-care market. As consumers are unable to accurately assess the quality of care provided by doctors and hospitals, the government provides a service to us all by regulating health-care providers.
Provision of Insurance
The government, through its Medicaid and Medicare programs, provides insurance to both low-income and elderly households. There is continuing debate about expanding the availability of health insurance to the general population. On March 23, 2010, President Obama signed a health-care reform bill.Ample discussion by the White House along with the final bill is available at “Health Reform Puts American Families and Small Business Owners in Control of Their Own Health Care,” The White House, accessed March 14, 2011, www.whitehouse.gov/health-care-meeting/proposal. The main goal of the bill is to reduce the number of individuals without health insurance in the United States. This bill seeks to achieve this by requiring that everyone purchase health insurance, either through an employer or individually. The legislation provides opportunities for households to obtain insurance on their own through subsidies and a “marketplace for insurance.”
The bill regulates insurance policies in several ways. For example, it places limits on the ability of insurance companies to exclude people from coverage due to preexisting health conditions or other health risks. It also restricts the ability of insurance companies to set and change rates on insurance policies.
The new policy will not be fully in force until 2014. It is extremely complex (the bill itself is almost 1,000 pages long), and its impact on health-care outcomes, health-care costs, and the deficit remains an open question. (Even the short summary of the actLibrary of Congress, “Bill Summary & Status: 111th Congress (2009–2010), H.R.3590, CRS Summary,” accessed March 14, 2011, thomas.loc.gov/cgi-bin/bdquery/z?d111:HR03590:@@@D&summ2=m&. does not make easy reading.) By the time of its implementation, details on the new law may be clearer. In particular, exactly how insurance markets will be organized and regulated will be made more precise. Further, when the bill was passed, estimates were made of the cost savings from the measure. Over time, we will be better able to forecast the spending and taxation implications of the bill once household and firm responses are observed. Then we can see if this legislation improves the efficiency of the health-care market.
A more fundamental question is whether the government should even be in the business of providing health insurance. One set of arguments for government involvement rests on the various market failures that we have identified in this chapter. Health care is complicated, and there are many ways in which health-care markets depart from the competitive ideal. It is sometimes argued that spending on health services in the United States is very high because the market is very inefficient. From that perspective, having the government in charge of this sector of the economy might reduce inefficiencies. Second, government involvement can be justified on the grounds of equity and fairness.
Provision of Information
One of the primary roles of the government is to provide information to the public about health matters. This comes in a variety of forms. In January 1966, the following warning first appeared on cigarette packs: “Warning: Cigarette Smoking May be Hazardous to Your Health.” This initial warning from the Surgeon General’s office of the United States was followed by many others concerning the consumption of cigarettes and other potentially harmful products. Such warnings are a good example of government provision of information. Each consumer of these products wants to know the impact on health. Gathering such information is a public good because the information is available to everyone and can be “consumed” by everyone simultaneously.
Another form of information is through drug testing. The US Food and Drug Administration (FDA; http://www.fda.gov) is responsible for testing drugs before they appear on the market. The FDA also supplies public information about a wide range of food items.
Key Takeaways
• Government intervention in this market reflects inefficiencies in the market as well as concerns over equity.
• Government intervention takes many forms around the world, including the provision of health insurance, the direct provision of health-care services, and the regulation of drug companies.
Exercises
1. What is the commitment problem of a hospital?
2. Recent concerns about the H1N1 virus led the governments in many countries to intervene. How would you explain the basis for this intervention using the list of market failures provided in this section?
3. Give a recent example where the government provided a health warning. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/16%3A_A_Healthy_Economy/16.04%3A_Government_Policy.txt |
In Conclusion
The debates that we have introduced in this chapter are far from settled. The issue of health-care policy is one that is not likely to be quickly resolved in the United States or elsewhere in the world. At the moment, we see many different ways in which health care is provided in different countries.
There is enormous pressure within the United States to deal with the perceived problem of uninsured households. As we have seen, this is a key element of the health-care bill that was signed into law in 2010. In addition, there are unsolved problems associated with Medicare and Medicaid. These government programs are in need of reform to deal with the escalating costs of medical care. According to the General Accounting Office, the current level of Medicare and Medicaid spending is about 4 percent of the gross domestic product (GDP). If there are no changes in current programs, this fraction is expected to increase to about 11 percent by 2050.This draws the discussion of the US budget through 2075: “A 125-Year Picture of the Federal Government’s Share of the Economy, 1950 to 2075,” Congressional Budget Office, July 3, 2002, accessed February 1, 2011, http://www.cbo.gov/ftpdoc.cfm?index=3521. Also see David M. Walker, “U.S. Financial Condition and Fiscal Future Briefing,” US Government Accountability Office, January 2, 2008, accessed February 1, 2011, http://www.gao.gov/cghome/d08395cg.pdf. To put this in perspective, government outlays as a fraction of GDP have typically been about 20 percent of GDP over the past 40 or so years. This number is forecast to increase to nearly 27 percent by 2050, with a significant fraction of this driven by Medicare and Medicaid programs.
There are two overarching lessons to be drawn from this chapter.
1. Incentives matter. Whatever programs are deemed to be desirable for dealing with health-care problems, we need to be sure to take into account the incentives that these policies will create.
2. People are different. Health-care providers, insurance companies, and the government cannot observe many of these differences. Policies must take into account all these differences and recognize the importance of adverse selection. To the extent that markets fail because of adverse selection, government policy must address this source of the underlying problem of health care.
The nature of adverse selection is heavily influenced by technology. Recently, the US Congress has been considering legislation, HR 493,Govtrack.us, “Text of H.R. 493 [110th]: Genetic Information Nondiscrimination Act of 2008,” accessed March 14, 2011, http://www.govtrack.us/congress/billtext.xpd?bill=h110-493&show-changes=0&page-command=print. which limits the ability of insurance companies to use genetic information. If insurance companies have more information about individual health risks, then they can design more targeted insurance contracts. From the perspective of efficiency, this might seem to be a good thing because it eliminates some adverse selection problems. Imagine that technology were to reach a point where all your major health risks could be identified from your genetic code at birth. Almost all the uncertainty over your health would disappear, and there would be almost no role for health insurance. (There could, of course, still be insurance for accident risk.) Although this world might be more efficient, it would also be much more unequal. People with genetic predispositions to certain illnesses would face steep medical bills, while healthy people would not.
In this world people would want insurance before they were born, while there was still uncertainty about their genetic makeup, which takes us back to the Rawlsian thought experiment that we discussed earlier. It might be that, paradoxically, one of the most compelling arguments for government-provided universal health care will turn out to be the gradual elimination of market failures from adverse selection.
Key Links
exercises
1. Is health insurance a complement or a substitute for the demand for health-care services?
2. If doctors no longer needed a license to practice so that there was free entry into the provision of that service, what would happen to the price and quantity of health-care services? What would happen to the quality?
3. Give an example of technological innovation in the health-care industry.
4. If adverse selection is a problem, does allowing an insurance company to know your entire health history improve market efficiency?
5. What type of inefficiencies does the commitment problem of a hospital create? Why don’t restaurants have this same problem?
6. One government intervention in health care is compulsory vaccinations for children against various infectious diseases. Can you explain why governments might enact such policies? (Hint: are there any externalities involved?)
7. In some countries and some regions, there are shortages of doctors. Why is this problem not quickly resolved by the normal workings of supply and demand in the labor market?
8. As the United States has become richer, an increasing proportion of GDP is spent on health care. Does this fact, in and of itself, indicate inefficiencies in health care? (Hint: to what extent are aspects of health care luxury goods?)
9. One complicated part of the demand for health care is that consumers are not quite sure of the quality of the product they are buying. Can you think of other goods or services that have this same property? Are there measures to protect consumers? Why don’t sellers sell only low-quality goods to consumers who are not able to judge quality?
10. In the health-care market, private and public hospitals coexist. Can you think of another market in which both public and private providers exist? What are the differences in that market among the public and private firms?
11. What are the incentives for parents to provide health care for their children?
12. The next time you visit a doctor, ask for a price list. Discuss what happens.
13. The government provides deposit insurance so that funds deposited at a bank are insured even if the bank goes out of business. What are the moral hazard implications of providing deposit insurance?
14. What does the link of health-care coverage to employment do to the incentives of someone to quit one job and look for another?
Economics Detective
1. Table 16.2.2 "The Uninsured (in Millions)" came from a 2006 and 2010 census. What is the current number of uninsured? What fraction is under 18 and in the 18–24 age group?
2. Find out about the health-care system in France, Sweden, or Canada. How does it compare with the US system? How do health outcomes in the country you have chosen compare with those in the United States?
3. The election results in November 2010 reflected, in part, concerns over the health-care bill signed into law in March 2010. What were the main concerns discussed in the election campaign with regard to the bill? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/16%3A_A_Healthy_Economy/16.05%3A_End-of-Chapter_Material.txt |
Cars are so common that we rarely give them a second thought. If you live in the United States, then you either already have a car or will most likely have one in a few years’ time; over 90 percent of households in the United States either own or lease a car. Although other countries do not have quite the same levels of car ownership as the United States, there are more than half a billion automobiles in the world.
The familiarity of the car is so great that it is easy to forget how the automobile transformed the world. The automobile made modern cities and suburbs possible because people were no longer obliged to live close to where they worked. The automobile made it easier to transport goods from place to place, dramatically altering patterns of trade in the global economy. At the same time, automobile emissions have degraded the air we breathe to the point where they sometimes seriously damage people’s health. Indeed, because emissions also contribute to the accumulation of greenhouse gases in the atmosphere, the automobile may be changing the very climate of the planet.
Although you may own a car, it is likely that you are unfamiliar with how it works. Half a century ago, car owners were typically very knowledgeable about how their vehicles operated. They needed to be because cars broke down frequently. People knew how to adjust spark plugs, clean distributor caps, and so on. But the modern automobile is a remarkably sophisticated and complex piece of engineering. Today, it is unlikely that an owner of a modern-day car knows how to do much more than very basic maintenance. Even car mechanics rely on computer diagnostics to perform repairs.
Just as the product itself has become increasingly complex, so too has its method of manufacture. In the early years of the 20th century, cars were produced in small numbers and largely by hand. In 1913, however, Henry Ford introduced mass production of cars at Ford’s Highland Park plant.The Library of Congress has an extensive discussion of Henry Ford, including photos of production in 1923 at http://memory.loc.gov/ammem/today/jul30.html. By the middle of the 20th century, cars were typically produced on assembly lines. In contrast to the early years of car production, there were far fewer workers at this stage of the production process.You can find more details at How Stuff Works, “1957–1959 Ford Fairlane 500 Skyliner,” accessed March 14, 2011, http://auto.howstuffworks.com/1957-1959-ford-fairlane-skyliner3.htm.
If you were to visit the production line at a modern automobile manufacturing plant, you would hardly see any people at all. Modern production uses a great deal of capital and relatively little labor. Computerized robots perform manufacturing roles. Yet despite the relative absence of workers on the production line, over one million workers are employed in this sector of the economy in the United States.Basic information about firms and workers in this sector comes from the Bureau of Labor Statistics, “Career Guide to Industries, 2010–11 Edition,” www.bls.gov/oco/cg/cgs012.htm. In 2006, about 360,000 jobs were associated with the production of automobile parts alone.This number is from a Bureau of Labor Statistics study of employment in the automobile parts industry: Benjamin Collins, Thomas McDonald, and Jay A. Mousa, “The Rise and Decline of Auto Parts Manufacturing in the Midwest,” Monthly Labor Review Online 130, no. 10 (2007): 14–20, accessed March 14, 2011, http://www.bls.gov/opub/mlr/2007/10/art2full.pdf. In the 21st century, though, there have been significant job losses in this part of the economy.
Road Map
This chapter is different from others in this book because it is a capstone discussion. We use the automobile industry to illustrate the different ideas we have explained in the book. We also use this industry to provide further examples of how to use the different tools we introduced in previous chapters. Whereas other chapters were largely self-contained, here we will repeatedly remind you of ideas that we have already studied.
We begin our look at cars in a familiar way, using the supply-and-demand framework. All of us who own cars reside on the demand side of the market. We make choices about the type of car we want, whether to buy a new car or a used one, and when to replace it. We also make decisions about related products like gasoline and insurance. The supply side of the car market illustrates technological progress, enormous growth in product diversity, the impact of trade on domestic markets, and the social costs of automobiles. We examine some decisions of automobile producers, including where to locate their operations, why they introduce new models, and what price they should set.
We then study the equilibrium of the car industry. The US car industry began around the start of the 20th century, survived the Great Depression of the early 1930s, and has been transformed by international competition. Understanding these dynamics provides a perspective on other industries. After understanding industry equilibrium, we look at the variety of government policies that impact this industry, including trade and environmental policies. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/17%3A_Cars/17.01%3A_Looking_into_Cars.txt |
Learning Objectives
1. What determines a household’s demand for a car?
2. In what sense is a car an asset?
3. What are some of the complementary goods and services for cars?
People don’t buy cars only because they want to look at a piece of fine engineering and enjoy a luxurious ride (although this sometimes plays a role). They buy cars because they want to be able to travel from one place to another. The demand for automobiles is a piece of a larger market: the demand for transportation in general. As the price of a particular car increases, the law of demand tells us that the quantity demanded of that car will decrease. There are three kinds of substitution at work here. In response to a price increase, households can
• delay the purchase of a new car,
• choose to purchase another type of car, or
• choose not to buy a car and use another mode of transportation instead.
Suppose you are thinking of buying a car, but the price of your favorite model increases. One possible response would be to delay your purchase until a later time. With this form of substitution, you decide not to buy a new car right now. This does not mean you will never buy a new car. Instead, you are keeping your options open for the future: you will drive your old car for perhaps another year and then search again next year for a replacement. Next year, of course, you might decide to defer your purchase still further. A second possible response to a price increase in your preferred model is to purchase another type of car. There is a substitution effect at work again, but now it applies across cars rather than over time. Perhaps you are indifferent between buying a Ferrari racing car and a Mini Cooper. If the price of the Mini Cooper increases, you would be induced to buy the Ferrari. Finally, if the price of your preferred car increases, you might substitute another form of transportation for your car, such as a bicycle or the bus. From this perspective, your demand for a car is really a demand for transportation.
Household Demand for Cars
The decision to buy a car is best understood as an example of unit demand. Most households—even if they own more than one car—do not buy a large number of cars at a time. Instead, they buy a single car. The decision about whether or not to purchase a car thus involves comparing the valuation a household places on the car with the price of the car. One way to illustrate this is to look at the household’s budget line when it does or does not purchase a car.
Toolkit: Section 31.1 "Individual Demand"
You can review unit demand, valuation, and budget lines in the toolkit.
The household’s choice is shown in Figure 17.2.1 "The Household’s Budget Line When It Does or Does Not Buy a Car". (This draws on our presentation of unit demand in Chapter 4 "Everyday Decisions".) The household can spend income on three items: chocolate bars, downloads, and a new car. If the household chooses not to buy a car, then it consumes the combination of downloads and chocolate bars indicated by point A in the graph. This is the household’s most preferred point in the budget line, given that it does not buy a car. If the household buys a car, then the combination of downloads and chocolate bars it consumes is given by point B. The budget line is shifted inward by the amount of income the household spends on the car—that is, by an amount equal to the cost of the car. The household’s decision about whether to purchase the car involves comparing bundle A to (bundle B plus a car).
Here we illustrate a household’s choice about whether or not to purchase a car.
Remembering the idea of buyer surplus, this is the same as saying that the household would buy the car if the purchase gave it some surplus. In other words, the household’s decision rule is
\[purchase\ car\ if\ valuation\ of\ car\ −\ price\ of\ car\ =\ buyer\ surplus\ >\ 0.\]
If the price of the car is greater than the household’s valuation, the household prefers point A to point B and does not buy the car. If the price of the car is less than the household’s valuation, it prefers point B to point A and buys the car.
Toolkit: Section 31.10 "Buyer Surplus and Seller Surplus"
Buyer surplus was introduced in Chapter 6 "eBay and craigslist". You can also review the various kinds of surplus in the toolkit.
There is another way of looking at the same decision that gives us a way to measure the household’s valuation of the car. Remember that the household’s valuation of the car is the maximum amount that it would be willing to pay for it. Look again at Figure 17.2.1 "The Household’s Budget Line When It Does or Does Not Buy a Car" and begin at point A. Now move the budget line inward until we find that the household is just as happy at point A or point B. We have now found the point where the household is indifferent between the combination of chocolate bars and downloads it buys without a car and the bundle it buys along with the car. The amount by which we have moved the budget line is the household’s valuation of the car.
If there were only a single model of car for the household to choose from, we could stop here. The household would compare the valuation of the car against the price and buy the car as long as the valuation is greater than the price. Today, however, cars differ in numerous ways. Like many goods, a car consists of many different features all bundled together. These include the car’s performance features, styling, color, and sound system; whether it has leather seats, a sunroof, and air conditioning; and hundreds of other attributes that we could list. The household’s valuation of a car embodies a valuation of each attribute of a car.
This complexity makes the decision to buy a car a challenge. How can this decision be made? For every car available on the market, the household can calculate the buyer surplus attainable from that car. After considering all these alternatives, the household should then buy the car that gives the most surplus. Of course, households do not literally sit down with a list of cars and try to calculate the exact surplus from each one. But this is a useful, if stylized, representation of how such choices are made. In effect, the household is making a unit demand decision—buy or not buy—about every single car. For almost all cars, the household chooses to purchase zero.
(There is a subtlety you may be wondering about here. Hundreds of different cars might yield positive surplus, but obviously the household does not buy hundreds of cars. The trick is that, once the household has bought the car that gives the highest surplus, the valuation of all other cars it might consider buying decreases substantially. If you don’t own a car, then a Ford Focus might be very valuable to you. If you already own a Mazda 5, then the value of a Ford Focus would be much smaller.)
Deciding what car to buy is only one part of the household’s decision. As we already noted, the household must decide when it wants to buy a car. A car is a durable good; it lasts for several years. If a household already has a car, it can decide to defer purchase of a new car until later. A household is likely to do this if (1) there is substantial uncertainty about future income (perhaps members of the household fear losing their jobs) or (2) cars are likely to be relatively cheaper in the future. To understand this choice, we turn to some of the tools introduced in Chapter 5 "Life Decisions", and Chapter 10 "Making and Losing Money on Wall Street".
A car is an asset: it yields a flow of services. As a consequence, buying a car is both an act of consumption and an act of saving. This means that the decision to buy a car is an example of decision making over time. The household looks at both current and expected future income when deciding about the purchase, and it knows that the car will yield benefits for many years. Furthermore, because a car is an asset, its valuation today depends on its value in the future. You might buy a car this year and then discover your transportation needs have changed. In that event, you can sell your car in the used car market. The more you expect to get for your car whenever you might sell it, the more you are willing to pay for it today.
The demand for a particular car also depends on factors other than the price of the car itself. The prices of other goods—most importantly, other cars and other forms of transportation—also matter. Household income, both now and in future years, is another determinant of demand. Finally, because you often purchase a car with a car loan, the interest rates charged on loans may matter for your car purchase. A decrease in the interest rate for car loans will increase the demand for cars.
In sum, buying a car is a very complex decision. There are rich substitution possibilities involving the choice of different models, the timing of the purchase, and the possibility of using public transportation rather than owning a car at all. The law of demand applies to cars, just as it does to other goods and services. But as we move along the demand curve in response to a change in the price of cars, the substitution possibilities are complex. Understanding these substitution possibilities is critical when firms are choosing the prices to set for the cars that they produce.
Complementary Products
There are several products that are complementary to the purchase of a car. Here we look at three: gasoline, insurance, and infrastructure. A complementary product is one for which the cross-price elasticity of demand is negative. In other words, we expect that if the price of gasoline increases, the quantity of cars purchased will decrease.
Toolkit: Section 31.2 "Elasticity"
The cross-price elasticity of demand measures the response of the quantity demanded of a good to a change in the price of another good. Formally, it is the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good:
• If the cross-price elasticity of demand is a negative number, then the quantity demanded of one good decreases when the price of the other good increases. In this case, we say that the two goods are complements.
• If the cross-price elasticity of demand is a positive number, then the quantity demanded of one good increases when the price of the other good increases. In this case, we say that the two goods are substitutes.
Gasoline
During late spring of 2008, the price of oil and gasoline rose considerably. By the end of May, the price of unleaded gas averaged over \$4.00 per gallon in major US cities. Figure 17.2.2 "Gasoline Prices: Pennies per Gallon" shows the price of regular gasoline in the United States. The first series is just the price of a gallon of gas in pennies. The second shows prices after correcting for inflation; all prices are quoted relative to the price level in the base year of 1990. You can see from this figure that the dollar price of gas has increased steadily since August 1990, but once we correct for changes in the overall price level, the real price of gas was actually decreasing until around 1998. Since then, it has increased to about twice its 1990 level.
Toolkit: Section 31.8 "Correcting for Inflation"
You can review how to correct for inflation in the toolkit.
Figure \(2\): Gasoline Prices: Pennies per Gallon
What is the impact of an increase in the price of gasoline on the demand for cars?
• As the price of gas increases, buying and operating a car becomes more expensive. Thus we expect the demand for cars to decrease.
• An increase in the price of gasoline induces a move away from cars with low mileage per gallon to cars with higher mileage per gallon. This type of substitution is often seen after rapid increases in the price of gasoline.
• As the price of gasoline increases, individuals substitute competing means of transportation for cars. For example, an increase in the price of gasoline might induce commuters to use bicycles, take buses or trains, or walk to work.
All of these channels were in the news in 2008 as consumers responded to higher gasoline prices by driving less and buying more fuel-efficient vehicles.
If we think of cars in general, then the cross-price elasticity of demand with the price of gasoline is negative. But the second channel reminds us that, for fuel-efficient models, the cross-price elasticity of demand might be positive. Higher gas prices mean that fewer cars will be purchased, but households that do purchase favor cars that are more fuel-efficient. Remembering that cars typically last for several years, households think about not only the current price of gas but also what they expect gas prices to do in the next few years. If gas prices increase but consumers think that this increase is likely to be temporary, then people will drive less, but the demand for cars will be little affected. Conversely, if gas prices increase and consumers expect them to stay high for some years, we see a much bigger effect on the demand for automobiles.
The gas price increase in 2008 coincided with an intense battle between Senator Hilary Clinton and Senator Barack Obama for the Democratic presidential nomination. By this time, Senator John McCain had effectively won the Republican nomination. Senator Clinton and Senator McCain proposed a temporary reduction in the tax on gasoline in an effort to shield households from the high price of gasoline during the summer season. To see the effects of such a tax, we can use the tool of tax incidence, which we introduced in Chapter 12 "Barriers to Trade and the Underground Economy".
Toolkit: Section 31.11 "Efficiency and Deadweight Loss"
You can review tax incidence in the toolkit.
Figure 17.2.3 "The Incidence of a Tax on Gasoline" shows the effect of a tax on the price paid by a buyer and the price received by a seller. In part (a) of Figure 17.2.3 "The Incidence of a Tax on Gasoline", the demand for the product is very inelastic. As a consequence, when a tax is imposed, the price paid by the buyer increases a lot compared to the price in the absence of a tax. This means that when demand is inelastic, buyers bear the tax burden. Consequently, if a tax is removed, even temporarily, the price buyers pay will decrease considerably. As shown in part (b) of Figure 17.2.3 "The Incidence of a Tax on Gasoline", we reach the opposite conclusion if supply rather than demand is inelastic. When supply is inelastic, the price received by the seller varies with the tax, while the price paid by the buyer is almost independent of the tax.
When demand is inelastic (a), the price paid by buyers increases a lot, and the price received by sellers decreases only a little bit, so most of the tax burden is borne by buyers. The opposite is true when supply is inelastic (b).
Whether a temporary repeal of the gas tax would reduce the price of gas depends on the elasticities of supply and demand in this market. The more inelastic demand is relative to supply, the more the tax reduction will lower the price paid by households. In fact, the supply of gas tends to be very inelastic in the short run because refining capacity is limited. Part (a) of Figure 17.2.3 "The Incidence of a Tax on Gasoline" is the one relevant for a temporary change in the gas tax.
Insurance
A second complementary product is car insurance. In most countries, having car insurance is mandatory. Typically, drivers must at the very least purchase some liability coverage, meaning that your insurance company will pay out if you are responsible for an accident that injures or kills another person or causes damage to a car or property. You may also choose to buy collision coverage to cover damage to your own car. You can also purchase “uninsured motorist coverage,” which protects you in the event you are in an accident with someone who is uninsured. Exactly what type of coverage you are able (or required) to purchase varies from country to country and from state to state in the United States.
You may be aware that your insurance rates depend on your age, gender, and driving record. Insurance companies work very hard to determine the probability you will have an accident and make a claim for funds from them. But they do not know exactly what that probability is for each person individually. Thus they rely on information about us, such as our age and sex, and also look at driving records for indicators of the likelihood that we will file a claim. If you have an accident and file a claim, the insurance company will often revise its assessment of how safe a driver you are and increase your premium. Such adjustments can be so severe that sometimes people prefer to fix their own car after a minor incident than have the insurance company handle a claim. It is even possible to obtain insurance against the costs of obtaining a traffic ticket. Getting a ticket can be expensive, both directly in terms of a fine and then through an increased insurance premium. Recognizing the desire of a household to shed this risk, insurance policies that compensate ticketed drivers for these costs are available.One such program can be found at the TraffiCare International home page, accessed March 14, 2011, trafficare.net.
Government restrictions on trades often lead people to avoid these restrictions. This was one of our themes in Chapter 12 "Barriers to Trade and the Underground Economy". In many states, insurance is required by law, yet drivers sometimes flout this law, choosing to drive without insurance instead. The law of demand tells us that the higher the cost of insurance, the more likely people are to drive without insurance.
If high insurance rates lead to a large number of uninsured motorists, then it is more likely that, if you have an accident, the other driver will be uninsured. In this case, your insurance company will be obliged to cover your damages, even if the other driver was at fault. Think for a moment about what this means from the perspective of an individual insurance company. If there are more uninsured motorists, then the insurance company expects to make higher payouts per accident, on average. This means that when there are more uninsured motorists, insurance premiums will be higher.
Economists Eric Smith and Randy Wright noticed that insurance premiums are very different in different places. In a paper titled “Why Is Automobile Insurance in Philadelphia So Damn Expensive?” they speculated that this was because of a coordination game. They argued that the decision to purchase insurance could lead to payoffs like those in Table 17.2.1 "A Coordination Game for Automobile Insurance". The rows show your decision about whether to buy insurance or not. The columns show other people’s decisions. The numbers in the table refer to your payoff from every combination of what you choose to do and what everyone else chooses. (To keep things simple, we state what your payoffs are when everyone else does the same thing. We also suppose that everyone else faces the same payoffs you do.)
Toolkit: Section 31.18 "Nash Equilibrium"
You can review the coordination game in the toolkit.
Everyone Else Buys Insurance Everyone Else Does Not Buy Insurance
You Buy Insurance 10 2
You Do Not Buy Insurance 4 8
Table \(1\): A Coordination Game for Automobile Insurance
Look at the first column. This says that if everyone else purchases insurance, then you have an incentive to do so as well. We see this in the table because 10 is greater than 4. Because everyone else buys insurance, the price of insurance will be relatively low, and you will be induced to buy insurance as well. Thus one Nash equilibrium of this game is for everyone to buy insurance. Now look at the second column. Here, everyone else is an uninsured motorist. If no one else buys insurance, your insurance will be very costly. This will induce you not to buy insurance either (8 is greater than 2). Thus there is a second Nash equilibrium of this game in which no one buys insurance.
If, as Smith and Wright suggested, Philadelphia was an example of a city in which no one bought insurance, you can see from Table 17.2.1 "A Coordination Game for Automobile Insurance" that everyone there wished that other people bought insurance. Everybody is better off in the Nash equilibrium where everyone buys insurance. But starting from the equilibrium in which no one buys insurance, no single individual, acting alone, can coordinate everyone else’s choices to reach the preferred outcome.
Infrastructure
Gasoline and insurance are products that are complementary to automobiles. There is another significant complementary product—the roads on which you can drive your car. Without roads, cars have limited value. The same argument applies to bridges and highways and even to the police who enforce the laws of the road. These various kinds of infrastructure serve to increase the value of a car.
Figure \(4\): Idealized Effect of Good Roads on the American Rural Landscape
Source: Better Roads and Streets, Vol. 5, December 1915, p. 9.
This cartoon, which is taken from an article on the history of automobiles in the early 20th century, illustrates the link between car demand and roads.The cartoon comes from Peter Hugill, “Good Roads and the Automobile in the United States 1880–1929,” Geographical Review, July 1982, 327–49. The value of a car is much higher in the setting labeled “good roads” compared to that labeled “bad roads.” In the developed countries of the world, we now take good roads as a given, but that was not the case at the start of the automobile industry. The evolution of roads was directly linked to the spread of automobiles as a form of transportation. There was a seasonal aspect to this as well. After a long hard winter, the roads were not ready for use, and additional maintenance was needed to put them back into shape for drivers.
The infrastructure of an economy is a special type of good, called a public good. A public good has two characteristics:
1. Nonrivalry. Public goods are nonrival. A good is nonrival if one person’s consumption of that good does not prevent others from consuming the good as well. In other words, if you supply a nonrival good to one person, you can supply it to everyone.
2. Nonexcludability. Public goods are nonexcludable. We discussed this idea in Chapter 14 "Cleaning Up the Air and Using Up the Oil". A good is nonexcludable if it is not possible to selectively exclude people from access to the good. In other words, if you supply a nonexcludable good to one person, you must supply it to everyone.
There are many examples of public goods, such as roads, bridges, highways, police services, national defense, and lighthouses. Because public goods are nonexcludable, it is difficult for a private firm to produce them. After all, it is hard to expect someone to pay a positive price for a good if she can always get it for free. Instead, governments generally provide these goods. In the United States, local or state governments may provide roads and bridges, while the federal government is the provider of the highway system. Because these goods are not privately produced and traded in the economy, we cannot rely on supply and demand to determine the quantity of these goods produced in an economy. The quantity of public goods produced is an outcome of a political process.
Suppose the government is thinking about building a bridge. The cost of building the bridge depends on the design and the cost of materials and labor. We take this cost as given. Because everyone in the community can use the bridge, the benefits flow to everyone, not to any particular individual. Suppose the government knows how much each citizen in the community values the bridge: call these the individual valuations. Consider then the following procedure.
1. The government adds together the individual valuations of the bridge. Call the total the social benefit from the bridge.
2. The government builds the bridge if the social benefit of the bridge exceeds the cost of the bridge and does not build it otherwise.
3. The government uses its power of taxation to raise revenues to build the bridge.
This is a rule that determines which public goods should be provided. It is a rule that leads to the efficient provision of public goods: those with a large enough social benefit are provided, those with a lower benefit are not. More precisely, by following this rule, it is possible for the government to make sure that public goods are provided only when their provision makes everybody better off. Whenever the rule justifies the building of the bridge, the government can tax each individual an amount that is less than that person’s individual valuation of the bridge and still raise enough money to finance the building of it.
There are two major problems with this scenario. First, we supposed the government knew everybody’s valuation. Obviously, this will not be true in practice. The government could ask people to provide their valuations, but the problem here is that people have no incentive to tell the truth. In particular, if people thought that the amount they would be taxed was related to their valuation, then they would have an incentive to understate their valuations. Second, even if people truthfully revealed their valuations, the tax scheme might be perceived as very unfair because different people would be taxed different amounts.
To see in more detail how this incentive problem arises, imagine a different rule. Individuals in the community individually decide how much to contribute to the construction of the bridge.Marco Haan and Peter Kooreman, “Free Riding and the Provision of Candy Bars,” Journal of Public Economics, February 2002, 277–92. The bridge is built if the sum of everyone’s contributions exceeds the cost. Because the bridge is a public good, each resident enjoys the benefit of the total bridge, not only the segment built by their individual contribution. You benefit from the contributions of others, and they benefit from your contribution. If everyone independently decided how much to contribute to the construction of the road, they would be unlikely to contribute at all. If others are not contributing, then there is no reason to contribute because the bridge will not be built anyway. And if others are contributing enough to finance the bridge, then you can benefit without having to pay.To be more precise, you would contribute only in the unlikely event that the amount you are willing to pay would make the difference between the bridge being built or not. We expect that the contributions will, from a social perspective, be small or zero because each member of the community ignores the benefit of his or her contribution to others.
More generally, there will be underprovision of public goods because individuals do not take into account the effects of their contributions on others’ well-being. This is sometimes called a “free-rider problem.” The term comes from the fact that if everyone else pays for the good, you can travel for free.
Key Takeaways
• The demand for cars is an example of unit demand.
• A car is an asset because it is a durable good that can be resold.
• Gasoline and insurance are two important complementary products to cars. Infrastructure, such as roads and bridges, is also a complementary product to cars. Because such infrastructure often has the characteristics of a public good, the government often provides it.
Exercises
1. Suppose there is a temporary shortfall in refining capacity, so the supply of gasoline decreases for a three-month period. Use a supply-and-demand diagram to show what happens to the price of gasoline and to the quantity traded. What implications will this have for (a) how much people drive and (b) the demand for automobiles?
2. If everyone is required by law to have car insurance, what will happen to the demand for cars? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/17%3A_Cars/17.02%3A_The_Demand_for_Automobiles.txt |
Learning Objectives
1. What factors determine the price of a car?
2. How do car manufacturers compete beyond their choice of price?
3. What factors influence the choices that automobile producers make about the location of their production?
If you walk around the streets of your town, you could conduct a survey of the cars you see. For each car, you could make your best guess as to the answers to the following questions:
• What was the sticker price of the car when it was first sold?
• How old is the car?
• What is the car’s estimated value now?
• What are the car’s most important features?
• Which company produced the car?
• Is the car manufacturer a US company or a foreign company?
• In which country was the car assembled?
• At which manufacturing plant was the car assembled?
We start with the price of a car. We then look at other aspects of the production decision, such as the key attributes of the car and the choice of production location.
Car Prices
The basic rule for pricing is as follows: set the price so that
\[marginal\ cost = marginal\ revenue.\]
This rule was explained and developed in Chapter 7 "Where Do Prices Come From?". Marginal cost is the extra cost incurred by producing an additional unit, and marginal revenue is the extra revenue earned by producing an additional unit. To understand how this rule applies to cars, we need to look more carefully at both the costs of production and the demand for cars.
Marginal Cost
Cars are produced in automobile assembly plants using a variety of inputs, such as steel, rubber, glass, and labor. Lying behind the assembly of the car is an organization that engineered the car and designed the production process. At one level, there is nothing special about the cost structure for car production. We can decompose costs into three components: entry costs, fixed operating costs, and variable costs. We explained these notions of cost in Chapter 9 "Growing Jobs".
• Entry costs are incurred prior to production. For cars, the most significant entry costs are design costs and the costs of establishing the production line. Many of these expenses are incurred in the research and development stage of the product. Once the car has been designed, the production line must be organized to manufacture the car efficiently. Finally, specialized machinery must be ordered or custom built for the production line. All of these expenses are incurred before a single car can be produced.
• Fixed operating costs include the costs of managing the automobile plant. Think of these as the costs of the various divisions of the plant not directly engaged in production: the operations department, the human resources department, and so on. These costs are the same no matter how many automobiles are being produced.
• Variable costs depend on the number of cars being produced. To build more cars, the firm must hire more labor. If the firm wants to produce fewer cars, it needs to buy less steel. These and other variable costs fluctuate according to the number of cars rolling off the production line.
By definition, entry costs and fixed operating costs are the same no matter how many cars are produced. The only costs that matter for the pricing decision are the firm’s variable costs. Managers in auto plants must do their best to determine how much these variable costs change when they produce one extra vehicle. In other words, they need an estimate of the marginal cost of production.
Toolkit: Section 31.14 "Costs of Production", and Section 31.15 "Pricing with Market Power"
You can review different cost definitions and the definition of marginal revenue in the toolkit.
The history of automobile manufacture reveals that costs of production change over time. Technological progress is visible as we compare production processes at different dates. Ford’s move to mass production was key to its success in the early 1900s because this new production method reduced costs substantially. Meanwhile, modern, highly automated, capital-intensive production facilities make those Ford production techniques seem primitive.
Even today, however, the labor input into the production process differs across producers. A recent report compared the labor hours required to produce a car at different manufacturing facilities.See Gary S. Vasilash, “Assembly Plants: How They Compare,” Automotive Manufacturing & Production, August 1997, accessed March 14, 2011, http://findarticles.com/p/articles/mi_m0FWH/is_n8_v109/ai_20855370/pg_2. For 2006, a Nissan plant in Smyrna, Tennessee, required 28.32 labor hours to produce one vehicle. A Toyota plant was next at 29.54 hours. In contrast, a General Motors (GM) car required 44.59 hours of labor input. Thus GM is using a much more labor-intensive method of production than Toyota or Nissan, whose facilities are more automated. These are not exactly measures of marginal cost because they measure average labor hours rather than the labor hours required to produce one extra car. Still, it is very likely that the GM plant has a higher marginal cost than the Nissan plant.
Marginal Revenue
We can take marginal revenue = marginal cost and rewrite it as a markup pricing formula:
\[price\ =\ (1 + markup)\ ×\ marginal\ cost.\]
For example, if the marginal cost of producing the last unit is \$30,000 and the markup is 0.50 (50 percent), then the firm sets a price of \$45,000. For a given value of marginal cost, a higher markup translates into a higher price. And for a given markup, higher marginal cost translates into a higher price. The markup depends on the own-price elasticity of demand.
Suppose a firm has a lot of market power. This means it can increase its price with relatively small changes in the quantity demanded: that is, demand is inelastic so −(elasticity of demand) is small. In this case, a firm will choose a large markup. If demand is more elastic, a firm will choose a smaller markup.
Toolkit: Section 31.2 "Elasticity", and Section 31.15 "Pricing with Market Power"
You can review the definition and measurement of own-price elasticity of demand and markup pricing in the toolkit.
The markup pricing equations seem easy to implement, at least in principle. For an automobile producer, pricing is actually quite complex. There are several reasons for this:
• With something as complicated as an automobile, the calculation of marginal cost is not straightforward. The operations department must determine how much additional labor and raw materials are needed to produce exactly one more car.
• Extensive market research and a certain amount of careful experimentation may be required to find the elasticity of demand. Remember that we saw that a household’s decision about whether to buy a car depends on many different factors, including income, interest rates, the current and expected price of gasoline, the price of public transportation, and so on.
• The price elasticity of demand depends on the decisions of other producers. We discussed this idea in Chapter 15 "Busting Up Monopolies". When there is a relatively small number of suppliers, firms have to keep a close eye on the strategies of their competitors. For example, if other producers increase the prices of their cars, then you can expect households to substitute toward purchasing your car. The demand curve for your car will shift to the right. This is good news. But to determine whether to change your own price in response, you have to determine the elasticity of the demand curve for your product, given the new prices set by the other producers. You also have to worry about whether changes in your price will in turn lead other producers to change their prices again.
• Automobile producers manufacture many different models of vehicles. In effect, they compete with themselves as well as with other producers. If Ford cuts the price of, say, a Thunderbird, then the demand curve for other Ford vehicles will shift to the left as at least some potential buyers now choose the Thunderbird ahead of other Ford products. Ford must take into account how its various pricing decisions interact.
• As we explained earlier, an automobile can be thought of as a “bundle of attributes,” such as performance, style, color, and so on. The valuation that a potential buyer places on a car depends on the buyer’s valuations of these various attributes. Thus when manufacturers want to assess how much a car is worth to potential buyers, they really need to determine how much each attribute might be worth. Sophisticated statistical techniques are used to develop these numbers, and this information is used in both the pricing of vehicles and the decisions about which attributes to include in new models, which to exclude, and which to have as available options.
Pricing is only one of many decisions made by car producers. They make other key choices as well. Two of the most significant are design changes when they introduce new models and the decision about where to locate their production facilities. We turn to these next.
Model Introductions
A century has passed since Henry Ford introduced one of the most famous automobiles ever: the Ford Model T.For details on the history of the Model T, see The Henry Ford Museum website, “The Model T,” accessed March 2011, www.thehenryford.org/exhibits/showroom/1908/model.t.html. This car remained in production for almost two decades, with 15 million automobiles produced. There were two versions of the Model T: a car and a truck. Otherwise, there were very few changes made to the vehicle design throughout its years of production. Famously, Henry Ford is claimed to have said, “You can paint it any color, so long as it’s black.”
In July 2008, 59 different vehicles were listed on the Ford website, including an entire family of brands: Ford, Land Rover, Lincoln, Mercury, Mazda, and Jaguar. In other words, Ford produced an immense variety of vehicles—available in more than one color. The same is true of other automobile producers. And, of course, such product variety means more than just a large number of models: any particular model may be available with all sorts of different styling, performance, and features. Interestingly, a visit to the Ford website in 2011 yields a different picture. There are Ford vehicles available, but the other brands are gone. Both Jaguar and Land Rover were sold by Ford in 2008, partly in response to the financial crisis. Over time, companies decide both to introduce and to remove models from their range of offerings.
Cars are not the only products that display such diversity. You can buy many different kinds of laptop computers, breakfast cereals, or mobile phones, for example. As economies grow and develop, we typically see an increasing variety of goods available. But product variety is particularly noticeable with cars because automobile producers come out with new models each year.
New model introductions began early in the history of the automobile. In the 1920s, Ford faced stiff competition from other producers, particularly GM. In the mid-1920s, under the leadership of company president Alfred Sloan, GM had adopted a strategy of introducing new models.This discussion draws on the history of automobiles at David Gartman, “Tough Guys and Pretty Boys The Cultural Antagonisms of Engineering and Aesthetics in Automotive History,” Automobile in American Life and Society, accessed March 14, 2011, http://www.autolife.umd.umich.edu/Design/Gartman/D_Casestudy/D_Casestudy3.htm. In part, the strategy came from recognizing that automobiles were durable goods that households kept for many years. The introduction of new models was a strategy to motivate the exchange of old for new cars. This strategy worked. Ford’s sales of the Model T fell off and, at the end of the decade, Ford also adopted the strategy of model turnover.
The tactic remains in place today. Each year, car companies introduce new models. In some years, they make radical changes, while in other years new cars do not deviate much from previous models. The design and production of new models is one element of the competition among automobile producers. Although we often emphasize price competition, producers also compete in terms of the attributes of their models. Thus competition is very complex.
Plant Location
You have probably given little thought to why firms build factories in one location rather than another. But imagine for a moment that you must decide where to construct a new automobile plant. What kinds of factors might influence your decision?
You would certainly think about the cost of your inputs—that is, the items you need to manufacture new vehicles. Cars require substantial amounts of raw materials, such as steel, that have to be brought to your factory. If those inputs have to be brought in from a long way away, then your inputs will be more expensive. These costs depend also on the local infrastructure: are there good road and rail links to your prospective site? Another input, of course, is labor. Ideally, you want to locate your factory where labor is cheap but also sufficiently skilled for the positions you need to fill.
Once you have manufactured the cars, you have to get them to their final destinations: dealers throughout the country or even throughout the world. Because cars are large and heavy, they are expensive to ship to other locations. Thus, other things being equal, you would also like to locate your manufacturing site near your final demand. Of course, producers must usually serve many markets from a single plant.
Where you ultimately choose to locate the plant will depend on the costs of transporting both inputs and output. If your inputs are very costly to transport, then you will produce near the source of inputs and ship your finished goods to your markets. Alternatively, if your inputs are easy to transport but your output is costly to ship, then you might locate your production near some of your markets. You might even consider multiple production plants to lower the costs of transporting the final good.
You also care about local policies, such as the level of taxes. Countries, states, regions, and cities often compete to attract factories. They do so because a factory brings with it jobs and greater prosperity for a region. In some places in the world, you also have to worry about whether your property rights are well protected. If you set up a factory in the United States, you can be reasonably confident that the government will not try to confiscate either your capital or profits. In some other countries, however, you may justifiably be concerned for the safety of your assets.
The automobile industry in the United States was initially located in and around Detroit. This was partly due to the fact that access to the Great Lakes provided low-cost transportation of the necessary inputs into the production process. As time passed, plants began to appear outside the Detroit area, particularly in the southern part of the United States.
One of the factors motivating these location decisions was labor costs. The automobile plants in and around Detroit were dominated by a union, the United Auto Workers ( www.uaw.org/node/39), which was formed near the end of the Great Depression. In the short run, firms must negotiate with the unions that represent its workers. In the longer run, though, firms have other options. One of them is to locate plants in areas with cheaper labor costs. Over time, firms have indeed shifted some of their production facilities to other parts of the United States and other countries around the world where labor is cheaper.
Key Takeaways
• The price of a car is a markup over the marginal cost of production. The markup depends on the elasticity of demand.
• Car producers compete by introducing new models.
• Plant location choices are made in an effort to reduce the costs of production as well as the costs of transporting intermediate goods to a plant and finished goods to the market.
Exercises
1. How might you explain the differences in labor input per car across automobile assembly plants?
2. Under what conditions would a car producer locate a production plant in Alaska?
3. What other goods have new models introduced into the market? Does this happen every year? Why do the producers of these goods change models? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/17%3A_Cars/17.03%3A_Supply_of_Cars.txt |
Learning Objectives
1. What kind of competition is there in the automobile industry?
2. How do market outcomes differ in the short run compared to the long run?
The interactions among buyers and sellers in the car market ultimately lead to prices and quantities of all the different cars that are produced. But what is the right way to think about that interaction? Automobile markets are not examples of competitive markets—many firms each producing an identical product. Nor is there a single car producer acting as a monopolist. To study markets such as the car market, we have an intermediate situation where firms
• sell goods that are imperfect substitutes for other goods in the markets in the short run, and
• enter and exit in response to profit opportunities in the long run.
Competition among Producers in the Short Run
When we think about market outcomes for automobiles, there are two different markets to consider. There are business-to-business markets in which manufacturing firms sell cars to dealerships, and there is the business-to-consumer market in which dealerships sell cars to the final consumer. This pattern of trade is quite normal: most firms do not sell directly to the final consumer but instead sell their goods through retailers.
So far we have said that automobile producers determine prices for their cars. But the companies do not actually set the price you will ultimately pay for a new vehicle. That price is determined through a bargain between you and a dealer. The price that the company sets is the price at which it sells to the dealer. Given the numerous dealers, you would not expect them to be able to make much profit. Competition will force the price to be close to the cost of the car to the dealer. But the producer retains market power and can dictate a price for selling the car to the dealer.
This might make it tempting to think about the final market for cars as being roughly competitive. After all, one of the conditions for a competitive market is that there should be a large number of buyers and sellers. Another condition, though, is that sellers should be selling identical goods. In the case of cars, this is evidently not the case. We have already pointed out that firms produce many different models of vehicles with various options available. On top of that, dealerships may differ in terms of the quality of service they offer both before and after the sale of a vehicle. Consumers, when choosing which car to buy and where to buy it, are choosing from a large set of different, imperfectly substitutable products. We call these differentiated products.
Each dealer therefore possesses a degree of market power. Some of this market power comes from the fact that there will be only a small number of sellers of a particular model in a given region. Some of the dealer’s market power stems from specific features of the dealership, such as location and after-sales service. The key point is that each dealership faces a downward-sloping demand curve for the cars that it sells. The seller chooses a point on the demand curve. Because there are competing cars available from other dealerships in the market, the position of the demand curve depends on the prices set by other firms for other models.
Although dealerships possess some market power, the retail market for automobiles is still quite competitive. Demand is relatively elastic because consumers have different dealerships and cars to choose from. In addition, information about the price at which dealers obtain vehicles from manufacturers is readily available. Under most circumstances, therefore, dealers are able to enjoy only a small markup over this price. (The exception is when a particular model of vehicle is in particularly high demand for some reason.)
From a dealer’s perspective, marginal cost is determined largely by the price at which it obtains the car from the manufacturer. The producer sets the price to the dealer to maximize its own profit. Producers understand that the demand for their products is affected by the prices of competing vehicles. This strategic interaction means that the elasticity of demand (and hence the markup) for a particular car depends on the prices set by other manufacturers. We explained this in detail in Chapter 15 "Busting Up Monopolies". Likewise, dealers set their prices based in part on the prices at other dealerships. On the demand side, households take the set of products offered in the market and their prices (subject to a little bargaining with dealers) as given as well. Their decisions about which cars to purchase and when to purchase them generate the market demand curves faced by dealerships.
Market Dynamics in the Long Run
So far we have taken as given the types of cars produced, the location of plants, and the identity of the automobile producers. Over a short period of time, such as a year, this is a good way to think about the market for cars. But over longer periods of time, the market is much more dynamic. There are changes in the models of vehicles; there are changes in the location of manufacturing plants; and there is entry and exit of manufacturers. One way to see this is to look at the evolution of the automobile market since the early part of the 20th century.
The beautiful car shown in this picture is called a Marmon.This discussion draws a history of the Marmon that can be found at Bill Vance, “Motoring Memories: Marmon,” accessed March 14, 2011, http://www.canadiandriver.com/2000/03/16/motoring-memories-marmon.htm. The photo is of a 1932 model. A Marmon won the first Indianapolis 500, and nearly 22,000 models were sold in 1929. But by 1934, the company was gone, a casualty of the Great Depression. Small fringe producers like Marmon disappeared from the automobile industry. Left behind were the large producers who were to dominate the US automobile industry from that time onward. By the mid-1930s, the US market was largely ruled by three manufacturers.
Figure \(1\)
A 1932 Marmon.
Economists Tim Bresnahan and Daniel Raff looked at data on automobile plants during this time period. See Timothy Bresnahan and Daniel Raff, “Intra-industry Heterogeneity and the Great Depression: The American Automobile Industry, 1929-1935,” The Journal of Economic History, June 1991, 317–31. They found that the number of plants (remember that one firm may have multiple plants) that were producing cars fell from 211 in 1929 to 121 in 1935. There is no single explanation of exactly why these producers failed and had to close their plants. The Great Depression evidently led to a large decrease in the demand for automobiles. But on top of that, surviving firms were marked by advances in product and process development. In the early stages of the automobile industry, small producers operated at a small scale. Such producers simply could not compete with Ford’s lower-cost production process. This competition from Ford led to the exit of producers of cars like the Marmon. In the end, the industry was left with a small number of powerful firms.
In this market, firms were selling differentiated products, so they had market power. Over the long run, there was entry and exit of competing products (that is, firms introduced new products and retired old ones). There was also entry and exit of entire firms. The conditions governing entry and exit are the same as those that we explained in Chapter 9 "Growing Jobs". A firm will introduce a new product if it expects to make sufficient profits (in terms of discounted present value) to justify the fixed entry costs. A firm will discontinue a product if the discounted present value of profits that it expects from that product is less than the value of the firm’s recoverable assets. Similar conditions apply to entire firms in the market.
Over the past 70 or so years, after the shakeout in the 1920s and 1930s, the big three producers have remained the dominant sellers. From that perspective, you might think that there was little entry and exit. However, the story is more complicated. First, the market share of the three main producers declined due to foreign competition. American consumers started buying cars made in Europe, Japan, and elsewhere. Second, the products produced by the firms have evolved considerably over time. This is a very dynamic market in terms of product innovation. Although there may not have been very much entry and exit of firms, there was considerable entry and exit of products. Sometimes, manufacturers retire entire brands, such as the Hummers that General Motors (GM) stopped producing in 2010.
The Used Car Market
When households choose a car, one option is not to purchase a new car but instead to buy a (as the dealers like to put it) “preowned” vehicle. From the perspective of the buyer, there is one critical difference between a new car and a used car. With a new car, it is relatively easy to make a reasonably good judgment about the attributes of a product, partly from reviews in magazines and on the Internet. With a used car, it is much harder to judge the quality of the product and thus place an accurate valuation on it. We explained a similar problem in terms of health care in Chapter 16 "A Healthy Economy".
With new cars, you bear only a small risk that the car will not perform properly when you buy them. This is not the case in the market for used cars. Imagine (or perhaps you have actually experienced this) going to a used car lot to look for a car. Here is what you might hear from a member of the sales force: “This is the best used car I have ever seen. No lie—it was purchased new by an elderly woman a few years back, and she treated it like one of her kids. It is only here on our lot because she has decided to stop driving. At this price, it is a steal.” You are much less likely to hear this: “Yeah, that car is a lemon. Some guy bought it from the dealer a few months back, and it never was right. One problem after another; it was back in the shop every week. Sure there is low mileage, but my guess is that there are no more miles from that car anyway. Go ahead, buy it if you like. But don’t say I didn’t warn you.”
When you see a used car for sale, ask yourself: why is that car here? The true answer could be one of these two stories. If it is the first situation, then the car is probably a good buy. But if it is the second, then you could be getting ripped off. And the problem is that the seller may give you the first story even when the second is the truth.
The fundamental difficulty here is that you and the seller have very different information. The seller of the product knows its quality (is the car good or bad?) while you, as a buyer, do not know its quality. This does not mean you should never buy a used car. But it does mean that your willingness to pay for a used car should reflect the uncertainty you face with regard to the quality of that car. Because all buyers face the same problem, the end result is that the market valuation of used cars will be low. Accordingly, the price of a used car is lower than it might be if the quality of cars was known. And this can also mean that there are fewer good used cars on the market. This is the problem that economists call adverse selection.
You can also perhaps spare some sympathy for the used car dealer as well. We have described this problem from the perspective of a buyer. Even if a dealer really does have a car that is of high quality, it is hard for him to convince prospective buyers of that fact. If you want to sell a car you own, you will probably encounter this problem: you may know that your car is high quality, but you cannot convince buyers.
Key Takeaways
• Car companies compete in markets where they sell differentiated products.
• In the long run, the entry of competitors (in the form of either new firms or new products) continues until profits are equal to zero.
Exercises
1. Use the condition that marginal revenue = marginal cost (consult the toolkit if needed) to explain the difference in the price of two cars of your choice.
2. Some used car sellers include a warranty with your purchase. Would that help overcome the lemons problem?
3. If two cars are close substitutes, what do you predict about their prices? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/17%3A_Cars/17.04%3A_Market_Outcomes_in_the_Automobile_Industry.txt |
Learning Objectives
1. What are some policies to control the emissions from cars?
2. How do trade policy and international investment affect the car market?
3. What is the problem of congestion, and what can governments do about it?
There are many ways in which government policies impinge on automobiles. Here we highlight a few such issues.
Environmental and Resource Concerns
In Chapter 2 "Microeconomics in Action", we showed a photograph of smog in Mexico City. At the same time that cars have transformed the economic world, they have also transformed our natural environment. The exhaust from cars contributes to air pollution, which is hazardous to health. Car exhausts are a source of greenhouse gas emissions and thus contribute to climate change.
Pollution from cars is a classic example of an externality. (We discussed externalities in detail in Chapter 14 "Cleaning Up the Air and Using Up the Oil".) An individual’s decision to purchase and drive a car does not take into account the effects on third parties. In this case, some of the affected third parties are those in the immediate vicinity who suffer from a reduction in air quality. To the extent that emissions contribute to climate change, however, the third parties potentially include everyone in the world.
Toolkit: Section 31.19 "Externalities and Public Goods"
You can review the definition and use of externalities in the toolkit.
Governments in the United States and elsewhere have enacted various policies that are motivated, at least in part, by the desire to take into account such environmental externalities and resource use. First, there are taxes on gasoline. These are relatively low in the United States but are much higher in Europe. Second, there are technological restrictions, such as the requirement that automobiles be fitted with catalytic converters and designed to run on unleaded fuel. In the United States, the government has taken action to improve the fuel consumption of cars produced within US borders. These are called Corporate Average Fuel Economy (CAFE) standards.CAFE standards are described in detail at the National Highway Traffic Safety Administration site, “CAFE Overview—Frequently Asked Questions,” accessed March 14, 2011, www.nhtsa.gov/CARS/rules/CAFE/overview.htm. You can notice two things from this term: (1) the restrictions are in terms of fuel economy (miles per gallon), and (2) the restriction does not apply to individual automobiles but rather to the set of cars sold by a corporation. For example, the standard is applied to the entire set of models produced by General Motors (GM), not model by model, so GM makes some cars that are below the standard and others that are above. Corporations that do not meet the standard are fined.
The CAFE standard comes from legislation passed in 1975 in response to the embargo by oil-producing countries in 1973. The initial motivation was to reduce energy consumption and, in part, make the United States less dependent on imported oil. The arguments today for these standards also include the effect of car emissions on global warming.
Trade and Investment Policies
A second government policy that has had a huge impact on the automobile industry is the opening of the world economy to trade and international investment. The current automobile market is no longer just a US market. The United States is part of the world market. US producers interact with the rest of the world by
• selling cars in many countries,
• buying parts from suppliers throughout the world,
• producing in many countries,
• being financed by debt and equity held in foreign countries.
Meanwhile, US citizens
• own cars produced in other countries and imported into the United States,
• consume imported oil,
• work for foreign companies that produce cars in the United States,
• work at car production facilities in other countries.
For example, let us look at Ford Motor Company. In 2007, Ford had 95 plants worldwide and employed about 246,000 people. The Ford operations in North America (United States, Canada, and Mexico) had 94,000 employees. In other words, 62 percent of the workforce was employed outside North America. There are Ford plants all over the world. Ford’s 2009 annual report tells us that Ford sold 4.82 million cars in 2009. Of these, 2.0 million were sold in North America, 1.6 million in Europe, and the remainder in South America and Asia.Ford Motor Company, “Annual Reports,” accessed March 14, 2011, corporate.ford.com/microsites/annual-reports.
This international structure permits diversification. Ford produces and sells cars in China, South America, and elsewhere around the world. If you browse Ford’s global activities,Ford Motor Company, “About Ford: Global Vehicles Sites,” accessed March 14, 2011, corporate.ford.com/about-ford/global-vehicles-sites. you will get a sense of its worldwide sales and production operations.Ford Motor Company, “About Ford: Global Operations,” accessed March 14, 2011, corporate.ford.com/about-ford/global-operations.
Each producer of cars has its own story of expansion across international borders, both through trade and through production. Honda began operations in the United States by creating a motorcycle sales division in the late 1950s. This eventually led to the production of motorcycles in the United States in 1978 and ultimately the production and sales of Honda cars in the United States.Honda Worldwide, “Establishing American Honda Motor Co. (1959),” accessed March 14, 2011, http://world.honda.com/history/challenge/1959establishingamericanhonda/index.html.
None of this would be possible without governments permitting the movement of goods and capital.
The first trade policy action directly impacting car production was the Canadian-US Automotive Products Trade Agreement of 1965. The goal of this agreement was to create an integrated market for cars between the United States and Canada by eliminating tariffs. Concerns that US companies would sell but not produce cars in Canada were met by some restrictions on production, including requirements that cars built in Canada had to have a certain domestic content.
The second trade policy action was called the North American Free Trade Agreement (NAFTA).US Department of Agriculture, Foreign Agricultural Service, “North American Free Trade Agreement (NAFTA),” accessed March 14, 2011, www.fas.usda.gov/itp/Policy/NAFTA/nafta.asp. NAFTA was a controversial trade agreement. One of the big issues was whether the reduction in trade barriers would lead to job destruction in the United States. (We discussed this in Chapter 9 "Growing Jobs".) A 2001 study looking back at the effects of NAFTA directly on the production of cars did not find large effects at all.
Most fears about the ill effects of NAFTA on the U.S. auto industry, whether in term of employment, wages, or investment, have been proven wrong. The U.S. auto industry did experience rationalization of production and hence job displacements. But overall, NAFTA appears to have helped the U.S. auto sector (U.S. Trade Representative, 1997). Employment in the American automotive industry grew by 14.1 percent overall, with an increase of 16.1 percent in the auto parts sector and 10.1 percent in the motor vehicle assembly sector from 1994 to 1996. Hourly earnings for production workers in the U.S. automotive sector grew by 5.6 percent between 1993 and 1996. The Big Three U.S. automobile manufacturers invested \$39.1 billion from 1993 to 1996 in new manufacturing plants and equipment in the United States, while investing only \$3 billion in Mexico over the same period.Mary E. Burfisher, Sherman Robinson, and Karen Thierfelder, “The Impact of NAFTA on the United States,” Journal of Economic Perspectives 15 (Winter 2001): 125–144.
These statistics, of course, refer to what actually happened in the auto sector over this time period. What would have happened had NAFTA not been implemented requires a more sophisticated analysis.
Congestion
If you travel to Mexico City or Manchester, Beijing or Buenos Aires, Jakarta or Johannesburg, Los Angeles or Lagos, you will see that these cities all have something in common: traffic jams. Such road congestion is another example of an externality. The decision of one person to drive has an effect on other drivers.
One way of solving externality problems is to create new markets. In most cases, there is no market for the use of roads. However, if we charge people to use roads, then market incentives come into play. Toll roads are an example of the introduction of a market mechanism to combat congestion problems.
Congestion fees and tolls are in use in some cities around the world, such as London and Singapore.This June 21, 2006, press release from the UK Commission for Integrated Transport provides some discussion of the London system and others around the world: “New study shows road pricing progress,” accessed March 14, 2011, http://cfit.independent.gov.uk/pn/060621/index.htm. The system in London, started in February 2003, charges drivers for entering the central city area between certain hours. Details of the system are available from Transport for London.Transport for London, “Congestion Charging,” accessed March 14, 2011, http://www.tfl.gov.uk/roadusers/congestioncharging/default.aspx. The cost in May 2008 was £8 (about \$15.60) for access to the charging zone in Central London between 7 a.m. and 6 p.m., Monday through Friday. The system is enforced by a series of cameras that record license numbers and then check them against a record of who has paid for access to the zone. According to the Transport for London, the traffic flow into the zone has been reduced by 21 percent, and there is now less pollution and more cycling in the area.
The Electronic Road Pricing (ERP) system in Singapore, although older, is much more sophisticated. It was introduced in April 1998 along Singapore’s expressways and in the city’s central business district. All vehicles contain a transponder, mounted on the windscreen, into which the driver inserts a prepaid cash card. There are gantries located at various points around the city, and whenever a car passes under a gantry, a toll is automatically deducted. The rates differ for different categories of vehicle: motorcycles and light goods vehicles pay less than cars; heavy goods vehicles pay more than cars.
The most striking feature of the Singapore system is that the charges vary by time of day. Charges are imposed only at the peak hours, and the charges vary within those hours. Thus, for example, a driver passing a typical gantry might pay SGD 0.80 (about \$0.58) from 08:00 to 08:05, SGD 1.50 from 8:05 to 8:30, SGD 2.00 from 08:30 to 09:00, SGD 1.50 from 09:00 to 09:25, SGD 1.00 from 09:25 to 09:30, and so on. You can see that these rates are quite finely tuned, with some rates being in effect for only a five-minute period.
The rates just quoted were in effect in mid-2008. By now, they may be quite different because a second feature of the system is that these rates are revised frequently. The Singapore Land Transport Authority has targets for the desired average speed of traffic on Singaporean roads: the target speed for expressways is 45–65 kilometers per hour (28–41 miles per hour), and the target speed for arterial roads is 20–30 kilometers per hour (13–19 miles per hour). Thus if they observe that traffic is flowing below these speeds, they consider raising the rates; if traffic is flowing smoothly, they consider reducing rates. They also adjust rates on a seasonal basis—for example, ERP charges are lower during school vacations.
Key Takeaways
• Gas taxes and actions to improve fuel efficiency of cars are policies that reduce pollution from cars.
• In the United States, households benefit from the importation of foreign-produced cars and also from the ability to work at automobile factories owned by foreign companies.
• The opening of the car market to imports creates some job displacements.
• In some countries, governments tax the use of roads when they are congested.
Exercises
1. Give two reasons why the government taxes gasoline.
2. Why might a government choose to limit car access to a city center? What policies are available to a government for doing that? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/17%3A_Cars/17.05%3A_Policy_Issues.txt |
In Conclusion
When you study economics from a textbook such as this, you learn different economic theories. In this book, we have looked at the theory of the consumer, which helps explain how individuals make their choices about what goods to buy. We have looked at the theory of the firm, which explains how firms make decisions about which goods to produce and what price to sell them at.
Our goal in this book is to help you see that economics is not only a matter of graphs and definitions but also the study of the world around you. Economists see economic decisions and economic forces everywhere they look. This chapter gave you many examples linked to one particular and very familiar product. Yet we have only scratched the surface in terms of the ways in which we could apply economic analysis to cars and the car industry.
Perhaps you can think of other ways in which you could apply the things you learned from your study of economics to the market for automobiles. In any case, we hope that, now, every time you see a car, you will remember that you are also seeing economics in action.
Key Links
exercises
1. (Advanced) A car is an asset, like a house. How would you use the principles of asset valuation to ascertain the value of a car? (Hint: see Chapter 10 "Making and Losing Money on Wall Street".)
2. List the products and/or services that are substitutes for cars.
3. Because a household can delay the purchase of a new car when the price increases, what does this do to the price elasticity of demand for cars?
4. List the car characteristics and household characteristics that would increase a household’s valuation of a car.
5. Would an increase in the price of gasoline decrease the demand for all cars or only some? What are the effects of an increase in gas prices on alternative forms of transportation?
6. In the coordination game for automobile insurance, is it desirable for the government to require that everyone buy automobile insurance?
7. There are three people in a community. The government is proposing to build a bridge in that community. The bridge costs \$120 to construct. Everyone values the bridge at \$60. Is it efficient to build the bridge? Suppose the government asks people what the bridge is worth to them and plans to tax them the amount that they say. If two people truthfully reveal to the government that the bridge is worth \$60 to them, will the third person give his true valuation as well?
8. Using the equation linking the price of a car to markup and marginal cost, if the markup is 60 percent and marginal cost is \$20,000, what is the price? Show with this example that a firm facing a more elastic demand curve will set a lower price.
9. Is a car dealership more valuable in a small city with little competition or in a big city with more competition but also more potential buyers?
10. Car dealers make profits from goods and services that are complementary to the cars they sell. List and discuss some of these complementary products.
11. Why do automobile companies offer warranties with new cars? Why do these warranties expire after a few years?
12. What factors determine the choice of an automobile producer to create a new model?
13. If you were a seller of a used car and you knew it was high quality, would you have an incentive to offer the buyer a warranty on the car? Would you have that same incentive if you knew the car was low quality? What then should you as a buyer infer if you see a seller willing to offer a used car with a warranty?
14. One concern with opening markets in the United States is that domestic car producers are forced to compete with foreign producers. In some cases, this competition leads to job losses in the United States. Who gains from this competition?
15. (Advanced) If you were designing a policy of charging for road use, would you include or exempt taxis?
16. In what sense is buying a car like buying health care? What do car companies do to provide buyers with assurance over the functioning of the car? Why doesn’t this happen in the health-care market?
17. If you look at the market for cars, high-income households are more likely to buy new cars, and lower income households are more likely to buy used cars. Why is that the case?
18. Following a recession, it is likely that the average age of cars will be higher than prior to the recession. Why?
19. Would you say that the market for higher education is a market with monopolistic competition or a monopoly? How does competition occur in that market?
Economics Detective
1. In addition to car production being shifted to the southern part of the United States to reduce labor costs, car production has also moved overseas. What information can you find on the wages of workers at automobile plants outside the United States?
2. What is the current penalty on companies that do not meet the CAFE standard?
3. In June 2009, the US government became a majority owner of GM. What prompted that action? Why did the US government not buy Ford Motor Company? What has happened to US government ownership of GM? What has happened to the sales and profitability of Ford and GM in recent years?
4. What products other than cars have a “model year”? Are new models introduced simultaneously or at different times of the year? What factors might determine the timing of new model introductions?
Spreadsheet Exercise
1. Based on the equations for markup pricing, create a spreadsheet to calculate the price you would set as a car producer. To do this, input the elasticity of demand and marginal cost. Use your program to calculate the markup and product price. Produce graphs to show how the product price will change as the elasticity of demand changes. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/17%3A_Cars/17.06%3A_End-of-Chapter_Material.txt |
In early 2002, a team from the International Monetary Fund (IMF) flew to Buenos Aires, Argentina. Argentina had been prospering during most of the 1990s, but more recently it had begun to run into economic problems. The IMF is an organization that attempts to help countries having financial difficulties.
An IMF team consists of professionally trained economists. These teams visit many countries, such as Argentina, on a regular basis. In this chapter, we imagine that the IMF added you to this mission and asked you to report back on the state of the Argentine economy. As we proceed, we think about how you might have approached this task.
You arrive at Aeropuerto Internacional Ministro Pistarini de Ezeiza Airport, which is a clean and modern airport on the outskirts of Buenos Aires. You ride into the city in a new car along modern highways lined with fancy billboards. When you get to the city center, you notice that there are luxurious shopping malls. You see high-end stores selling luxury brands, such as Louis Vuitton, Versace, Hermes, and Christian Dior. The city seems prosperous, reminiscent of Paris or New York. Just looking around, you see immediately that you are not in one of the really poor countries of the world.
Source: Image taken by authors.
As you explore the city, though, you begin to look more closely and notice that things are not quite what they seemed at first glance. The luxury stores do not have many customers in them. Some buildings show signs of a lack of maintenance; it has been a while since they were repainted. Some stores are boarded up or bear signs saying that they are going out of business. There seem to be a lot of people who are not working or who are making a living selling goods on the street.
Reflecting on these conflicting clues to Argentina’s prosperity, you quickly realize that it is difficult to assess the health of an economy by casual observation. In addition, you have seen almost nothing of the country. Argentina covers over one million square miles; it is almost one-third of the size of the United States and has a population of nearly 40 million. The more you think about this, the harder the problem seems. Forty million people are buying things, selling things, making things, and consuming things every day. It seems an impossible task to make sense of all this activity and say anything useful about the economy as a whole. That challenge is the subject of this chapter.
How can we evaluate the overall performance of something as complicated as an economy?
Road Map
If you think about this question for a bit, you will realize that it has more than one dimension.
• First, we need measurement. We must summarize the economy in a manageable way, which is impossible unless we find some way of measuring what is going on in the economy. One of the primary tasks of economics is accounting. That leads to other questions: what should we count, and how should we count it?
• Data are not enough. Measurement will not take us very far unless we can combine it with some understanding of how the economy works. We need to know how to interpret the things we count. We need to know what our numbers mean. For this, we need frameworks that help us make sense of the economy.
These two ideas guide our discussion in this chapter.
Think for a moment in very general terms about what happens in an economy. An economy possesses some resources. These include the time and abilities of the people who live in the economy, as well as natural resources, such as land or mineral deposits. An economy also possesses various means of changing, or transforming, one set of things into other things (see the following figure). For example, we have a process for making tea. We produce tea by taking cold water, energy, and dried leaves and transforming those inputs into a hot beverage that people like to drink. The simple act of making a cup of tea is an example of production.
Figure \(2\): From Inputs to Output
One of the main economic activities is production: the transformation of inputs (raw materials, labor time, etc.) into output (goods and services that people value).
We are interested in measuring how much production occurs in an economy. Obviously, however, we cannot hope to count all the times that people drop a teabag into a cup, and it would not make much sense to do so. Economic activity typically involves more than production; it also includes the notion of exchange—buying and selling. If you make a cup of tea for yourself at home, we do not think of this as economic activity. If you buy a cup of tea at your local coffee shop, we do think of this as economic activity. A very rough definition of economic activity is as follows.
Economic activity is the production of goods and services for sale.
Any definition this straightforward is bound to be too simple, and we will see that there are several subtleties in the actual measurement of economic activity, particularly since some goods and services are not actually bought and sold. Still, if you keep this idea in mind, it will help you as we progress through the basics of economic measurement in this chapter. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/18%3A_The_State_of_the_Economy/18.01%3A_The_IMF_Comes_to_Town.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is the measure of total output of an economy?
2. What is the difference between real and nominal gross domestic product (GDP)?
Macroeconomics is data driven. Government statisticians and other organizations gather vast amounts of data on the performance of various aspects of the macroeconomy, and macroeconomists try to make sense of all this information.
If we want to explain economic data, then we first have to get the measurement right, and a big part of this is ensuring that we get the accounting right. To make sure that we do, we begin by constructing simple examples. This is not because a simple example is enough to describe an economy; but because cannot hope to understand the complicated accounting unless we do the simple accounting correctly.
To understand the economic health of Argentina—or any other country—we begin by looking at production in the economy. Let us imagine that Argentina produces a single good—pizza. Each pizza is sold for 10 pesos (which is about US$3.33). To be concrete, suppose that every worker in the economy works in a pizza factory in which (1) each hour worked produces 1 pizza, (2) each worker works 40 hours per week, and (3) each worker works 50 weeks per year. Suppose there are about 15 million workers in the economy. We measure total economic activity by determining the total value of the pizzas produced in this economy. We obtain this by multiplying the previous numbers together. There are $40\ pizzas\ per\ worker\ per\ week,$ so there are $2,000\ pizzas\ per\ worker\ per\ year\ (= 40 × 50),$ which means that there are $30,000,000,000\ pizzas\ per\ year\ (= 40 × 50 × 15,000,000).$ The value of those pizzas is $300,000,000,000\ pesos\ per\ year\ (= 40 × 50 × 15,000,000 × 10).$ The total value of all the production in the economy is called nominal gross domestic product (nominal GDP). The word nominal indicates that something is being measured in terms of money—in this case, Argentine pesos. For this economy, nominal GDP is 300 billion pesos per year. The economy we have just described is extremely stylized and somewhat dull from a culinary perspective. We begin with such a simple economy because it allows us to understand the basic workings of the economy without getting bogged down in a lot of details. We did, however, choose numbers that are the right order of magnitude for the Argentine economy in 2002: the total number of workers in Argentina in 2002 was about 15 million, and nominal GDP was about 300 billion pesos. In 2010, estimated GDP for Argentina was 1.4 trillion pesos, and the workforce was over 16 million. Measuring Nominal GDP We now consider a more formal definition of nominal GDP and go through it term by term. Nominal GDP is the market value of the final goods and services produced by an economy in a given period of time. Market Value Our example pretended that there was only a single good produced in the economy—pizza. In real economies, millions of different goods and services are produced, ranging from cars at an assembly plant to haircuts sold by a local barber. If our goal is to measure the overall output of an economy, we are faced with the problem of how to add together these goods and services. How do you add 60,000 cubic meters of natural gas, 1,000 trucks, and 2,000 head of cattle (to pick just a few examples of goods produced in Argentina)? We need a common denominator. Economists use the market value of the goods and services. This means that the common denominator is dollars in the United States, pesos in Argentina, kroner in Sweden, euros in Portugal, and so on. Nominal GDP equals total output produced in a year, valued at the actual market prices prevailing in that year. We choose market value for two reasons. One is simplicity: data on the market prices of goods and services are relatively easy to come by. The second reason is much more important. Market value tells us how much people are willing to pay for different goods and services, which gives us a measure of the relative value of different commodities. For example, if a new laptop computer costs$2,000 and a new hardcover novel costs $20, then the market is telling us that people are willing to trade off these goods at the rate of 100 novels to 1 laptop. In effect, the market is telling us that the laptop is 100 times more valuable than the novel.We take as given here that the market price—which tells us how much people are willing to spend—is a reasonable measure of the value of a good or a service. More precisely, it measures the value of the good or service “at the margin,” meaning it measures the value of having one more unit of the good or the service. Explaining why this is usually a sensible interpretation of the market price (and when it is not) is a topic covered in microeconomics courses. Let’s look at an example of the calculation. Table 18.2.1 "Calculating Nominal GDP" considers a very small economy that produces three goods and services: T-shirts, music downloads, and meals. We show data for two years. To calculate GDP in 2012, we take the market value of the T-shirts ($\ 20 \times 10 = \ 200$), the market value of the music downloads ($1 × 50 = $50), and the market value of the meals ($\ 25 \times 6 = \ 150$). Adding these, we discover that nominal GDP is$400:
$\ 20 \times 10)+(\ 1 \times 50)+(\ 25 \times 6)=\ 200+\ 50+\ 150=\ 400$
Doing the same operations for 2013, we find that nominal GDP is $442: $(\ 22 \times 12)+(\ 0.80 \times 60)+(\ 26 \times 5)=\ 264+\ 48+\ 130=\ 442$ We can see that lots of things changed between the two years. The price of T-shirts and meals slightly increased, while music downloads became cheaper. Firms produced more T-shirts and music downloads but fewer meals. Year T-shirts Music Downloads Meals Nominal GDP ($)
Price ($) Quantity Price ($) Quantity Price ($) Quantity 2012 20.00 10 1.00 50 25.00 6 400.00 2013 22.00 12 0.80 60 26.00 5 442.00 Table $1$: Calculating Nominal GDP On the surface, 2013 appears to have been a good year in this economy. Nominal GDP increased substantially relative to 2012. Dig a little deeper, however, and it is harder to interpret this change. Production increased for some products and decreased for others. Some prices increased, and others decreased. Was 2013 really better than 2012? We come back to this question shortly. Final Goods and Services In Table 18.2.1 "Calculating Nominal GDP", we assumed that all of the goods and services purchased were purchased by their final users. That is, the T-shirts, music downloads, and meals were all purchased by households for consumption purposes. (Households are not the only group that consumes final goods and services in an economy. Firms, the government, and households in other countries can also be final consumers.) We term these final goods (T-shirts) and final services (music downloads and restaurant meals). In contrast, intermediate goods and services are products such as raw materials and energy that are used—and completely used up—in the production of other goods and services.There are two kinds of goods used in the production of other goods. Intermediate goods are completely used up as part of the production process. Capital goods—such as factories and machines—are not completely used up but live to produce another day. We discuss capital goods in more detail in Chapter 20 "Globalization and Competitiveness". We do not include intermediate goods in GDP. Think about a bottle of wine, for example. It might be bought by a consumer at a wine store, in which case it is counted in GDP. Alternatively, it might be bought by a restaurant to sell with its meals. In this case, the cost of the meal is included in GDP, and the cost of the wine is already included in the cost of the meal. The restaurant may have purchased the wine from a supplier, but that purchase is not included as part of GDP. If both the sale of wine to the restaurant and the sale of that wine to a customer of the restaurant were counted in GDP, the same bottle of wine would be counted twice. By excluding the sale of intermediate goods in calculating GDP, we avoid such double counting. Being intermediate is therefore not a feature of the good itself. It depends on how the good is used. Wine sold to a consumer directly is a final good; wine sold to a restaurant is an intermediate good. This fits with the idea that we want GDP to measure goods as they are valued by consumers. Produced by an Economy Most of the time when we talk about an economy, we are speaking of a particular country. Thus we talk about US GDP, Argentine GDP, Indian GDP, or Uruguayan GDP. Similarly, most of the statistics that are collected refer to economic activity within a country. The term economy can be much more general, though, for it simply means a particular set of households and firms. We can speak of the world economy, the North Dakota economy, the Buenos Aires economy, or even the economy of a street of your hometown. The basic concepts are the same no matter what region we choose to discuss. Over a Given Period GDP is measured over a specified period of time. In principle, that time period could be anything—a week, a month, a quarter (three months), or a year. In the United States and many other countries, GDP is measured on a quarterly basis. However, it is typically reported on an annual basis. In other words, government statisticians might measure GDP for the first three months of 2012 and find that it was$4 trillion. That is, over that three-month period, $4 trillion worth of goods and services was produced. The number would typically be reported as “$16 trillion on an annual basis.”
It does not make any sense to talk about US GDP at the instant the clock strikes noon on February 29, 2012. The amount of GDP produced at any instant of time is, for all intents and purposes, zero. Instead, we think of GDP as a flow. We can count the number of pizzas produced only if we specify some interval of time. Other variables can be sensibly measured even at a given instant. For example, we could—in principle at least—count the number of pizza ovens in existence at any given time. The number of pizza ovens at a point in time is an example of a stock.
The requirement that we count goods and services produced in a certain period means that we should also ignore the resale of goods produced in earlier periods of time. If a construction company builds a new house and sells it to you, the production of that home is counted as part of GDP. By contrast, if you buy a house that is 10 years old, the sale of that house is not counted in GDP. (However, if you employed a real estate company to find the old house for you, payment to that company would be included as part of GDP.) In the same way, if you purchase a used textbook that was produced 3 years ago, that purchase is not counted in GDP.
Nominal GDP in the United States and Argentina
In macroeconomics, our data come to us in the form of time series. Time series are a sequence of dated variables: GDP in 2000, GDP in 2001, GDP in 2002, and so on. Usually these data are annual, but they could also be quarterly or monthly (or even daily or hourly). If we go to the Economic Report of the President ( www.gpoaccess.gov/eop), we can find data for nominal GDP. In the United States, the Bureau of Economic Analysis (BEA; http://www.bea.gov/national/index.htm) in the Department of Commerce is responsible for calculating nominal GDP. Table 18.2.2 "Nominal GDP in the United States, 2000–2010" gives an example of a time series.
Year Nominal GDP (Billions of Dollars)
2000 9,951.5
2001 10,286.2
2002 10,642.3
2003 11,142.1
2004 11,867.8
2005 12,638.4
2006 13,398.9
2007 14,061.8
2008 14,369.1
2009 14,119.0
2010 14,660.2
Table $2$: Nominal GDP in the United States, 2000–2010
It is often more revealing to show a time series as a picture rather than a list of numbers. Figure 18.2.1 "Nominal GDP in the United States, 2000–2010" shows the data from Table 18.2.2 "Nominal GDP in the United States, 2000–2010" in a graph. Looking at this figure, we see immediately that the US economy grew over these years. The level of nominal GDP (in billions) was $9.8 trillion in 2000 and$13.2 trillion in 2006.
Figure $1$: Nominal GDP in the United States, 2000–2010
Nominal GDP in the United States grew for most of the last decade but declined in 2009.
Source: 2011 Economic Report of the President, accessed July 29, 2011, www.gpoaccess.gov/eop/tables11.html, Table B-1.
Let us return to your International Monetary Fund (IMF) mission in Argentina. From talking to other members of the team, you learn that the Argentine government has statistics on nominal GDP. This is good news, for it means you do have information on the total value of production in the economy. Figure 18.2.2 "Nominal GDP in Argentina, 1993–2002" shows nominal GDP for Argentina over the decade prior to your arrival (1993–2002). In 1993, it was 237 billion pesos. In 2002, it was 313 billion pesos. Thus nominal GDP grew by about one-third over the course of the decade.
Figure $2$: Nominal GDP in Argentina, 1993–2002
The graph shows nominal GDP in Argentina between 1993 and 2002. Nominal GDP grew overall during this period, although it decreased for several years in the second half of the decade.
Source: International Monetary Fund World Economic Outlook database ( http://www.imf.org/external/pubs/ft/weo/2010/01/index.htm).
Now suppose that in your hotel room one morning you hear on the radio that government statisticians in Argentina forecast that nominal GDP next year will be 300 million pesos greater than this year. How should you interpret this news? Without some context, it is difficult to make any judgment at all.
The first thing to do is to work out if 300 million pesos is a big number or a small number. It certainly sounds like a big number or looks like a big number if we write it out in full (300,000,000). If we stacked 300 million peso bills on top of each other, the pile would be over 100 miles high. But the real question is whether this is a big number relative to existing nominal GDP. We have been told that the change in nominal GDP is 300 million, but we would like to know what this is as a growth rate, which is a percentage change.
Toolkit: Section 31.21 "Growth Rates"
A growth rate is a percentage change in a variable from one year to the next. That is, a growth rate is the change in a variable over time divided by its value in the beginning period.
For example, the growth rate of GDP is calculated as follows:
In our example for Argentina, the percentage change is equal to the change in nominal GDP divided by its initial value. Remember than nominal GDP in 2002 was about 300 billion pesos, so
When we express this change in nominal GDP as a percentage, therefore, we see that it is in fact very small—one-tenth of 1 percent. If you heard on the radio that nominal GDP was expected to grow by 300 million pesos in a 300-billion peso economy, the correct conclusion would be that nominal GDP would hardly change at all. By contrast, if the news announced a projected increase in nominal GDP of 30 billion pesos, the percentage change is 30 billion/300 billion = 0.1 = 10 percent. This is a substantial change in nominal GDP.
Measuring Real GDP
In your bid to understand the economy of Argentina, you have seen that nominal GDP increased by one-third between 1993 and 2002. One possibility is that Argentina is producing one-third more pizzas than it was a decade ago—30 billion pizzas instead of 22.5 billion pizzas. This would be good news. Producing more pizzas is something we would normally think of as a good thing because it means that we are experiencing economic growth: there are more goods and services for people to consume.
In talking to people about the Argentine economy, however, you learn something disconcerting. They tell you that the prices of goods and services are greater this year than they were last year and much greater than they were a decade ago. You begin to wonder: perhaps Argentina is producing no more pizzas than before but instead pizzas have become one-third more expensive than they formerly were. We would typically feel very differently about this outcome. Yet another possibility is that there has been an increase in both the number of pizzas produced and the price of pizza, and the combined effect doubled nominal GDP. We need a way of distinguishing among these different possibilities.
Separating Nominal GDP into Price and Output
In our pizza economy, it is easy to tell the difference between an increase in production and an increase in prices. We can measure increased production by counting the number of pizzas, and we can measure increased prices by looking at the price of a pizza. We call the number of pizzas real gross domestic product (GDP) (the word real here indicates that we are effectively measuring in terms of goods and services rather than dollars), and we call the price of a pizza the price level in the economy.
Then it follows that
$nominal\ GDP\ =\ price\ level \times \ real\ GDP.$
In our example, the price level is 10 pesos, and real GDP is 30 billion pizzas. Multiplying these numbers together, we find that nominal GDP is indeed 300 billion pesos. Sometimes, for shorthand, we use the term price to mean the price level in a given year and the term output to mean real GDP in a given year.
Real GDP is the variable that most interests us because it measures the quantity of goods and services produced in an economy. We would therefore like to find a way to decompose nominal GDP into the price level and the level of real GDP in actual economies. But real economies produce lots of different goods and services, the prices of which are continually changing. In addition—unlike our fictional economy, where it makes sense to measure real GDP as the number of pizzas—there is no “natural unit” for real GDP in an actual economy.
In fact, even in our pizza economy, there is still an arbitrariness about the units. Imagine that we cut each pizza into 10 slices. Then we could just as easily say that real GDP is 300 billion pizza slices instead of 30 billion pizzas, but that the price level—the price per slice—is 1 peso. We would still conclude that nominal GDP—the number of slices multiplied by the price per slice—was 300 billion pesos.
So is it possible to say, in a real economy producing multiple goods and services, that nominal GDP is equal to the product of the price level and the level of real GDP? Does it still make sense to write
$nominal\ GDP\ =\ price\ level \times \ real\ GDP$
as we did for the pizza economy? The answer, as it turns out, is yes.
To see how this works, we begin by looking at how prices and output change from one year to another. Specifically, we divide 2013 nominal GDP by 2012 nominal GDP. This is one measure of the growth in nominal GDP from 2012 to 2013.Specifically, this measures the gross growth rate of nominal GDP. It is equal to 1 + the percentage change in nominal GDP. See the toolkit for details of the mathematics of growth rates. Remember that nominal GDP equals total output produced in a year, valued at the prices prevailing in that year. Comparing nominal GDP in 2012 and 2013 therefore gives us
Now we use a trick. Multiply above and below the line by “output in 2013 valued at 2012 prices” and then rearrange:
Look carefully at this calculation to make sure you understand what we did here.
Now examine the two ratios on the right-hand side of the second line. The first compares the cost of the same bundle of goods (output in 2013) at two different sets of prices—those prevailing in 2013 and those prevailing in 2012. Think of the bundle as being a grocery cart full of goods. If you compare how much it costs to buy exactly the same collection of goods at two different times, you have a measure of what has happened to prices.
The second ratio on the right-hand side is a measure of the increase in real GDP. It uses the same prices to compare the value of output in 2012 and 2013. In other words, it tells you how much it costs to buy two different collections of goods at exactly the same prices.
To reiterate, the first ratio compares the same bundle of goods at two different sets of prices. The second ratio compares two different bundles of goods at the same prices. We have succeeded in separating the change in nominal GDP into two components: a price change and a change in real GDP.
Measuring Real GDP and the Price Level
We can illustrate this technique using the data in Table 18.2.1 "Calculating Nominal GDP". In that example, the growth in nominal GDP equals 10.5 percent because
Now we choose an arbitrary year that we call the base year. For the base year, we set the price level equal to 1. In our calculations, we choose 2012 as our base year. Because nominal GDP equals the price level times real GDP, this means that real GDP in 2012 is $400. When we choose 2012 as our base year, we use the prices of T-shirts, music downloads, and meals in 2012 for our calculations of real GDP for 2012 and 2013. Table 18.2.3 "Real GDP Using 2012 as the Base Year" shows what we find. The first row is exactly the same as in Table 18.2.1 "Calculating Nominal GDP". Nominal GDP in 2012 is—by definition—the same as real GDP in 2012 because we are using 2012 as the base year. The second row of the table calculates real GDP for 2013; it uses 2013 quantities but 2012 prices. Notice also the heading in the final column of the table: “Real GDP (Year 2012 dollars).” The term in parentheses tells us that everything is being measured according to the prices that prevailed in our base year of 2012. Year T-shirts Music Downloads Meals Real GDP (Year 2012 Dollars) 2012 Price ($) Quantity 2012 Price ($) Quantity 2012 Price ($) Quantity
2012 20 10 1 50 25 6 400
2013 20 12 1 60 25 5 425
Table $3$: Real GDP Using 2012 as the Base Year
We previously calculated that 2013 nominal GDP—output in 2013 valued at 2013 prices—was $442. By contrast, Table 18.2.3 "Real GDP Using 2012 as the Base Year" shows that, when valued in year 2012 dollars, the total output of this economy in 2013 is$425. In other words,
Nominal GDP increased by 10.5 percent between the two years, but real GDP is increased by only 6.25 percent. From this we see that not all of the increase in nominal GDP is due to increased output. Some of the increase is because prices increased between 2012 and 2013.
In our pizza economy, we said that nominal GDP was equal to the price per pizza multiplied by the quantity of pizza. In our example here, we have calculated something very similar. Nominal GDP equals the price level multiplied by real GDP. In the base year, the price level equals 1 (that is what it means to choose the base year), and so real GDP equals nominal GDP in that year. Because we can calculate the increase in the price level and the increase in real GDP from one year to the next, we can obtain a time series for the price level and a time series for real GDP. In each year, nominal GDP equals the price level in that year times real GDP in that year.
There is, however, one difference between the calculation for our pizza economy and measurement in real economies. In the pizza economy, because there was a single good, we were able to measure real GDP in physical units—the number of pizzas. In real economies, there is no single good, and so we measure real GDP in base year dollars rather than as a physical quantity. The price level in, say, 2013 is not, strictly speaking, the price of real GDP in terms of 2013 dollars but rather is the price of a base year dollar in terms of 2013 dollars.
But this is a technical difference. From an intuitive point of view, it is simplest to think about real GDP as being a physical quantity—a number of pizzas. In this book we therefore imagine that real GDP is actually a bundle of goods and services all melded together to create a composite good. We call that good “units of real GDP,” and we call the price level the price of a unit of GDP. In fact, we could think about the pizza economy in that same way. Even a basic pizza is itself composed of dough, sauce, and cheese: it is a bundle of items melded into one. So when we talk about the physical quantity of pizza, we are really talking about the number of bundles of these ingredients. Likewise, when we talk of real GDP, we are talking about a bundle of goods that we measure in base year dollars.
Real GDP is our most basic measure of economic performance. It is a very broad measure because it tells us how much economic activity of any kind (at least, any kind that we can measure) is going on in our economy. Real GDP tells us how much we have produced of all the different goods and services that people enjoy and want to consume. For this reason, real GDP statistics are among the most closely watched of all the figures released by a government. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/18%3A_The_State_of_the_Economy/18.02%3A_Measuring_Economic_Activity.txt |
learning objective
After you have read this section, you should be able to answer the following questions:
1. How are price indices such as the Consumer Price Index (CPI) calculated?
2. What is the difference between the CPI and gross domestic product (GDP) deflator?
3. What are some of the difficulties of measuring changes in prices?
If nominal GDP increased in Argentina but real GDP did not, then prices must have increased. So now we look in more detail at the measurement of prices.
The Price Index
Remember that we defined the change in prices as follows:
We can use the data in Table 18.2.1 "Calculating Nominal GDP" to calculate this ratio as well. This time, however, we compare the cost of the same basket of goods (in this case, output in 2013) according to the prices prevailing at two different times. The basket of goods in 2013 is shown in Table 18.3.1 "Calculating the Price Index" as the quantities of the three goods and services produced that year: 12 T-shirts, 60 music downloads, and 5 meals. As we saw earlier, the cost in dollars of this basket of goods and services is \$442.
Year T-shirts Music Downloads Meals Cost of 2013 Basket (\$) Price Index
Price (\$) Quantity Price (\$) Quantity Price (\$) Quantity
2012 20 12 1 60 25 5 425 1.00
2013 22 12 0.80 60 26 5 442 1.04
Table \(1\): Calculating the Price Index
Table 18.3.1 "Calculating the Price Index" also shows the total cost of consuming the 2013 basket in 2012, which we already know is \$425. Thus the price index for 2012 is \$425/\$425 = 1, and the price index for 2013 is \$442/\$425 = 1.04.Frequently, the value for the price index is multiplied by 100, so the price index for 2013 would be given as 104. For the simple three-good economy described in Table 18.2.1 "Calculating Nominal GDP", we therefore have the following:
Prices increased by 4 percent, real GDP increased by 6.25 percent, and nominal GDP increased by 10.5 percent.
To summarize, the basic principle for calculating inflation is as follows: (1) We decide on a bundle of goods and look at how much it costs in a given year. (2) Then we look at the same bundle of goods in the following year and see how much it costs. (3) The ratio of the two is called a price index and provides a measure of one plus the inflation rate.
Toolkit: Section 31.8 "Correcting for Inflation"
A price index for a given year is calculated as the cost of a bundle of goods in that year divided by the cost of the same bundle in the base year. The growth rate of the price index from one year to the next is a measure of the inflation rate.
Different Price Indices
There are many different price indices that are constructed and used for different purposes. They can be constructed for particular categories of goods or regions, for example. If you listen to the news, you may hear references to the Producer Price Index or the Wholesale Price Index. Ultimately, the differences among different price indices simply come down to the bundle of goods that is chosen.
Figure 18.3.1 "An Example of a Price Index" shows an example of a very particular price index that was used by a supermarket in Thailand to advertise its prices. The store placed two supermarket carts at the entrance with the same bundle of goods in each. The one on the left, with the black label, showed the cost of this cartload of goods at the old prices. It used to cost 1,059.50 Thai baht (approximately US\$28). The one on the right, with the red label, showed that the cost of this same bundle of goods was now 916.00 Thai baht. The reduction in price for the basket of goods was 143.50 Thai baht, or about 13.5 percent.
A supermarket in Phuket, Thailand, used an actual basket of groceries to show that its prices had been reduced. This is an example of a price index.
Source: Image taken by the authors.
The Consumer Price Index
In this book, we use price indices that measure the general level of inflation. There are several such measures, but we do not need to worry about this. The differences among these different measures are usually small and typically unimportant for our basic understanding of the economy. The measure of inflation that we have used so far is called the GDP deflator, a price index that uses as the bundle of goods everything that goes into GDP. A more common measure of inflation is the Consumer Price Index (CPI), which uses as the bundle of goods the typical purchases of households.
The CPI is the most familiar measure of prices. When economic commentators speak of inflation, they usually mean the percentage change in the CPI. As the name suggests, the CPI is intended to measure inflation as consumers experience it. The bundle of goods included in the CPI is supposed to correspond to the bundle of goods purchased by a typical household. This means that certain goods that are included in GDP do not show up in the CPI. For example, an increase in the price of stealth bombers does not show up in the CPI because (we hope!) households do not buy stealth bombers. However, stealth bombers do show up in the GDP deflator. At the same time, certain goods that are not part of GDP are included in the CPI—most importantly, consumer goods that are imported from other countries. Because imported goods are not produced in the domestic economy, they do not show up in the GDP deflator; however, because domestic consumers purchase imported goods, they do show up in the CPI.
Households differ dramatically in their consumption patterns, so different households have very different experiences of inflation. An individual who drives 100 miles daily to get to work views variations in the price of gasoline very differently from someone who rides a bicycle to work. The CPI captures the average experience of all households, which can be quite different from the actual experience of an individual household.
Figure 18.3.2 "The Inflation Rate in the United States, 1914–2008" shows the CPI inflation rate (that is, the percentage change of the CPI) from 1914 to 2008 in the United States.Inflation data and more details about the construction of price indices can be found at the website of the Bureau of Labor Statistics (BLS; http://www.bls.gov). In some early years, prices actually decreased from one year to the next, meaning that the inflation rate was negative. Since 1960, however, the United States has experienced a positive inflation rate.
Figure \(2\): The Inflation Rate in the United States, 1914–2008
Figure 18.3.3 "The Price Level in Argentina" shows the price level in Argentina between 1993 and 2002. The most striking thing about this picture is that there was very little inflation for most of this period. In the final year, however, prices increased substantially. Notice that our picture for the United States shows the inflation rate, whereas for Argentina we are looking at the level of prices. Either way of presenting the data is valid, but it is critical to understand the difference between them. Make sure you understand the difference between the level of prices and the percentage change in prices.
Figure \(3\): The Price Level in Argentina
The price level in Argentina was roughly constant between 1993 and 2001. However, there was a big jump in the price level in 2002.
Source: International Monetary Fund World Economic Outlook database ( http://www.imf.org/external/pubs/ft/weo/2010/01/index.htm).
Calculation of the CPI in Practice
The actual calculation of the CPI is more complicated than our example suggests. The Bureau of Labor Statistics (BLS; http://www.bls.gov/cpi) is the US government agency that is responsible for this calculation, while other countries have similar agencies. The BLS procedure is, in essence, the one we have described: it compares the cost of the same bundle of goods in different years. However, the BLS confronts several difficulties that we have ignored so far.
1. Quality changes. Imagine that you now work for the BLS (you took this job after you left the International Monetary Fund [IMF]) and are asked to look at changes in the price of laptop computers. You decide to use the IBM ThinkPad computer.For the history of the ThinkPad, see “ThinkPad: A Brand That Made History,” Lenovo, accessed June 28, 2011, http://www.pc.ibm.com/ca/thinkpad/anniversary/history.html; for the 2011 specifications and prices, see “Lenovo Announces Premium ThinkPad Edge E220s, E420s SMB Notebooks,” ThinkPads.com, January 3, 2011, accessed July 20, 2011, www.thinkpads.com/2011/01/03/lenovo-announces-premium-thinkpad-edge-e220s-e420s-smb-notebooks. You discover that in 1992 a ThinkPad cost \$4,300 on average. Then you find that it is possible to purchase a ThinkPad in 2011 for \$899. You calculate the percentage change in the price as (\$899 − \$4,300)/\$4,300 = −\$3,401/\$4,300 = −0.79 and conclude that the ThinkPad is 79 percent cheaper than two decades previously. You report this to your boss and then go home.
But then you start to worry. The 2011 ThinkPad is nothing like the 1992 version. The 1992 computer had 120 MB of memory and weighed over 5.5 pounds. The 2011 ThinkPad has 4 GB of memory and weighs 2 pounds less. It has a vastly bigger hard drive, wireless Internet connection, and a superior display. In short, there were huge quality improvements over this period. A computer with the specifications of the 1992 ThinkPad would be worth much less than \$899. By ignoring the improvements in quality, you have understated how much the price of computers has fallen.
This problem is particularly acute for computers, but it applies to all sorts of different goods. The new car that you purchase today is very different from a car that your mother or your grandfather might have bought. Cars today come equipped with computerized braking systems, global positioning system (GPS) navigational tools, and numerous other sophisticated engineering features. They are also much more reliable; your grandparents will tell you that cars used to break down all the time, whereas now that is a relatively rare event. It would be a big mistake to say that a 2012 automobile is the same as a 1961 automobile.
2. New goods and old goods. The typical basket of goods bought by consumers is changing. In 1970, no one had a mobile phone, an MP3 player, or a plasma television. Similarly, people today are not buying vinyl records, videocassette recorders, or Polaroid cameras. The BLS needs to keep up with every change. As the economy evolves and new goods replace old ones, they must change the basket of goods.
3. Changes in purchasing patterns. The bundle purchased by the typical household also changes over time because of changes in the prices of goods and services. The typical household will substitute away from expensive goods to relatively cheaper ones. If the basket of goods is held fixed, the calculation of the CPI will overstate the increase in the cost of living. This effect is most severe if there are two goods that are very close substitutes and the price of one increases significantly relative to another.
Perhaps these seem like minor details in the calculation of the CPI. They are not. A government commission chaired by the economist Michael Boskin provided an extensive report on biases in computing the CPI in 1996. The Boskin Commission concluded the following: “The Commission’s best estimate of the size of the upward bias looking forward is 1.1 percentage points per year. The range of plausible values is 0.8 to 1.6 percentage points per year.” That is, the Boskin Commission concluded that if inflation as measured by the CPI was, say, 3.1 percent, the true inflation rate was only 2 percent. In response to these concerns with measurement, the BLS responded by taking actions to reduce the biases in the measurement of the CPI and deal more effectively with the introduction of new goods.For the complete Boskin Commission Report, see Advisory Commission to Study the Consumer Price Index, “Toward a More Accurate Measure of the Cost of Living,” Social Security Administration, December 4, 1996, accessed June 28, 2011, http://www.ssa.gov/history/reports/boskinrpt.html. For the BLS response to the report, see “Consumer Price Index: Executive Summary,” Bureau of Labor Statistics, October 16, 2011, accessed June 28, 2011, www.bls.gov/cpi/cpi0698b.htm.
Correcting for Inflation
The data on nominal and real GDP in Argentina illustrate the dangers of looking at nominal rather than real variables. Had you looked at only nominal GDP, you would have concluded that the Argentine economy had been growing between 1993 and 2002, when it was actually stagnating.
But many economic statistics—not only nominal GDP—are typically quoted in terms of dollars (pesos, euros, ringgit, or whatever the currency of the country is). To make sense of such statistics, we must understand whether changes in these statistics represent real changes in the economy or are simply a result of inflation.
Toolkit: Section 31.8 "Correcting for Inflation"
If you have some data expressed in nominal terms (for example, in dollars) and you want to covert them to real terms, use the following steps.
1. Select your deflator. In most cases, the CPI is the best deflator to use.
2. Select your base year. Find the value of the index in that base year.
3. For all years (including the base year), divide the value of the index in that year by the value in the base year. (This means that the value for the base year is 1.)
4. For each year, divide the value in the nominal data series by the number you calculated in Step 3. This gives you the value in base year dollars.
Here is an example of how to correct for inflation. Suppose that a sales manager wants to evaluate her company’s sales performance between 2000 and 2005. She gathers the sales data shown in Table 18.3.2 "Sales, 2000–2005".
Year Sales (Millions of Dollars)
2000 21.0
2001 22.3
2002 22.9
2003 23.7
2004 24.1
2005 24.7
Table \(2\): Sales, 2000–2005
At first glance, these numbers look reasonably encouraging. Sales have grown every year between 2000 and 2005. But then she remembers that these data are in nominal terms, and there was also some inflation over this time period. So she decides to correct for inflation. She first goes to the Economic Report of the President and downloads the data in Table 18.3.3 "Consumer Price Index, 2000–2005".See Economic Report of the President, 2011, Table B-60, accessed June 28, 2011, www.gpoaccess.gov/eop. She decides to use 2000 as the base year—she wants to measure sales in year 2000 dollars. So there are two steps to her calculations, as shown in Table 18.3.4 "Sales Data Corrected for Inflation, 2000–2005". First, she takes the CPI series and divides every term by the 2000 value (that is, 172.2). This gives the third column of Table 18.3.4 "Sales Data Corrected for Inflation, 2000–2005", labeled “Price Index.” Then she divides each of the sales figures by the corresponding price index to obtain the real (that is, corrected for inflation) value of sales. These are given in the final column of the table.
Year CPI
2000 172.2
2001 177.1
2002 179.9
2003 184.0
2004 188.9
2005 195.3
Table \(3\): Consumer Price Index, 2000–2005
Year CPI Price Index (Base = 2000) Sales (Millions of Dollars) Real Sales (Millions of Year 2000 Dollars)
2000 172.2 1.00 21.0 21.0
2001 177.1 1.03 22.3 21.7
2002 179.9 1.04 22.9 21.9
2003 184.0 1.06 23.7 22.2
2004 188.9 1.10 24.1 22.0
2005 195.3 1.13 24.7 21.8
Table \(4\): Sales Data Corrected for Inflation, 2000–2005
We can see that the sales data are much less rosy after we account for inflation. Sales were increasing between 2000 and 2003 in real terms, but real sales decreased in 2004 and 2005. Had she just looked at the dollar measure of sales, she would have completely missed the fact that the business had experienced a downturn in the last two years.
Economic statistics reported in the news or used by businesspeople are very often given in nominal rather than real terms. Perhaps the single most important piece of “economic literacy” that you can learn is that you should always correct for inflation. Likewise, you should be on your guard for misleading statistics that fail to make this correction. Here is an example from an article that appeared in the Washington Post. “The Clinton recovery has been far less egalitarian than the much-criticized Reagan ‘era of greed.’ Between 1990 and 1995, the [real average] family income actually declined slightly while the number of people with a net worth over \$1 million more than doubled.”See J. Kotkin and D. Friedman, “Keep the Champagne on Ice,” The Washington Post, reprinted in The Guardian Weekly, June 7, 1998. In fact, the quote in the newspaper was even more misleading because it did not even make it clear that the family income figure was adjusted for inflation.
Can you see why this sentence is so misleading? It mixes together a real measure and a nominal measure in the same sentence. Real family income—that is, family income corrected for inflation—declined in the first half of the 1990s. But the number of millionaires is a nominal measure. In a time of inflation, we would expect to have more millionaires, even if people are not really getting any richer.
Key Takeaways
• A price index is created by calculating the cost of purchasing a fixed basket of goods in different years.
• The CPI is a price index for goods and services, including imported goods, consumed by households, while the GDP deflator is based on all the goods and services that compose GDP.
• Calculating a price index is difficult due to the introduction of new products, quality changes, and changes in purchasing patterns.
Exercises
1. The BLS has an inflation calculator on its website ( http://data.bls.gov/cgi-bin/cpicalc.pl), which is shown in Figure 18.3.4 "BLS Inflation Calculator".
Figure \(4\): BLS Inflation Calculator
1. You enter an amount and two different years, and then it tells you the other amount. Explain the calculation that this program performs.
2. In Table 18.3.4 "Sales Data Corrected for Inflation, 2000–2005", calculate the inflation rate (that is, the percentage change in the price index) and the growth rate of sales in each year. What is the relationship between these two variables (a) when real sales are increasing and (b) when real sales are decreasing? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/18%3A_The_State_of_the_Economy/18.03%3A_Measuring_Prices_and_Inflation.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is the circular flow of income?
2. What is the national income identity?
Looking at some basic measurements of the economy has allowed you to be more concrete about the problems in Argentina. You report back to the International Monetary Fund (IMF) team that production has been declining in recent years. You also report that there was a recent increase in the price level. As yet, though, you do not know anything about either the causes or the consequences of these events. Measurement of the economy tells you what has happened, but it tells you neither why it happened nor what it means. Measurement is not enough. We need frameworks to help us make sense of the data that we gather.
Economists use many different kinds of frameworks to make sense of an economy. One of the most important is called the circular flow of income. To understand the circular flow, recall our working definition of economic activity: “goods and services produced for sale.” So far, we have focused on production. Now we think about the “for sale” part.
Toolkit: Section 31.27 "The Circular Flow of Income"
As individuals and firms buy and sell goods and services, money flows among the different sectors of the economy. The circular flow of income describes these flows of dollars. From a simple version of the circular flow, we learn that, as a matter of accounting,
\[gross\ domestic\ product\ (GDP)\ =\ income\ =\ production\ =\ spending.\]
This relationship lies at the heart of macroeconomic analysis.
There are two sides to every transaction. When you purchase a piece of computer software, you give money to the seller, and the seller gives the software to you. (You might literally hand over dollar bills and receive a CD, or you might enter a credit card number into a website entitling you to a download. The idea is the same either way.) There is a flow of money from you to the seller and a flow of goods or services from the seller to you. This is true for all transactions: as individuals and firms buy and sell goods and services, money flows among the different sectors of the economy. Macroeconomists follow the money. By tracking these flows, we can understand the links between different markets; by understanding these links, we gain insight into the functioning of an economy.
One linkage is between income and spending. The spending by households on goods and services is funded by the income that households earn. But this income comes from firms, and they get their income from the spending of households. Thus there is a circular flow of income in an economy as a whole.
Household income comes from two main sources: (1) Households contain workers who sell their time to firms and receive wages in return. (2) Households are the ultimate owners of the firms—shareholders live in houses too—and thus any profits that firms make are returned to households. All firms in an economy are owned by someone, and any profits they make do not vanish into thin air but must eventually show up as someone’s income.
Households take this income and do one of two things: they either spend it or save it. To start, let us figure out what would happen if no household income is saved. Households spend all their income, and this money becomes the revenue of firms. Firms send these revenues back to households, either as labor income or profits, and so the circular flow continues.
The Simplest Version of the Circular Flow
We can make this idea more precise, using the pizza economy to illustrate. Imagine that our economy is composed of two sectors, which we call households and firms. Households supply labor to firms and are paid wages in return. Firms use that labor to produce pizzas and sell those pizzas to households. There is a flow of goods (pizzas) from firms to households and a flow of labor services (worker hours) from households to firms. Because there are two sides to every transaction, there is also a flow of dollars from households to firms, as households purchase pizza, and a flow of dollars from firms to households, as firms pay workers.
For now, think of firms as very simple entities that pay out all the income they receive in the form of wages to workers. As a result, 300 billion pesos flow from the household sector to the firm sector (the purchase of pizzas) each year, while 300 billion pesos flow from the firm sector to the household sector (the payment of wages). These flows of pesos are illustrated in Figure 18.4.1 "The Simplest Version of the Circular Flow". Think of this diagram as representing the interaction of many households with many firms. A particular household works for one (or perhaps a few firms) but purchases goods and services from many firms. (If you like, imagine that different firms specialize in different kinds of pizza.) A feature of modern economies is that individuals specialize in production of goods and services but generalize in consumption by consuming many varieties of goods and services.
Figure \(1\): The Simplest Version of the Circular Flow
The circular flow of income follows the money in an economy. In the pizza economy, firms produce pizzas and sell them to households, while households sell labor to firms and purchase pizzas from them.
The circular flow reveals that there are several different ways to measure the level of economic activity. From the household perspective, we can look at either the amount of income earned by households or their level of spending. From the firm perspective, we can look at either the level of revenues earned from sales or the amount of their payments to workers and shareholders. In all cases, the level of nominal economic activity would be measured at 300 billion pesos.
Corresponding to the flows of pesos shown in Figure 18.4.1 "The Simplest Version of the Circular Flow", there are flows of goods and services between these sectors, as shown in Figure 18.4.2 "The Flows of Goods and Labor within the Circular Flow". The wage income received by consumers is payment for labor services that flow from households to firms. The consumption spending of households is payment for the goods that flow from firms to households.
There are flows of goods and labor services that correspond to the flows of pesos shown in Figure 18.4.1 "The Simplest Version of the Circular Flow". Three hundred billion pesos worth of pizza flows from firms to households, and 300 billion pesos worth of labor services flow from households to firms.
Of course, there are also flows of dollars within the household and firm sectors as well as between them. Importantly, firms purchase lots of goods and services from other firms. One of the beauties of the circular flow construct is that it allows us to describe overall economic activity without having to go into the detail of all the flows among firms.
Figure 18.4.3 "Income, Spending, Payments to Inputs, and Revenues in the Simple Circular Flow" shows us that the flows in and out of each sector must balance. In the household sector, total spending by the household equals total income for the household. If spending equals income for each individual household, then spending also equals income for the household sector as a whole. Similarly, each firm has a balance sheet. Accounting rules ensure that all of a firm’s revenues must ultimately show up on the other side of the balance sheet as payments for the inputs that the firm uses (in our simple example, the firm’s only input is labor). As this is true for each individual firm, it is also true for the sector as a whole.
Figure \(3\):
Income, Spending, Payments to Inputs, and Revenues in the Simple Circular Flow
In each household, and thus in the household sector as a whole, income must equal spending. In each firm, and thus in the firm sector as a whole, revenues must equal payments to inputs. GDP measures the production of the economy and total income in the economy. We can use the terms production, income, spending, and GDP interchangeably.
Although this version of the circular flow is simple, it teaches us four key insights that remain true (albeit in slightly refined forms) in more sophisticated versions as well.
1. Spending = production. The total value of all spending by households becomes an inflow into the firm sector and thus ends up on the revenue side of a firm’s balance sheet. The revenues received by firms provide us with a measure of the total value of production in an economy.
2. Production = payments to inputs. Flows in and out of the firm sector must balance. The revenues received by firms are ultimately paid out to households.
3. Payments to inputs = income. Firms are legal entities, not people. We may talk in common speech of a firm “making money,” but any income generated by a firm must ultimately end up in the hands of real people—that is, in the household sector of an economy. The total value of the goods produced by firms becomes an outflow of dollars from the firm sector. These dollars end up in the hands of households in the form of income. (This ownership is achieved through many forms, ranging from firms that are owned and operated by individuals to giant corporations whose ownership is determined by stock holdings. Not all households own firms in this way, but in macroeconomics it is sufficient to think about the average household that does own stock in firms.)
4. Income = spending. We complete the circle by looking at the household sector. The dollars that flow into the household sector are the income of that sector. They must equal the dollars that flow out of the household sector—its spending.
The circular flow of income highlights a critical fact of national income accounting:
\[GDP\ =\ income\ =\ spending\ =\ production.\]
Earlier, we emphasized that GDP measures the production of an economy. Now we see that GDP is equally a measure of the income of an economy. Again, this reflects the fact that there are two sides to each transaction. We can use the terms income, spending, production, and GDP completely interchangeably.
What does this mean for your assessment of Argentina? For one thing, it tells you that the decline in real GDP implies a corresponding decline in income. Economists pay a great deal of attention to real GDP statistics for exactly this reason: such statistics provide information on the total amount of income earned in an economy.
The Complete Circular Flow
Figure 18.4.4 "The Complete Circular Flow" shows a more complete version of the circular flow. It includes five sectors: the household and firm sectors that we have seen already, a government sector, a financial sector, and a foreign sector. In every sector of the circular flow, accounting rules tell us that the flow of money in must equal the flow of money out. When we look at this sector by sector, we discover five accounting relationships, each playing an important role in macroeconomics. For now, we take a very quick look at each one in turn.When we revisit each sector in different chapters of this book, we include more precise definitions and more detailed discussion of the individual flows (such as consumption or government purchases).
The circular flow of income describes the flows of money among the different sectors of an economy. This representation includes the five main sectors: households, firms, government, the financial sector, and the rest of the world.
The Firm Sector
The flows in and out of the firm sector of an economy must balance. The total flow of dollars from the firm sector measures the total value of production in the economy. The total flow of dollars into the firm sector equals total expenditures on GDP, which we divide up into four categories.
Toolkit: Section 31.27 "The Circular Flow of Income"
The national income identity is the condition that
\[production\ =\ consumption\ +\ investment\ +\ government\ purchases\ +\ net\ exports.\]
It is the most fundamental relationship in the national accounts.
Consumption refers to total expenditures by households on final goods and services. Investment refers to the purchase of goods and services that, in one way or another, help to produce more output in the future. Government purchases are all the purchases of goods and services by the government. Net exports are the difference between exports and imports: they measures the total expenditure flows associated with the rest of the world.These terms are explained in detail in Chapter 22 "The Great Depression".
The Household Sector
Households receive income from firms. They also receive money from the government (transfers) and must pay money to the government (taxes). Households spend some of their disposable income and save the rest. In other words,
\[income\ +\ transfers\ −\ taxes\ =\ consumption\ +\ private\ savings.\]
There are many different ways of saving, but we do not focus on these differences. We simply imagine that households take their savings to financial markets to purchase interest-bearing assets. Some individual households are net borrowers, but, overall, the household sector saves. There is, on net, a flow of dollars from the household sector to the financial sector of an economy. These dollars are then available for firms to borrow to build new factories, install up-to-date equipment, and so on. That is, they are available for investment.The flows in and out of the household sector are discussed in Chapter 27 "Income Taxes".
The Government Sector
From a macroeconomic perspective, the key functions of government are as follows:
• It purchases goods and services.
• It collects revenues through personal and corporate taxes and other fees.
• It gives transfers to households.
The amount that the government collects in taxes does not need to equal the amount that it pays out for government purchases and transfers. If the government spends more than it gathers in taxes, then it must borrow from the financial markets to make up the shortfall.
Figure 18.4.4 "The Complete Circular Flow" shows two flows into the government sector and one flow out. Since the flows in and out of the government sector must balance, we know that
\[government\ purchases\ =\ tax\ revenues\ −\ transfers\ +\ government\ borrowing.\]
Government borrowing is commonly referred to as the budget deficit. It is also possible that the government takes in more than it spends, in which case the government is saving rather than borrowing, so there is a budget surplus rather than a deficit.Government finances are discussed in Chapter 29 "Balancing the Budget".
The Financial Sector
The financial sector of an economy is at the heart of the circular flow. It summarizes the behavior of banks and other financial institutions. Most importantly, this sector of the circular flow shows us that the savings of households provide the source of investment funds for firms. On the left-hand side, the figure shows a flow of dollars from the household sector into financial markets, representing the saving of households. (Though we have not included it in Figure 18.14 "The Complete Circular Flow", firms also save, by means of profits that they retain to finance new investment rather than distribute to their shareholders. As far as the national accounts are concerned, it is as if firms sent these funds to the financial market and then borrowed them back again.) When we borrow from other countries, there is a second flow of dollars into the financial markets. On the right-hand side, there is a flow of money from the financial sector into the firm sector, representing the funds that are available to firms for investment purposes. The linkage between the saving of households and the investment of firms is one of the most important ideas in macroeconomics.
The financial sector is also linked to the government sector and the foreign sector. These flows can go in either direction. As we have already seen, if the government runs a deficit, it does so by borrowing from the financial markets. There is a flow from the financial sector to the government sector. This is the case we have drawn in Figure 18.14 "The Complete Circular Flow". If the government were to run a surplus, the flow would go in the other direction: government would provide an additional source of saving. The foreign sector can provide an additional source of funds for investment, if those in other countries decide they want to use some of their savings to purchase assets in our economy. In this case, there is a flow from the foreign sector into the financial sector. Again, this is the case we have drawn. If we lend to other countries, then the flow goes in the other direction.
The flows in and out of the financial sector must balance, so
\[investment\ +\ government\ borrowing\ =\ private\ savings\ +\ borrowing\ from\ other\ countries.\]
The Foreign Sector
The foreign sector is perhaps the hardest part of the circular flow to understand because we have to know how international transactions are carried out.
Some of the goods produced in an economy are not consumed by domestic households or firms in an economy but are instead exported to other countries. Whenever one country sells something to another country, it acquires an asset from that country in exchange. For example, suppose a US movie company sells DVDs to an Australian distributor. The simplest way to imagine this is to suppose that the distributor hands over Australian dollar bills to the movie company.. The movie company—and, more generally, the US economy—has now acquired a foreign asset—Australian dollars.
Because these Australian dollars can be used to purchase Australian goods and services at some time in the future, the US economy has acquired a claim on Australia. In effect, the United States has made a loan to Australia. It has sent goods to Australia in exchange for the promise that it can claim Australian products at some future date.
Similarly, some of the goods consumed in our economy are not produced locally. For example, suppose that a US restaurant chain purchases Argentine beef. These are imports. We could imagine that the restaurant chain hands over US dollars to the Argentine farmers. In this case, the United States has borrowed from Argentina. It has received goods from Argentina but has promised that it will give some goods or services to Argentina in the future.
Of course, international transactions in practice are more complicated than these simple examples. Yet the insight we have just uncovered remains true no matter how intricate the underlying financial transactions are. Exports are equivalent to a loan to the rest of the world. Imports are equivalent to borrowing from the rest of the world.
If we import more than we export, then we are borrowing from the rest of the world. We can see this by looking at the flows in and out of the foreign sector:
\[borrowing\ from\ abroad\ =\ imports\ −\ exports.\]
If we export more than we import, then—on net—we are lending to the rest of the world, and there is a flow of dollars from the financial markets to the rest of the world.
The Causes of a Decrease in Real GDP
We saw that, in Argentina, real GDP decreased between 1998 and 2002. The circular flow of income tells us that when real GDP decreases, it must also be the case that real production decreases and real spending decreases. The IMF team in 2002 wanted to understand why real GDP decreased. We are not going to answer that question in this chapter—after all, we are still at the very beginning of your study of macroeconomics. Still, the circular flow still teaches us something very important. If real GDP decreased, then there are really only two possibilities:
1. For some reason, firms decided to produce less output. As a consequence, households reduced their spending.
2. For some reason, households decided to spend less money. As a consequence, firms reduced their production.
Of course, it could be the case that both of these are true. This insight from the circular flow is a starting point for explaining what happened in Argentina and what happens in other countries when output decreases.
Key Takeaways
• The circular flow of income illustrates the links between income and spending in an economy. In its simplest form, revenue earned by firms by selling their output ultimately flows to households, which spend this income on the output produced by firms.
• The national income identity says that total spending must equal total output and also must equal total income.
Exercises
1. What changes in Figure 18.4.4 "The Complete Circular Flow" if the government takes in more revenue than it spends?
2. We said that borrowing from abroad equals imports minus exports. Is there an analogous relationship that holds for an individual? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/18%3A_The_State_of_the_Economy/18.04%3A_The_Circular_Flow_of_Income.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. When the focus is on real gross domestic product (real GDP), what aspects of economic welfare are then missed?
2. What are some other useful measures of economic welfare?
As you leave Argentina, you might well find yourself wondering about the implications of your work. You know that real GDP decreased, and from your study of the circular flow, you know that income decreased as well. Argentines have become poorer, as you might have guessed from the boarded-up stores you saw when you arrived in the country. You hope that, with the help of your observations, the International Monetary Fund (IMF) and the Argentine government will together find a way to enact good policies to increase the welfare—that is, happiness—of the individuals who live and work in the economy.
Our happiness is surely influenced by our material well-being—our ability to live in comfort; enjoy good food; have access to books, music, computers, and videogames; and so forth. In addition, it depends on our having the leisure time to enjoy these comforts; socialize with our friends; and go to movies, plays, and restaurants. However, our happiness depends on many other factors that are beyond the purview of economics and the influence of economic policymakers. Our happiness depends on our friends, families, health, and much more. Economics cannot help us very much with such matters. So, you wonder, is it enough to look at real GDP?
Real GDP and Economic Welfare
Real GDP is certainly a useful indicator of how well an economy is performing. This does not necessarily mean that it tells us about the welfare of those who live there. Some countries, such as China or India, have a large real GDP simply because they have large populations. Living standards in these countries are nonetheless relatively low because the large GDP must be shared by a very large number of people. To correct for this, we look at real GDP per person, which measures how much GDP would be available if we shared it equally across the entire population.
If two countries have substantially different levels of real GDP per person, we can fairly reliably infer that the richer country, by this measure, is also the country with higher living standards. Real GDP per person in Germany is about 25 times greater than real GDP per person in Kenya. Even a few minutes spent in the streets of Nairobi and Berlin would confirm that Germany enjoys much higher material living standards. However, when we compare countries with similar levels of real GDP per person, it is rash to assume that a richer country necessarily enjoys a higher standard of living. This is because there are several ways in which real GDP per person is flawed as an indicator of economic welfare.
Remember, first, that GDP measures market transactions only. National income accounts can measure activities that are traded only in markets. If people clean their own homes, tend their own gardens, repair their own cars, or cook their own meals, these activities are not included in our measurement of GDP. (There are a few exceptions. Most notably, GDP statistics impute a value to owner-occupied housing: GDP statistics effectively pretend that homeowners rent their houses from themselves.)
This leads to some unfortunate inconsistencies in GDP accounting. Suppose you and your neighbor both work as auto mechanics. If you each maintain and repair your own cars, these activities do not show up in GDP. But if you hire your neighbor to maintain your car, and she hires you to repair her car, then GDP does include this economic activity. Yet another possibility is that you barter with your neighbor, so she looks after your car and you look after hers but no money changes hands. Again, this work goes unrecorded in national accounts. Barter is more prevalent in developing countries than in developed countries and causes more of a problem for measurement of GDP in poorer countries. It is a particular source of difficulty when we want to compare economic activity in different countries.
People also value their leisure time. GDP measures the goods and services that people consume but does not tell us anything about how much time they must give up to produce those goods. For example, people in the United States are richer, on average, than people in Spain. But people in the United States work longer hours than people in Spain, and Spanish workers also enjoy much longer vacations. If we use measures of GDP to compare welfare in the United States and Spain, we will capture the fact that Americans can afford more DVD players, but we will miss the fact that they have less time to watch DVDs. GDP measures material well-being rather than overall welfare.
The economic activity that goes into the production of GDP also often has negative consequences for economic welfare that go unmeasured. A leading example is pollution. Coal-generated power plants generate sulfur dioxide as a by-product of the production of electricity. When sulfur dioxide gets into the atmosphere, it leads to acid rain that damages forests and buildings. This damage is not accounted for in GDP. Emissions from automobiles contribute to the buildup of greenhouse gases in the atmosphere, contributing to global climate change. They also generate smog (technically, particulate matter) that is damaging to health. These adverse effects are not accounted for in GDP.There have been many attempts by economists to amend the GDP measure to take environmental issues into account. For an early discussion on this issue, see William D. Nordhaus and James Tobin, “Is Growth Obsolete?” Yale University, Cowles Foundation paper 398, accessed June 28, 2011, http://cowles.econ.yale.edu/P/cp/p03b/p0398a.pdf.
Critics sometimes argue that GDP not only fails to measure negative effects from production but also erroneously includes measures taken to offset those measures. This criticism is misplaced. Consider the 2010 oil spill in the Gulf of Mexico. The environmental damage from that spill is not included in GDP, which is indeed a problem with using GDP to measure welfare. The costs of cleaning up the gulf are included in GDP, and the inclusion of cleanup costs does make GDP a better measure of welfare. To clean up means to produce a cleaner environment from a dirty environment, which increases economic welfare. The problem is the failure to include the original environmental damage, not the inclusion of the cleanup costs.
Finally, real GDP is an aggregate measure. It does not reflect the ways in which goods and services are distributed across the many households of an economy. In comparing two economies, we may feel differently about an economy in which resources are distributed relatively equitably compared to one in which some people are very rich and others are very poor, even if overall real GDP per person is the same. Similarly, we may feel quite differently about changes in real GDP depending on who is reaping the benefit of those changes.
In summary, real GDP is far from a perfect measure of economic welfare, but then again it is not designed to be. It is designed to measure economic activity, and it is—at best—an imperfect measure of material well-being. Nevertheless, when we want to understand what is happening to overall economic well-being or get an idea of comparative welfare in various countries, we begin with real GDP per person. For all its flaws, it is the best single indicator that we have.
Other Indicators of Societal Welfare
Because real GDP is an imperfect a measure of well-being, we look at other statistics as well to gauge overall economic welfare. Here are some examples of economic statistics that we also use as indicators of economic welfare.
Unemployment
The unemployment rate is one of the most frequently cited statistics about the macroeconomy; it is the percentage of people who are not currently employed but are actively seeking a job. It signals the difficulty households face in finding employment. GDP data are reported on a quarterly basis only, but unemployment statistics are reported monthly and so contain more up-to-date information than GDP. Chapter 23 "Jobs in the Macroeconomy" contains more discussion of the definition and measurement of the unemployment rate.
Figure 18.5.1 "The Unemployment Rate in the United States" shows the unemployment rate in the United States from 1940 to 2010. On average, the rate of unemployment over this period was 6.0 percent. The unemployment rate was at its highest—14.6 percent—in 1940 and its lowest—1.2 percent—in 1944. The low unemployment in 1944 was largely due to World War II (and is an indication that low unemployment is not always a sign that all is well in an economy). From 1995 to 2008, the unemployment rate was never above 6 percent, but it jumped to 9.3 percent in the major recession of 2008 and by mid-2011 had still not fallen back below 9 percent.
In the United States, defining and measuring the unemployment rate and other labor market variables is the job of the Bureau of Labor Statistics (BLS; http://www.bls.gov/cps/home.htm). Each month, about 60,000 households are asked about their recent employment experience. The BLS takes care to be sure that the sample is representative of the entire population of the United States. Notice that it is households who are interviewed, not people. So when a household is interviewed, information is acquired about all household members age 16 and over.To be more precise, in addition to being age 16 or older, the survey excludes people in an institution (such as prison) or in the armed forces. As a consequence of the interview, individuals are placed in one of three categories: (1) out of the labor force, (2) in the labor force and working, and (3) in the labor force and looking for a job. Similar surveys are conducted to measure unemployment in other countries.
The (civilian) labor force is all individuals who are either working or actively looking for work. That is, it comprises all employed and unemployed workers. Individuals who are not in the labor force are neither employed nor looking for a job. These include those at school or choosing to stay at home. Individuals in the labor force are either employed or seeking work. Employment can be temporary or even part time; as long as someone has a job, he or she is counted as employed. Those who are not at work due to vacation, illness or family issues but who still have jobs are also counted as employed.
The other group in the labor force is a bit more problematic: what exactly does it mean to be looking for a job? The BLS considers you unemployed if you do not have a job and have been seeking one during the past four weeks. Here, “seeking” is intended to be active (going out for job interviews), not passive (reading want ads). Individuals on temporary layoff are considered to be unemployed even if they are not actively looking for a new job. The BLS does not directly ask individuals to classify themselves into one of these three categories. Instead, BLS interviewers ask a series of questions to facilitate the classification. The sum of the civilian labor force and those out of the labor force equals the civilian working age population. Figure 18.5.2 "The Unemployment Rate in Argentina" shows the unemployment rate in Argentina between 1993 and 2002. Unemployment was quite high throughout this period: it was in excess of 10 percent in every year from 1994 onward. In addition, the unemployment rate increased substantially in the period when real GDP was decreasing, from 12.8 percent in 1998 to almost 20 percent in 2002. The economic distress you witnessed on the streets of Buenos Aires is reflected in this statistic.
The unemployment rate in Argentina was about 10 percent in 1993. It increased sharply over the next two years, decreased somewhat in the mid to late 1990s, and then increased again to almost 20 percent in 2002.
Source: Ministra de Economía y Producción de Argentina.
Real Wages
Average real GDP figures tell us nothing about how GDP is shared in an economy. They tell us how big the pie is but not who has the largest and smallest slices. Economists therefore also look at other measures that tell us about the economic environment as it is experienced by workers and households.
Wages in an economy provide a sense of how workers are doing. However, the wage in dollars—the nominal wage—is not the best indicator. While salaries and pay scales for jobs are quoted in dollar terms, decisions on whether or not to take a job and how many hours to work at that job depend on what those dollars can buy in terms of goods and services. If all prices in the economy were to double, then \$10 would buy only half as much as it used to, so a job paying \$10 an hour would seem much less attractive than it did before.
For this reason, we instead look at the real wage in the economy. As with real GDP, real here refers to the fact that we are correcting for inflation. It is real wages—not nominal wages—that tell us how an economy is doing. To convert nominal wages to real wages, we need a price index, and because we are looking at how much households can buy with their wages, we usually choose the Consumer Price Index (CPI) as the index.
Toolkit: Section 31.3 "The Labor Market"
The real wage is the wage corrected for inflation. To obtain the real wage, simply divide the wage in dollars—the nominal wage—by the price level:
Figure 18.5.3 "Real and Nominal Wages" shows the nominal (hourly) wage paid to private sector industrial workers from 1964 to 2010. Over this period, the nominal wage rate increased almost eightfold from a low of \$2.50 in January 1964 to nearly \$19.00 by the end of the period.“Average Hourly Earnings: Total Private Industries” from the Bureau of Labor Statistics, The Employment Situation, which is seasonally adjusted. The CPI is the “Consumer Price Index for All Urban Consumers: All Items CPIAUCNS,” Bureau of Labor Statistics Consumer Price Index, 1982 − 84 = 100. The real wage series in Figure 18.5.3 "Real and Nominal Wages" shows the nominal wage divided by the CPI (times 100 so that the real and nominal wages are equal in the base year of the CPI). The nominal wage increased over this period by over five times, but the real wage actually decreased at times. It peaked at near \$9.50 in 1973, decreased to \$7.62 in 1995, and has risen only slowly since that time.
Figure \(3\): Real and Nominal Wages
Source: US Department of Labor, Bureau of Labor Statistics, http://stats.bls.gov/lpc/data.htm
It is a remarkable fact that, even though US real GDP is now more than 150 percent greater than it was in the early 1970s, real wages are still significantly lower than they were at that time. What is going on here? Part of the story is that other forms of nonwage compensation have become increasingly significant over the past few decades. The most important of these are health-care benefits. When these and other benefits are included, we find that overall compensation has increased reasonably steadily and is about 50 percent greater now than in the early 1970s.More precisely, real hourly compensation in the nonfarm business sector increased by 51.7 percent between 1970 and 2007. See “Labor Productivity and Costs,” Bureau of Labor Statistics, accessed June 28, 2011, http://stats.bls.gov/lpc/data.htm. Total compensation is, in fact, a better measure than real wages. Even so, total compensation has been increasing at a far slower rate than real GDP over the last few decades.
Noneconomic Indicators of Welfare
We turn finally to some noneconomic measures of societal welfare, such as statistics on health and education. Table 18.5.1 "Noneconomic Indicators of Welfare" shows some examples of indicators for four countries.“The World Factbook,” Central Intelligence Agency, accessed June 28, 2011, https://www.cia.gov/library/publications/the-world-factbook/index.html; “The Complete World Development Report Online,” World Bank, accessed June 28, 2011, wdr2011.worldbank.org/WDR2011_Data. Large differences in GDP per person, such as the difference between the United States and Argentina, are reflected in these other measures. GDP per person is about three times greater in the United States than in Argentina, and the United States also has higher adult literacy, higher secondary school enrolment, lower infant mortality, and higher life expectancy.
Indicator United States United Kingdom Greece Argentina
GDP per person, 2005 (\$US) 42,000 30,900 22,800 13,700
Infant mortality rate, 2006 (deaths per 1,000 live births) 6.43 5.08 5.43 14.73
Life expectancy at birth, 2006 (years) 77.85 78.54 79.24 76.12
Adult literacy rate, 2003 (%) 99.0 99.0 97.5 97.1
Secondary school enrollment ratio, 2002–3 (%) 88 95 86 81
Table \(1\): Noneconomic Indicators of Welfare
Differences in GDP per person are a much less reliable guide when we compare relatively rich countries. For example, the United States has greater GDP per person than the United Kingdom or Greece. But both of those countries have lower infant mortality rates and higher life expectancy. They also have similar rates of literacy and school enrollment. In fact, based on these measures, the United Kingdom looks like a more attractive country to live in than the United States, even though its GDP per person is 25 percent lower.
Key Takeaways
• Real GDP measures total output and thus total income in an economy, but it does not measure economic activity at home, ignores income distribution, and excludes the effects of economic activity on the environment.
• Measures of unemployment, real wages, and indicators of health and education are also useful indicators of economic welfare.
Exercises
1. If there is an increase in investment and an associated increase in real GDP, why does this increase economic welfare?
2. If there is a decrease in real wages and an offsetting increase in a firm’s profits, does this affect overall household income? If not, what effect does it have on the household sector? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/18%3A_The_State_of_the_Economy/18.05%3A_The_Meaning_of_Real_GDP.txt |
In Conclusion
Understanding the meaning and measurement of macroeconomic variables is vital for your ability to evaluate the abundance of information you receive through various forms of the media about the state of the aggregate economy. The difficulties faced by the team of International Monetary Fund (IMF) economists with which we opened the chapter are not that different from the problems each of us faces in understanding what is happening in the economy.
The concepts and variables you have discovered in this chapter are used over and over again in the various applications discussed in this book. We use the concepts of real gross domestic product (real GDP), the inflation rate, the unemployment rate, and so forth almost everywhere in our study of macroeconomics.
Key Links
exercises
1. Which of the following variables are stocks? Which are flows?
1. The number of cars parked on the street where you live.
2. The number of cars that drive past your house every day.
3. The number of people losing their jobs and becoming unemployed.
4. The blue jeans on the shelves of a GAP store.
5. The amount of water in a reservoir.
6. The amount of money you have on your person right now.
7. The amount of money you spent this week.
2. Suppose an economy produces at least as much—and maybe more—of every good and service this year compared to last year. Also suppose that the price of every single good and service is at least as high this year as it was last year. What, if anything, can you conclude about nominal GDP, real GDP, and the price level between the two years?
3. Why do we exclude intermediate goods when calculating GDP?
4. Redo Table 18.2.3 "Real GDP Using 2012 as the Base Year" assuming that 2013 is the base year.
5. Suppose that Australia had nominal GDP last year equal to 1 trillion Australian dollars and that in the first quarter of this year, its nominal GDP is 252 billion Australian dollars. What is Australia’s annualized growth rate of nominal GDP?
6. Suppose that, between 2012 and 2013, a country experiences 3 percent negative inflation (this is known as deflation). In other words, prices are on average 3 percent lower in 2013 compared to 2012. However, the economy also experiences real economic growth of 5 percent. Is nominal GDP in 2013 greater or less than in 2012?
7. If nominal GDP in country A grows faster than nominal GDP in country B, what, if anything, can you conclude about the inflation rates in the two countries?
8. Suppose that the price of Brazilian coffee decreases. What does that imply for the Consumer Price Index (CPI) in Germany? What does that imply for the GDP deflator in Japan?
9. Is it possible for prices to be increasing and the inflation rate to be decreasing at the same time? Explain why or why not.
10. Is it possible for an economy’s production to increase at the same time that total income in the economy decreases? Explain why or why not.
11. Which of the following people are classified as unemployed?
1. A full-time student who also works part time in a store selling CDs.
2. A worker who would like a job but has given up looking because she was unable to find one.
3. An autoworker who was recently laid off and is looking for a new job.
4. A member of the military who is not currently on active duty.
5. A woman on maternity leave from her job.
6. A 70-year-old man who is actively applying for jobs.
12. Give three reasons why real GDP is an imperfect measure of economic welfare.
Economics Detective
1. Update Table 18.2.2 "Nominal GDP in the United States, 2000–2010" and Figure 18.2.1 "Nominal GDP in the United States, 2000–2010" using data from the Bureau of Economic Analysis (BEA). Using the IMF World Economic Outlook Database ( http://www.imf.org/external/pubs/ft/weo/2010/01/weodata/index.aspx), create tables to show nominal GDP, the GDP price deflator, and real GDP for Argentina.
2. A version of GDP that takes into account environmental effects is called “environmental accounting” or “green accounting.” Use the Internet to find a discussion of this alternative way of calculating GDP. List some of the differences between the usual way of calculating GDP and the environmental or green accounting method. Do other countries employ these alternative measures?
3. Try to find out whether people in richer countries are happier than those in poorer countries.
Spreadsheet Exercise
Year T-shirts Music Downloads Meals
Price (\$) Quantity Price (\$) Quantity Price (\$) Quantity
2012 25 12 1 60 25 5
2013 30 10 1.80 50 23 2
TABLE \(1\): DATA
1. Using the data in the preceding table, reconstruct Table 18.2.1 "Calculating Nominal GDP" to calculate nominal GDP, Table 18.2.3 "Real GDP Using 2012 as the Base Year" to calculate real GDP, and Table 18.3.1 "Calculating the Price Index" to calculate a price index and the inflation rate. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/18%3A_The_State_of_the_Economy/18.06%3A_End-of-Chapter_Material.txt |
Here are some headlines from the fall of 2008. If you were following the news during this time period, you probably saw stories like these. The first excerpt talks about houses in the United States.
Fallout from Financial Crisis Hammers Housing
The nation is on track to build fewer homes this year than at any time since the end of World War II, adding to the woes of an economy that analysts said Friday has almost certainly entered a recession.
[…]
David Seiders, chief economist for the group, said builders are being hit by a double whammy from the financial turmoil: It’s harder for them to get loans to pursue new houses, and more difficult to sell those they do build.
[…]Martin Crutsinger, “Fallout from Financial Crisis Hammers Housing,” USA Today, Money, October 17, 2008, accessed June 28, 2011, http://www.usatoday.com/money/topstories/2008-10-16-3784489146_x.htm.
The next excerpt also concerns housing but this time in the United Kingdom.
Financial Crisis: House-Price Slump to Cost Economy £50 Billion
House prices are set to fall 35 per cent from last year’s peak, as the property slump costs the wider economy almost £50bn as people stop buying homes, economists warned.
With house prices predicted to make their biggest fall in British history by dropping 35 per cent by autumn next year, the associated consumer spending is expected to plunge, they said.
[…]
This is expected to have a huge impact on the wider economy as each house sale triggers around £4,000 in new spending on household goods, on items such as washing machines and other white goods.
[…]
The lack of spending in these areas will hit employment, with some analysts forecasting that the construction sector alone could see a loss of up to 350,000 jobs within the next five years.
[…]Myra Butterworth, “Financial Crisis: House-Price Slump to Cost Economy £50 Billion,” The Telegraph, October 21, 2008, accessed June 28, 2011, www.telegraph.co.uk/finance/economics/houseprices/3235741/Financial-crisis-House-price-slump-to-cost-economy-50-billion.html.
Taking these excerpts together, we notice four things: (1) There was a housing slump—fewer houses being bought and sold, and house prices decreasing—in both the United Kingdom and the United States at around the same time. (2) Both are linked to a financial crisis. (3) These slumps affect other parts of the economy. (4) The housing problems lead to job losses.
The next excerpt tells us that the crisis also affected the value of the US dollar.
Financial Crisis Has One Beneficiary: The Dollar
The great market upheaval of 2008 has stripped 45 percent from the value of global equities, led bank lending to nearly dry up and caused commodity prices to crash from stratospheric heights. And now, paradoxically, it is helping to lift the long-suffering dollar.
[…]See David Jolly, “Global Financial Crisis Has One Beneficiary: The Dollar,” New York Times, October 22, 2008, accessed June 28, 2011, http://www.nytimes.com/2008/10/22/business/worldbusiness/22iht-dollar.4.17174760.html.
This excerpt tells us that the financial crisis has also affected other prices in the economies of the world. The price of equities—shares in companies—decreased, as did the price of goods such as basic minerals (copper and tin, for example) and basic foods (rice and coffee, for example). But even as these items became less valuable, the US dollar became more valuable. The price of the US dollar increased.
The Chinese economy was also affected by the crisis:
Agricultural Products Export Growth Slows Down in 2008
China’s agricultural products exports rose 9.8 percent year-on-year in 2008 to \$40.19 billion, the General Administration of Customs said on Wednesday.
According to the statistics, export growth declined 8.2 percentage points from a year earlier. Exports in the last two months of 2008 fell 6.9 percent and 7.2 percent to \$3.47 billion and \$3.76 billion respectively over the same period of 2007.
Although the country has increased export rebates for some agricultural products and lowered or even canceled the export tax, exports are unlikely to see a quick rebound in the near future. Poor overseas demand and falling prices in the international market amid the financial crisis, as well as the increasing distrust in China’s food quality are likely to stifle export growth, the General Administration of Customs said.
[…]See Tong Hao, “Agricultural Products Export Growth Slows Down in 2008,” China Daily, February 11, 2009, accessed June 28, 2011, http://www.chinadaily.com.cn/bizchina/2009-02/11/content_7467089.htm.
The excerpt tells us that China’s exports of agricultural products have been growing rapidly, reaching a growth rate of nearly 10 percent in 2008. But they had been growing even faster in the previous year. The effects of the financial crisis and the economic downturn are clear: the amount of exports decreased at the end of 2008 (and in fact fell throughout 2009 as well).
We have shown a few headlines about the impact of the 2008 financial crisis. We could have picked thousands of others. For example, if you enter into a search engine the terms financial crisis and XYZ, where XYZ is just about any product or international currency, you will probably find dozens, perhaps hundreds, of articles. The financial crisis of 2008 affected just about every market—all around the world.
Our task in this chapter is certainly not to fully understand these events. Our goals here are much more modest. First, we want to develop the supply-and-demand framework—perhaps the most basic tool in economics—to understand how an event affecting some good or service leads to changes in the price of that good or service as well as changes in the quantity that is bought and sold. Second, we want to explore some of the ways in which different markets in the economy are linked, for linkages across markets are among the most important features of macroeconomic analysis. The financial crisis is a good illustration because this single event affected so many markets.
Understanding the sources and consequences of changing prices and quantities in the economy is one of the key tasks of an economist. There is an almost endless list of such analyses in economics. In fact, most of the applications in this textbook ultimately come down to understanding, explaining, and predicting changes in prices and quantities. The two questions that motivate this chapter are as follows:
What determines price and quantity in a market?
How are markets interconnected?
Road Map
The story of the crisis of 2008 is fascinating and worth understanding in some detail. We begin with the basics of supply and demand, looking at a single market—the market for houses. We explain how the equilibrium price and quantity in this market are determined, which allows us to understand why the price of housing changes. This is a first step to understanding the crisis of 2008 because the housing market was central to that story.
The story began in the housing market but did not end there. It spread across the economy and across the world. Hence we next look at three significant markets in the economy: the labor market, the credit market, and the foreign exchange market. Understanding how these three markets work is necessary for a good understanding of macroeconomics. We use these markets to provide more illustrations of supply and demand in action. Finally, we look at how markets are linked together to see how what might have seemed like a minor problem in one market turned into a cataclysmic event for the world’s economies.
Throughout this chapter, we use the term “the crisis of 2008” as shorthand, but the first signs of the crisis emerged well before that year, and the effects of the crisis are still being felt several years later. The crisis was a complex event, and right now, at the beginning of your studies of macroeconomics, we are not yet ready to delve deeply into a detailed analysis of those events. We return to the crisis in Chapter 30 "The Global Financial Crisis", which is a capstone chapter that brings together most of the tools of macroeconomics from this book. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/19%3A_The_Interconnected_Economy/19.01%3A_A_Financial_Crisis_in_the_News.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What factors underlie the demand for housing?
2. What factors underlie the supply of housing?
3. What determines the amount of housing traded and the price of housing?
The first two articles we quoted from made it clear that the housing market was heavily affected by the financial crisis. More than that, it was where the crisis began—and so it is where we begin our story.
We start with the market for new homes, which are part of real gross domestic product (real GDP). (The buying and selling of existing homes is not counted in GDP.) New homes are supplied by construction firms and demanded by families wishing to live in a new home. New homes are also bought by speculators who purchase houses in the hope that they can resell them for a higher price in the future.
Toolkit: Section 31.9 "Supply and Demand"
Supply and demand is a framework we use to explain and predict the equilibrium price and quantity of a good. A point on the market supply curve shows the quantity that suppliers are willing to sell for a given price. A point on the market demand curve shows the quantity that demanders are willing to buy for a given price. The intersection of supply and demand determines the equilibrium price and quantity that will prevail in the market.
The toolkit contains a presentation of supply and demand that you can use for reference purposes in this and the following chapters.
The supply-and-demand framework applies to the case that economists call a competitive market. A market is said to be competitive, or, more precisely, to exhibit perfect competition, under two conditions:
1. There are many buyers and many sellers, all of whom are small relative to the market.
2. The goods that sellers produce are perfect substitutes.
In a competitive market, buyers and sellers take the price as given; they think their actions have no effect on the price in the market.
Demand
The market demand for housing is shown in Figure 19.2.1 "The Market Demand for Houses". We call this the market demand curve because it reflects the choices of the many households in the economy. In macroeconomics, we typically look at markets at this level of aggregation and do not worry much about the individual decisions that underlie curves such as this one.
The market demand curve shows the quantity of houses demanded at each price.
As the price of housing decreases, the quantity demanded increases. This is an example of the law of demand, which derives from two effects:
1. As the price of a good or service decreases, more individuals choose to buy a positive quantity rather than zero.
2. As the price of a good or a service decreases, individuals choose to buy a larger quantity.
In the case of the market for housing, the first of these is more important. Most people own either zero houses or one house. As houses become cheaper, more people decide that they can afford a house, so the quantity demanded increases. A few people might decide to buy an additional house, but they would presumably be in the rich minority. For other goods, such as chocolate bars or shoeshines, the second effect is more important: as price decreases, people increase the quantity that they buy.
Shifts in Demand
When we draw a demand curve, we are varying the price but holding everything else fixed. In particular, we hold fixed the level of income, the prices of other goods and services in the economy, and the tastes of households. If these other factors change, then the market demand curve will shift—that is, the quantity demanded will change at each price.
A leftward shift of the market demand curve for houses, as indicated in Figure 19.2.2 "A Shift in the Market Demand Curve", could be caused by many factors, including the following:
• A decrease in the incomes of households in the market
• Concerns about the future health of the economy
• A reduction in the price of a typical apartment rental
• An increase in the interest rates for mortgages
• A change in social tastes so that buying a house is no longer viewed as a status symbol
Figure \(2\): A Shift in the Market Demand Curve
If there is a decrease in demand for houses, then fewer houses are demanded at each price. The demand curve shifts leftward.
Supply
The counterpart to the market demand curve is the market supply curve, which is obtained by adding together the individual supply curves in the economy. The supply curve slopes upward: as price increases, the quantity supplied to the market increases. As with demand, there are two underlying effects.
1. As price increases, more firms decide to enter the market—that is, these firms produce some positive quantity rather than zero.
2. As price increases, firms increase the quantity that they wish to produce.
Figure \(3\): The Market Supply of Houses
The market supply curve shows the quantity of houses supplied at each price. It has a positive slope: as the price of houses increases, the number of houses supplied to the market increases as well.
Shifts in Supply
When we draw a supply curve, we again vary the price but hold everything else fixed. A change in any other factor will cause the market supply curve to shift. A leftward shift of the market supply curve for houses, as indicated in Figure 19.2.4 "A Shift in Supply of Houses", could be caused by many factors, including the following:
• Increases in the costs of production, such as wages, the cost of borrowing, or the price of oil
• Bad weather that delays or damages construction in process
• Changes in regulations that make it harder to build
If there is a decrease in supply of houses, then fewer houses are supplied at each price. The supply curve shifts leftward.
Market Equilibrium: What Determines the Price of Housing?
We now put the market demand and market supply curves together to give us the supply-and-demand picture in Figure 19.2.5 "Market Equilibrium". The point where supply and demand meet is the equilibrium in the market. At this point, there is a perfect match between the amount that buyers want to buy and the amount that sellers want to sell.
Toolkit: Section 31.9 "Supply and Demand"
Equilibrium in a market refers to an equilibrium price and an equilibrium quantity and has the following features:
• Given the equilibrium price, sellers supply the equilibrium quantity.
• Given the equilibrium price, buyers demand the equilibrium quantity.
In a competitive market, equilibrium price and quantity are determined by the intersection of the supply and demand curves.
We speak of equilibrium because there is a balancing of the forces of supply and demand in the market. At the equilibrium price, suppliers of the good can sell as much as they wish, and demanders of the good can buy as much of the good as they wish. There are no disappointed buyers or sellers. Because the demand curve has a negative slope and the supply curve has a positive slope, supply and demand will cross once, and both equilibrium price and equilibrium quantity will be positive.
Table 19.2.1 "Market Equilibrium: An Example" provides an example of market equilibrium. It gives market supply and market demand for four different prices. Equilibrium occurs at a price of \$100,000 and a quantity of 50 new houses.
Price (\$) Market Supply Market Demand
10,000 5 95
50,000 25 75
100,000 50 50
200,000 100 0
Table \(1\): Market Equilibrium: An Example
Economists typically believe that a perfectly competitive market is likely to reach equilibrium. The reasons for this belief are as follows:
• If price is different from the equilibrium price, then there will be an imbalance between demand and supply. This gives buyers and sellers an incentive to behave differently. For example, if price is less than the equilibrium price, demand will exceed supply. Disappointed buyers might start bidding up the price, or sellers might realize they could charge a higher price. The opposite is true if the price is too high: suppliers might be tempted to try cutting prices, while buyers might look for better deals.
• There is strong support for market predictions in the evidence from experimental markets. When buyers and sellers meet individually and bargain over prices, we typically see an outcome very similar to the market outcome in Figure 19.2.5 "Market Equilibrium".
• The supply-and-demand framework generally provides reliable predictions about the movement of prices.
Pictures like Figure 19.2.5 "Market Equilibrium" are useful to help understand how the market works. Keep in mind, however, that firms and households in the market do not need any of this information. This is one of the beauties of the market. All an individual firm or household needs to know is the prevailing market price. All the coordination occurs through the workings of the market.
Key Takeaways
• The primary factor influencing demand for housing is the price of housing. By the law of demand, as price decreases, the quantity of housing demanded increases. The demand for housing also depends on the wealth of households, their current income, and interest rates.
• The primary factor influencing supply of housing is the price of housing. As price increases, the quantity supplied also increases. The supply of housing is shifted by changes in the price of inputs and changes in technology.
• The quantity and price of housing traded is determined by the equilibrium of the housing market.
Exercises
1. What would be the impact of a decrease in the cost of borrowing on the market supply curve of housing? What would be the impact of a decrease in the cost of borrowing on the market demand curve?
2. Name two events that would cause the housing market supply curve to shift rightward. Name two events that would cause the housing market demand curve to shift rightward. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/19%3A_The_Interconnected_Economy/19.02%3A_Housing_Supply_and_Demand.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What are exogenous and endogenous events?
2. How does the equilibrium of a market respond to changes in exogenous variables?
3. What is comparative statics, and how is it used?
A driving factor in the crisis of 2008 was a decrease in the price of new housing. We can use our supply-and-demand tool to help us understand that. We use the framework to make predictions about the effects of events on economic outcomes. More precisely, economists predict the effects of exogenous events on equilibrium prices and quantities.
Toolkit: Section 31.16 "Comparative Statics"
An exogenous variable is something that comes from outside a model and is not explained in our analysis. An endogenous variable is one that is explained within our analysis. When using the supply-and-demand framework, price and quantity are endogenous variables; everything else is exogenous.
A Shift in Demand for Housing
The following is a typical account of the housing market crisis in 2008:
The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006. High default rates on “subprime” and adjustable rate mortgages (ARM), began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. […] However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Falling prices also resulted in 23% of U.S. homes worth less than the mortgage loan by September 2010, providing a financial incentive for borrowers to enter foreclosure.“Subprime Mortgage Crisis,” Wikipedia, accessed June 28, 2011, http://en.Wikipedia.org/wiki/Subprime_mortgage_crisis.
This quote identifies two forces that influenced the demand for housing in 2007–8. The first was expectations of future home prices. One of the gains from owning a house is the possibility that you can sell it at a higher price in the future. Prior to 2007, there had been a fairly consistent tendency for house prices to increase, but the quote seems to indicate that people began to doubt that this trend would continue. As a consequence, the demand for new homes decreased. The second force in the market for new housing was the availability of credit. Most households buy a new home by obtaining a loan (a mortgage) to cover some of the price of the house. During 2007 and 2008, it became increasingly difficult to obtain a mortgage. This was in contrast to a few years earlier when lending standards were easier, and many households easily qualified for mortgages.
These forces affect market demand. The anticipation of lower home prices in the future implies that fewer individuals will choose to buy a home now. Further, if financing is more expensive, then less housing will be purchased. These effects operate given the current price of housing. That is, at any given current price of houses, a smaller quantity of houses is demanded. The market demand curve shifts leftward: at each given price, market demand is lower.
The shift in demand is shown in Figure 19.3.1 "A Decrease in Demand for Housing". Once the demand curve shifts, the market for new houses is no longer in equilibrium. At the original price, there is now an imbalance between supply and demand: at that price, buyers want to purchase fewer homes than sellers wish to sell. To restore equilibrium in the market, there needs to be a reduction in housing prices and a reduction in the quantity of new houses produced. The decrease in production comes about because the lower price of houses makes suppliers less willing to produce houses for the market. The shift in the demand curve leads to a movement along the supply curve.
A decrease in demand for houses means that the demand curve shifts leftward, leading to a decrease in both the price of houses and the quantity of houses that are produced and sold.
Shifts in a Curve versus Movements along a Curve
Understanding the distinction between moving along a curve (either supply or demand) and shifting the curve is the hardest part about learning to use the supply-and-demand framework. Journalists and others frequently get confused about this—and no wonder, for it requires practice to learn how to use supply and demand properly.
First, consider the market demand curve. As the price of houses increases, the quantity demanded will decrease. This is a movement along the market demand curve. Changes in anything else—anything other than price—that affects the quantity demanded appears as a shift in the market demand curve. That is, at each given price, the quantity demanded changes.
Analogously, as the price of houses increases, the quantity supplied will increase. This is a movement along the market supply curve. If a change in anything else leads to a change in the quantity supplied, this appears as a shift in the market supply curve. That is, at each given price, the quantity supplied changes.
Comparative Statics
The example that we just discussed is an illustration of a general technique used by economists for two purposes. First, we use it to explain changes in prices and quantities that we have observed in the past. Second, we use it to predict what will happen to market prices and quantities in the future. The technique is called comparative statics.
Toolkit: Section 31.16 "Comparative Statics"
Comparative statics is a technique that allows us to describe how market equilibrium prices and quantities depend on exogenous events. As such, much of economics consists of exercises in comparative statics. In a comparative statics exercise, you must do the following:
1. Begin at an equilibrium point where the quantity supplied equals the quantity demanded.
2. Based on a description of an event, determine whether the change in the exogenous factor shifts the market supply curve or the market demand curve.
3. Determine the direction of this shift.
4. After shifting the curve, find the new equilibrium point.
5. Compare the new and old equilibrium points to predict how the exogenous event affects the market.
The most difficult part of a comparative statics exercise is to determine, from a description of the economic problem, whether it is the supply or demand curve (or both) that shifts. Once you conquer the economics of determining which curve is shifting, then it is a matter of mechanically using the framework to find the new equilibrium. A comparison of the old and new equilibrium points allows you to predict what will happen to equilibrium prices and quantities following an exogenous change.
Key Takeaways
• Exogenous variables are determined from outside a framework, while endogenous variables are determined within the framework.
• Changes in exogenous variables lead to shifts in market supply and/or market demand curves. These shifts in supply and demand then lead to changes in quantities and prices.
• Comparative statics is a technique that describes how changes in exogenous variables influence equilibrium quantities and prices. It is used to answer questions about how markets respond to changes in exogenous variables.
Exercises
1. Name two exogenous variables that might affect the equilibrium outcome in the market for used cars.
2. Draw the market for housing when there is a decrease in supply and a decrease in demand. What happens to the price? Why can you not say for sure what happens to the quantity of houses bought and sold? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/19%3A_The_Interconnected_Economy/19.03%3A_Comparative_Statics-_Changes_in_the_Price_of_Housing.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is the credit market, and what determines the interest rate?
2. What is the labor market, and what determines the real wage?
3. What is the foreign currency market, and what determines the exchange rate?
The financial crisis of 2008 began in the housing market. But as the excerpts at the beginning of this chapter make clear, its effects rapidly spread beyond that market. Those excerpts talked of credit, jobs, and the impact of the crisis on foreign countries. We now look at the knock-on effects of the crisis and, in the process, describe three key macroeconomic markets: the credit market, the labor market, and the foreign exchange market.These markets are used in several places in the book. In particular, we look at labor in Chapter 23 "Jobs in the Macroeconomy", and credit and foreign exchange in Chapter 24 "Money: A User’s Guide".
The Credit Market
A credit market (or loan market) is a market in which credit is extended by lenders to borrowers. These credit arrangements, also called loans, are a specific kind of contract. A simple credit contract specifies three things: (1) the amount being borrowed, (2) the date(s) at which repayment must be made, and (3) the amount that must be repaid.Of course, since credit contracts are legal documents, lots of other details will be written into the contract as well. Here we focus on the most important features of the contract.
To be specific, suppose you go to your bank to inquire about a loan for \$1,000, to be repaid in one year. In this case the lender—the bank—is a supplier of credit, and the borrower—you—is a demander of credit. The higher is the repayment amount, the more attractive this loan contract will look to the bank. Conversely, the lower is the repayment amount, the more attractive this loan contract looks to you. The relationship between the current price and the future repayment can be summarized in a single number, known as the nominal interest rate.
Toolkit: Section 31.24 "The Credit (Loan) Market (Macro)"
The nominal interest rate is the number of additional dollars that must be repaid for every dollar that is borrowed. It is generally specified in annual terms; that is, it is the amount that must be paid per year.
For the one-year loan we are considering,
For example, suppose the repayment amount is \$1,050. Then the left-hand side of this expression is 1,050/1,000 = 1.05. It follows that the nominal interest rate is 0.05, or 5 percent.
Financial markets are typically good examples of competitive markets. Loans are homogeneous, and there are potentially many buyers and sellers. So if we imagine that there are lots of banks that might be willing to supply credit, and lots of people like you who might demand credit, then we could draw supply and demand curves as in Figure 19.4.1 "A Market for \$1,000 Loans". In this case, the units on the quantity axis are one-year \$1,000 loans. The price on the vertical axis is the interest rate, which tells us the amount of the repayment per dollar loaned. The higher the repayment is, the more willing are banks to supply credit, so the supply curve slopes upward. The higher the repayment, the less willing are people to take out these loans, and so the demand curve slopes downward. If the repayment price were acceptable to you, you would “buy” one of these \$1,000 loans. The equilibrium nominal interest rate is shown at the crossing of supply and demand.
In this credit market, lenders offer \$1,000 loans to borrowers. The equilibrium nominal interest rate is where the quantity of credit supplied equals the quantity of credit demanded.
The Credit Market in the 2008 Crisis
At the height of the financial crisis of 2008, credit became much more expensive—that is, interest rates increased. Why? As housing prices collapsed in the United States and elsewhere, a substantial number of mortgage loans became nonperforming. This means that borrowers were unable or unwilling to repay these loans and defaulted on them instead. In addition, because banks had sold and resold some of these mortgage loans, it was hard to identify which loans would be repaid and which would not. Some financial institutions that were holding a lot of bad loans went bankrupt, and others were in danger of going under as well.
As a consequence, lenders became much more cautious about the types of loans they made—not only in mortgage markets but also throughout the economy. They were more careful about evaluating the likelihood that borrowers would repay their loans. This led to a reduction in the market supply of credit. The reduced supply of loans in the mortgage market was particularly acute. This appears as a leftward shift of the supply curve in Figure 19.4.1 "A Reduction in Supply in the Mortgage Market". Nominal interest rates increased, and the quantity of mortgages extended decreased. (The full story of what happened in credit markets is more complicated because central banks around the world also took actions to offset these changes and keep interest rates low.)
As lenders became more cautious about making loans, the supply of mortgage loans shifted leftward. Interest rates in the economy increased, and the quantity of mortgages decreased.
Nominal Interest Rates and Real Interest Rates
Mortgage rates and other interest rates are based on underlying dollar amounts; the interest rate tells you how many dollars borrowers must pay to lenders for each dollar that they borrow. Because they are based on dollar amounts, they are called nominal interest rates. When you see a mortgage rate quoted by a bank or a rate on a credit card, it is a nominal rate.
The nominal rate does not tell us the true cost of borrowing, or return on lending, when there is inflation in an economy. For example, suppose that the nominal interest rate is 5 percent, but inflation is also 5 percent. If you took out a \$1,000 loan, you would have to pay back \$1,050 next year. But that \$1,050 would buy exactly the same amount of real gross domestic product (real GDP) next year as \$1,000 does this year—that is what it means to have 5 percent inflation. So, in terms of actual goods and services, you have to pay back the same amount that you borrowed. The real interest rate—that is, the interest rate corrected for inflation—is zero.
Toolkit: Section 31.8 "Correcting for Inflation"
The Fisher equation is a formula for converting from nominal interest rates to real interest rates, as follows:
\[real\ interest\ rate\ ≈\ nominal\ interest\ rate\ −\ inflation\ rate.\]
The real interest rate gives the true cost of borrowing and lending; it is the real interest rate that actually matters for the decisions of savers and borrowers. We derive the Fisher equation more fully in Chapter 24 "Money: A User’s Guide". That doesn’t mean, by the way, that our previous two diagrams were incorrect because they used the nominal interest rate. Provided that the inflation rate doesn’t change, a comparative static exercise using the nominal interest rate will give you exactly the same conclusion as one using the real interest rate.
Individual Credit Markets and the Aggregate Credit Market
We have described a market for a particular kind of loan, but more generally we know that there are all kinds of different ways in which credit is offered in an economy. Households borrow from banks to buy houses or cars. Households and firms make purchases using credit cards. Firms borrow from financial institutions to buy new equipment. The government borrows to finance its spending, and so on. There is a very large number of credit markets in the economy, each offering a different kind of credit, and each with its own equilibrium interest rate.
These different credit markets are linked because most households and firms buy or sell in more than one market. Financial institutions in particular trade in large numbers of different credit markets. For much of what we do in macroeconomics, however, the distinctions among different kinds of credit are not critical, and it is sufficient to imagine a single aggregate credit market and a single real interest rate. In Chapter 24 "Money: A User’s Guide", we look in more detail at the different kinds of credit—and the associated different interest rates—that we see in an economy. We also investigate in more detail how these markets are linked together. Figure 19.4.3 "The Aggregate Credit Market" shows the credit market for an entire economy. This is the market where all the savers in the economy bring funds to financial intermediaries, who then lend those funds to firms, households, and governments. The supply of credit increases as the interest rate increases. As the interest rate increases, other things being equal, households will generally save more and thus supply more to the credit market. The quantity of credit demanded decreases as the interest rate increases. When it is expensive to borrow, households and firms will borrow less.
In the credit market, the equilibrium real interest rate is where the quantity of credit supplied equals the quantity of credit demanded.
Toolkit: Section 31.24 "The Credit (Loan) Market (Macro)"
The credit market brings together suppliers of credit, such as households who are saving, and demanders of credit, such as businesses and households who need to borrow. The real interest rate is the price that brings demand and supply into balance. At the equilibrium interest rate, the amount of credit supplied and the amount of credit demanded are equal.
Two of the most important players in the credit market are the government and the monetary authority. If the US federal government borrows more, this shifts the demand for credit outward and increases the interest rate. (Notice that the government is a big player in this market, so its actions affect the interest rate.) The monetary authority, meanwhile, buys and sells in credit markets to influence interest rates in the economy.We study the actions of the Federal Reserve and other monetary authorities in Chapter 25 "Understanding the Fed". In the 2008 crisis, the Federal Reserve Bank, which is the monetary authority in the United States, took many actions to increase the supply of credit and ease the problems in the credit market.
The Labor Market
The story about the housing market in the United Kingdom at the beginning of this chapter contained some dire predictions about employment:
The lack of spending in these areas will hit employment, with some analysts forecasting that the construction sector alone could see a loss of up to 350,000 jobs within the next five years.
To understand this prediction, we need to look at another market—the labor market.
In the markets for goods and services, the supply side usually comes from firms, and the demand side comes from households. In the labor market, by contrast, firms and households switch roles: firms demand labor, and households supply labor. Supply and demand curves for construction workers are shown in Figure 19.4.4 "Equilibrium in the Market for Construction Workers". Here the price of labor is the hourly real wage that is paid to workers in this industry.
Toolkit: Section 31.3 "The Labor Market"
The real wage is the wage corrected for inflation. To obtain the real wage, simply divide the wage in dollars—the nominal wage—by the price level:
The individual demand for labor by firms comes from the fact that workers’ time is an input into the production process. This demand curve obeys the law of demand: as the real wage increases, the quantity of labor demanded decreases. At a higher real wage, a firm will demand less labor services (by hiring fewer workers and/or reducing the hours of workers) and will respond to the higher labor cost by reducing production.
Workers care about the real wage because it tells them how much they can obtain in terms of goods and services if they give up some of their time. The supply of labor comes from households who allocate their time between work and leisure activities. In Figure 19.4.4 "Equilibrium in the Market for Construction Workers", the supply of labor is upward sloping. As the real wage increases, households supply more labor because (1) higher wages induce people to work longer hours, and (2) higher wages induce more people to enter the labor force and look for a job.
Figure \(4\): Equilibrium in the Market for Construction Workers
This picture shows the supply of and demand for hours of work in the construction industry.
Figure \(5\): A Decrease in Demand for Construction Workers
Because builders are building fewer houses, they hire fewer construction workers, causing the labor demand curve to shift leftward.
The Labor Market in the 2008 Crisis
In the United Kingdom, there was a leftward shift in demand for housing (just like we showed in Figure 19.3.1 "A Decrease in Demand for Housing"). The response of homebuilders to such a shift is to build fewer homes and, therefore, demand less labor. As a result, there is a leftward shift in the demand curve for construction workers. Based on the supply-and-demand framework, we predict both lower wages and a reduction in employment in the construction sector of the economy, as shown in Figure 19.4.5 "A Decrease in Demand for Construction Workers".
Similar reductions in demand for labor occurred in the United States and many other countries around the world. There was a consequent reduction in employment and an increase in unemployment. The crisis was not restricted just to financial markets, in other words. It had consequences for the “real” economy as well.
Individual Labor Markets and the Aggregate Labor Market
Because there are many different jobs and many different kinds of workers, there is no single labor market and no single wage. Instead, you can think of there being many different labor markets just as there are many different credit markets. Like different credit markets, different labor markets are linked: households may participate in more than one labor market, and most firms purchase many different kinds of labor. As with the credit market, we sometimes look at the market for a particular kind of labor and the economy as a whole. Most of the time in macroeconomics, it is sufficient to think about an aggregate labor market, as shown in Figure 19.4.6 "Equilibrium in the Labor Market". In Chapter 23 "Jobs in the Macroeconomy", we pay more attention to the fact that workers and jobs are not all identical. As the real wage increases, households supply more hours, and more households participate in the labor market. For both of these reasons, as the real wage increases, the quantity of labor supplied also increases. Labor demand comes from firms. As the real wage increases, the cost of hiring extra labor increases, and firms demand fewer labor hours. That is, the firm’s labor demand curve is downward sloping.
Toolkit: Section 31.3 "The Labor Market"
The labor market is the market in which labor services are traded. The supply of labor comes from households. At the equilibrium real wage, the number of hours supplied and the number of hours demanded are equal.
Figure \(6\): Equilibrium in the Labor Market
The labor market is the market in which firms hire workers. The equilibrium real wage is the price where the quantity of labor supplied equals the quantity of labor demanded.
The Foreign Exchange Market
The excerpts at the beginning of this chapter reveal that the financial crisis also impacted other countries. For example, we included an excerpt about the effects of the crisis on the value of a dollar and also an excerpt about exports from China. We could have also cited effects of the crisis on other countries: for example, India’s information technology sector and Canada’s lumber industry were both affected. To understand the transmission of the crisis to other countries, we have to learn about another market—the market where different currencies are bought and sold.
If you travel abroad, you must acquire the currency used in that region of the world. For example, if you take a trip to Finland, Russia, and China, you will buy euros, rubles, and yuan along the way. To do so, you need to participate in various foreign exchange markets.
Toolkit: Section 31.20 "Foreign Exchange Market"
The foreign exchange market is the market where currencies are traded. The price in this market is the price of one currency in terms of another and is called the nominal exchange rate.
Dollars are supplied to foreign exchange markets by US households, firms, and governments who wish to purchase goods, services, or financial assets that are denominated in the currency of another economy. For example, if a US auto importer wants to buy a German car, it must sell dollars and buy euros. As the price of a dollar increases, the quantity supplied of that currency will increase.
Foreign currencies are supplied by foreign households, firms, and governments that wish to purchase goods, services, or financial assets (such as stocks or bonds) denominated in the domestic currency. For example, if a Canadian bank wants to buy a US government bond, it must sell Canadian dollars and buy US dollars. The law of demand holds: as the price of a dollar increases, the quantity of that currency demanded decreases.
Figure 19.4.7 "Equilibrium in the Foreign Exchange Market Where Dollars and Euros Are Exchanged" shows an example of a foreign exchange market: the market in which euros are bought with and sold for US dollars. The horizontal axis shows the number of euros bought and sold on a particular day. The vertical axis shows the exchange rate—the price of a euro in dollars. This market determines the dollar price of euros just like the gasoline market determines the dollar price of gasoline.
Currencies are traded in foreign exchange markets, such as the market shown here in which dollars and euros are exchanged. The equilibrium exchange rate is the price where the quantity of euros supplied equals the quantity of euros demanded.
On the supply side, there are households and firms in Europe who want to buy US goods and services. To do so, they need to buy dollars and, therefore, must supply euros to the market. This supply of euros need not come only from European households and firms. Anyone holding euros is free to sell them in this market. On the demand side, there are households and firms who are holding dollars and who wish to buy European goods and services. They need to buy euros.
There is another source of the demand for and the supply of different currencies. Households and, more importantly, firms often hold assets denominated in different currencies. You could, if you wish, hold some of your wealth in Israeli government bonds, in shares of a South African firm, or in Argentine real estate. But to do so, you would need to buy Israeli shekels, South African rand, or Argentine pesos. Likewise, many foreign investors hold US assets, such as shares in Dell Inc. or debt issued by the US government. Thus the demand for and the supply of currencies are also influenced by the asset choices of households and firms. In practice, banks and other financial institutions conduct the vast majority of trades in foreign exchange markets.
As well as households and firms, monetary authorities also participate in foreign exchange markets. For example, the US Federal Reserve Bank monitors the value of the dollar and may even intervene in the market, buying or selling dollars in order to influence the exchange rate.
Foreign Exchange Markets in the 2008 Crisis
One of the articles we used to open this chapter dealt with changes in the value of the dollar in the fall of 2008. The article pointed out that the dollar was getting stronger relative to other currencies, such as the euro. This means that the price of a dollar in euros was increasing or, equivalently, the price of a euro in dollars was decreasing. In fact, the euro price of a dollar was about 0.67 in late September 2008; the price increased to nearly 0.81 by late October and then decreased again through December 2008.
We can use the foreign exchange market to understand these events. Figure 19.4.8 "Comparative Statics in the Euro Market" shows the dollar market for euros once again. The increase in the value of the dollar discussed in the article is seen here as a rightward shift in the supply of euros, which decreases the value of the euro and—equivalently—increases the value of the dollar.
The rightward shift in the supply of euros leads to a decrease in the price of a euro in terms of dollars.
There are two consequences of this shift in the supply curve. First, the shift in supply decreases the dollar price of the euro. So people in the United States who are planning to visit, say, France will find that they can obtain more euros for a given amount of dollars. Second, the quantity of euros actually bought and sold is higher. This is not inconsistent with the lower dollar price of a euro since the supply curve shifts along the demand curve for euros.
Individual Foreign Exchange Markets and the Aggregate Foreign Exchange Market
We sometimes look at an individual exchange rate (e.g., dollar-euro) by thinking of the market where dollars are exchanged for euros. However, there are many different currencies that are exchanged for the US dollar. There are markets where dollars are exchanged for British pounds, Japanese yen, and so on. We can combine these into an aggregate foreign exchange market. Think of this as being the market where US dollars are bought with and sold for all the other currencies in the world. In this market, there is an aggregate exchange rate, which you can think of as an average of the exchange rates in all the individual markets.More precisely, you should think of a weighted average. Because the United States trades much more with Canada than with, say, South Africa, movements in the US dollar–Canadian dollar exchange rate matter more than movements in the US dollar–South African rand exchange rate. Chapter 24 "Money: A User’s Guide" has more on exchange rates. We show this market in Figure 19.4.9 "Foreign Exchange Market Equilibrium".
Figure \(9\): Foreign Exchange Market Equilibrium
Currencies are traded in foreign exchange markets, such as the market shown here in which dollars are bought and sold.
Key Takeaways
• The credit market brings together the suppliers of credit (households) with those who are demanding credit (other households, firms, and the government). The interest rate adjusts to attain a market equilibrium.
• The labor market is where labor services are traded. Households supply labor, and firms demand labor. The real wage adjusts to attain a market equilibrium.
• The foreign exchange market brings together demanders and suppliers of foreign currency. The exchange rate, which is the price of one currency in terms of another, adjusts to attain a market equilibrium.
Exercises
Figure 19.4.7 "Equilibrium in the Foreign Exchange Market Where Dollars and Euros Are Exchanged" shows the market where euros are bought and sold using dollars. We could equivalently think about this as the market where dollars are bought and sold using euros. Draw the graph for this market. How are the supply and demand curves in the two markets related to each other? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/19%3A_The_Interconnected_Economy/19.04%3A_Three_Important_Markets.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. How are the markets for goods, labor, credit, and foreign currency linked?
2. How do we use those links to understand the crisis that began in 2008?
In 19.3 Section "Three Important Markets", we talked about the markets for credit, labor, and foreign exchange. We explained that we sometimes look at individual examples of these markets and sometimes at versions of these markets that apply to the economy as a whole.
But the story of the economic crisis in 2008 was not about a single market. Instead, what started as a problem in the US mortgage market was felt in the housing market in England, the labor market in China, the foreign exchange market in Europe, and many other markets. These different markets are connected; in this section, we explore these linkages. We do so through the circular flow of income, shown in Figure 19.5.1 "The Circular Flow of Income". That model of the economy reveals the linkages across markets that the global financial crisis made so evident.
Toolkit: Section 31.27 "The Circular Flow of Income"
You can review the circular flow of income in the toolkit.
Figure \(1\): The Circular Flow of Income
We know from the circular flow that the production of goods and services generates income in an economy. Some of that income is paid to the government in the form of taxes, but the rest finds its way to households. Much of the flow of dollars from firms to households takes place through the labor market because firms demand labor to produce goods. If firms are producing large quantities of goods and services, then they demand lots of labor, and income from the sale of labor services in the economy is high.
Some of the income that households earn from selling labor services is saved. There is therefore a link, through the household sector, between the labor market and the credit market. So we can follow a connection from the production of goods and services to the supply of credit: if firms produce more, they generate more labor income, so there is more saving supplied by households to the credit market. There is also a link from the markets for goods and services to the demand for credit: firms borrow to purchase investment goods.
These markets are also linked—directly or indirectly—to foreign exchange markets. Whenever firms purchase imported goods, such as oil, this generates a demand for foreign exchange. When firms expand output, demand more labor, and so generate additional household income, households spend some of this income on imports, again generating a demand for foreign exchange. When households and firms in other countries want to buy our goods and services, that generates a supply of foreign exchange. And many transactions in credit markets also generate a demand for or supply of foreign exchange.
Comparative Statics in an Interconnected World
We could go on, but the point should be clear: the markets in every economy are intimately interconnected. This has a critical implication for our study of macroeconomics, which is that it both complicates and enriches our comparative static analyses. When a shift in supply or demand in one market affects the equilibrium price and quantity in that market, there are changes in other markets as well.There is a second, more abstract implication: we have to worry about whether all the markets in the economy are in equilibrium at the same time. In our analyses, we have looked at only one market at a time. But we now know that the outcome in one market (for example, the real wage) can affect supply and demand in other markets (for example, the supply of credit). In advanced studies in economics, we use complicated mathematics to see if there are prices that are consistent with all the markets being in equilibrium at once. The bottom line is good news: we can usually be confident that there is an equilibrium for all markets. But because this is such an advanced area of economics, we do not worry about it further in this book. In this section, we show how these interactions across markets help us understand the propagation of the 2008 crisis from the US housing market to the economies of the world. We have already hinted at some of these linkages, but now we make them more explicit.
Housing and Credit Markets in the 2008 Crisis
The story began with the first comparative static example that we looked at: a leftward shift in demand for housing. Potential buyers of houses started worrying that the future price of houses would decrease. This made people more reluctant to buy houses. Meanwhile, a tightening of lending standards made it harder for people to obtain loans. Both of these caused the demand for housing to shift leftward. Part (a) of Figure 19.5.2, which we already saw earlier in the chapter, shows us that this led to a decrease in both the price and the quantity of houses.
A decrease in demand for housing led to a decrease in supply of credit. (a) Worsening expectations about future house prices, together with tighter lending conditions, led to a decrease in demand for housing. (b) In the credit market, banks and other lending institutions found themselves with bad debt, so the supply of credit decreased.
Part (b) of Figure 19.5.2 also appeared earlier in the chapter. The decrease in housing prices, combined with the complicated way in which mortgages had been sold and resold by financial institutions, meant that many financial institutions found themselves in trouble. Some went bankrupt. This made financial institutions cautious about lending to each other, so the supply of credit shifted to the left. Interest rates rose. (Interest rates in the crisis were also affected by the actions of the US Federal Reserve and other monetary authorities around the world.We discuss such policies in detail when we return to the crisis in Chapter 30 "The Global Financial Crisis".)
A Shift in the Supply of Goods
If you run a business, you often have to rely on credit (loans) to finance the purchase of your inputs into the production process. For example, suppose you run a boutique clothing store. You have to buy the clothes to put on display first, and you get your revenues only when you sell the clothes. Weeks or even months may pass between the time you incur your costs and the time you get your revenues. Unless you have the funds available to buy all your stock up front, you will need to borrow. The same is true in many other businesses. Firms regularly take out short-term loans to pay for some of their costs of operation.
When interest rates increase, businesses see their costs increase. Higher costs make it less profitable to produce at any given price, so most businesses cut back on their production. Some may even leave the market altogether. As a consequence, the supply curve for most goods and services shifts leftward, as shown in Figure 19.5.3. We see that the equilibrium price increases, and the equilibrium quantity decreases. Going back to an individual producer, what does this mean? The producer sees costs increase. In the new equilibrium, the producer also obtains a higher price. However, the increase in price is not as big as the increase in cost.
Higher interest rates lead to higher prices and lower quantities for most goods and services. Higher interest rates increase the cost of doing business, so the supply curve for a typical good or service shifts leftward.
A Shift in Demand for Labor
The effect of the higher interest rates on the output decisions of firms also leads them to demand less of all their inputs, including labor. Decreases in production lead to decreases in labor demand, as shown in Figure 19.5.4 "A Decrease in Demand for Labor". In turn, decreases in wages and employment (more generally, a decrease in income) lead to decreased demand for goods.
A decrease in demand for labor causes the labor demand curve to shift leftward.
A Shift in Demand for Goods
Notice the connection back and forth between households and firms. As firms reduce their demand for labor services, less income flows to households. This reduction in income leads to a reduction in the demand for goods and services, leading firms to reduce output and employment even further. The interaction between income and spending on goods and services can lead to much larger reductions in output and employment than the original shift in demand in the original market (in this case, the housing market). This means that Figure 19.5.3 does not tell the whole story of goods markets. That figure shows the effects of interest rates on the supply of goods but does not include the reduction in demand stemming from the interaction of income and spending in the circular flow. Figure 19.5.5 completes the story by adding the shift in demand.
Figure \(5\)
Higher interest rates lead to a leftward shift in supply, and lower income leads to a leftward shift of demand, resulting in lower quantities for most goods and services. Higher interest rates increase the cost of doing business. Lower income decreases the demand for goods and services.
The following from 2008 story illustrates such a connection across markets.
How to Tell Business Is Cutting Back
From fewer shoe shines to a slowdown in corporate art purchases, subtle bellwethers can help take the temperature of business activity.
Nelson Villanova doesn’t need to watch the stock market indexes…or gross domestic product to gauge the health of the economy. He just has to look down. If he sees scuffed shoes, then he knows things are bad.
Villanova, general manager of Eddie’s Shoe Repair in New York’s Grand Central Terminal, has seen business drop 25% to 30% since August. The 15-year-old company employs 40 people across five locations in the sprawling train station, shining and repairing shoes and luggage. But lately, selling \$4 shines seems to be as hard as unloading mortgage-backed securities.
[…]John Tozzi, “How to Tell Business Is Cutting Back,” Bloomberg BusinessWeek, October 21, 2008, accessed June 28, 2011, http://www.businessweek.com/smallbiz/content/oct2008/sb20081020_372369.htm?chan=top\$+\$news_top+news+index+-+temp_small+ business.
Figure 19.5.6 "A Decrease in Demand for Shoeshines" shows the shoeshine market. Traders working on Wall Street started purchasing fewer shoeshines. This was not because shoeshines became more expensive. Rather, it was a shift in the demand for shoeshines because these traders saw that their incomes were decreasing.
A decrease in income leads to a decrease in demand (a leftward shift) for shoeshines.
Trade Flows and a Shift in the Demand for Foreign Exchange
One of the excerpts we used to introduce this chapter touched on the effects of the crisis on exports from China. We now broaden our discussion to include those effects as well. Looking back at Figure 19.5.4 "A Decrease in Demand for Labor", recall that part of household spending goes toward the purchase of goods and services produced in other countries. A significant fraction of imports to the United States come from China. China also sells goods and services to Japan, Europe, and most of the world.
When demand from these economies slumps, as it did in 2008, exports from China also decrease. Since exports are a part of overall spending, this leads firms in China to cut back their production and employment. Thus the Chinese economy was also slowed down by the effects of the financial crisis.
The reduced demand for imports has another effect. Because the demand for foreign currency is partly motivated by the desire to buy goods from that country, a decrease in the import of Chinese goods to the United States and other countries leads to a decrease in demand for the Chinese yuan. There is a leftward shift in the demand for that currency and thus a lower price in dollars. (As with all comparative static exercises, this assumes that nothing else is changing to offset these effects on the demand for the yuan.)
The current account balance is (roughly speaking) the difference between the value of exports and imports of goods and services. A country has a current account surplus if the value of exports of goods and services exceeds the value of its imports. A country has a current account deficit if the value of imports of goods and services exceeds the value of its exports. Looking at the United States and China, one sees very different behavior for the current account.This discussion draws on data from the International Monetary Fund. See Stephan Danninger and Florence Jaumotte, “Divergence of Current Account Balances across Emerging Economies,” World Economic Outlook, Chapter 6, accessed June 28, 2011, http://www.imf.org/external/pubs/ft/weo/2008/02/pdf/c6.pdf. In recent years, the United States has run a current account deficit of nearly 5 percent of its gross domestic product (GDP). China, in contrast, has run a current account surplus of about 6.1 percent of its GDP since 2002.
The reduced demand for imports from China has an effect on the current account balance of China. We would expect to see a reduction in the current account surplus of China due to the reduction in economic activity of its trading partners.
You might also wonder how the persistent deficits of the United States are paid for. When a country runs a current account deficit, it is borrowing from other countries. This is just like a household that pays for consumption above its income by means of borrowing. The rules of national income accounting tell us that the flows in and out of each sector must always be in balance. If we look at the flows in and out of the foreign sector we see that
\[borrowing\ from\ abroad\ =\ imports\ −\ exports\]
or
\[lending\ to\ abroad\ =\ exports\ −\ imports.\]
Net exports (sometimes called the trade surplus) equal exports minus imports. So lending to other countries equals net exports.
The circular flow of income tells us something powerful: whenever we import more than we export, we must, on net, be borrowing from abroad. On reflection, this is not so surprising. Other countries are giving us more goods and services than we are giving to them. This is not done out of generosity; they do so because they expect to be repaid at some point in the future. If we export more than we import, then this flow goes in the other direction, and we are lending to abroad.
Both China and the United States trade with many other countries, so this pattern of trade holds true bilaterally (that is, between them) as well. China has run systematic current account surpluses with the United States, meaning that China is lending to the United States. Those loans take many forms, with commentators highlighting Chinese purchases of US government debt. US Secretary of State Hilary Clinton alluded to this connection between the two economies during a visit to China in early 2009.
US Secretary of State Hillary Clinton yesterday urged China to keep buying US debt as she wrapped up her first overseas trip, during which she agreed to work closely with Beijing on the financial crisis.
[…]
By continuing to support American Treasury instruments the Chinese are recognizing our interconnection…“Keep Buying US Treasury Bills, Clinton Urges China,” Taipai Times, February 23, 2009, accessed June 28, 2011, www.taipeitimes.com/News/front/print/2009/02/23/2003436802.
The Crisis of 2008: A Brief Summary
The crisis began with a reduction in the demand for houses and a consequent decrease in the value of houses. This reduced the value of assets, particularly mortgage-backed securities, and meant that the supply of credit in the economy shifted inward. The consequence was higher interest rates and reduced credit. Since many firms in the economy borrow to finance production, the increased interest rates increased their marginal costs of production. Supply curves throughout the economy shifted inward, leading to lower output. Firms needed fewer workers, so there was a reduction in employment.
The spread to other countries came through a couple of avenues. First, households and firms in other countries were one source of credit to the US economy. When asset prices decreased, the portfolios of foreign banks were also adversely affected. This led to higher interest rates and lower output in those countries. In addition, as the US economy went into recession, it purchased fewer imports from other countries. This led to lower production in those countries.
Our description of the crisis is of necessity a simple one. We have neglected many details, and we have not discussed how government policies also affected interest rates and the demand for goods and services. Later chapters in the book provide more tools for understanding these aspects of the crisis, so when we return to the topic in Chapter 30 "The Global Financial Crisis", we can provide a more complete analysis of the crisis.
Key Takeaways
• Markets are linked because supply and demand in one market generally depend on the outcomes in other markets. The circular flow of income illustrates some of these connections across markets.
• Although the crisis in 2008 may have started in the housing market, it did not end there. Instead, the crisis impacted markets for labor, credit, and foreign exchange.
Exercises
1. We have explained that increases in interest rates shift the supply of goods leftward, and decreases in incomes shift the demand for goods leftward. Draw diagrams with both shifts at once and show that the quantity definitely decreases, but the price may increase or decrease.
2. Can you think of a good for which the demand curve might shift rightward when incomes decrease? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/19%3A_The_Interconnected_Economy/19.05%3A_Linkages_across_Markets.txt |
In Conclusion
The supply-and-demand framework is almost certainly the most powerful model in the economist’s toolkit. Armed with an understanding of this framework, you can make sense of much economic news, and you can make intelligent predictions about future changes in prices.
A true understanding of this framework is more than just an ability to shift curves around, however. It is an understanding of how markets and prices are one of the main ways in which the world is interlinked. Markets are, quite simply, at the heart of economic life. Markets are the means by which suppliers and demanders of goods and services can meet and exchange their wares. Since exchange creates value—because it makes both buyers and sellers better off—markets are the means by which our economy can prosper. Markets are the means by which economic activity is coordinated in our economy, allowing us to specialize in what we do best and to buy other goods and services.
Economists regularly point to these features of markets, but this should not blind us to the fact that markets can go wrong. There are many ways in which market outcomes may not be the most desirable or efficient, as the global financial crisis revealed. In the remainder of this book, we look in considerable detail at all the ways that markets can fail us as well as help us.
Key Links
exercises
1. What would the impact be on the market demand curve for new homes if there were an increase in the price of old homes?
2. Name two factors that cause market demand curves to shift outward.
3. Fill in the blanks in the following table. What can you say about the missing price in the table?
Price of Chocolate Bar Household 1’s Demand Household 2’s Demand Market Demand
1 7 22
2 11 16
10 .5 3 3.5
.75 4 4.75
TABLE $1$: INDIVIDUAL AND MARKET DEMAND
4. If the income levels of all households increase, what happens to the individual demand curves? What happens to market demand?
5. Suppose the price of coffee increases. Household 1 always eats a chocolate bar while drinking coffee. What will happen to Household 1’s demand for chocolate bars when the price of coffee increases? Household 2 has either coffee or a chocolate bar for dessert. What happens to Household 2’s demand for chocolate bars when the price of coffee increases? What happens to the market demand for chocolate bars when the price of coffee increases?
6. (Advanced) In Figure 19.2.3 "The Market Supply of Houses" we showed the market supply curve for new houses. Suppose that a change in government regulations makes it easier for people to become qualified electricians. What will happen to the supply curve for houses?
7. We said that the equilibrium price and quantity in a market is always positive. More precisely, this is true as long as the vertical intercept of the demand curve is bigger than the vertical intercept of the supply curve. If this is not the case, then the most that any buyer is willing to pay is less than the least any seller is willing to accept. Draw a version of Figure 19.2.5 "Market Equilibrium" to illustrate this possibility. How much trade do you expect in this market?
8. Suppose that households become worried about losing their jobs and decide to save more. What happens in the credit market? Do you expect interest rates to increase or decrease?
9. When interest rates decrease, firms find it cheaper to borrow. What do you think happens to the demand for labor? What happens to the real wage?
10. What happens to the value of the US dollar if
1. foreign investors decide they want to buy more US assets.
2. there is a recession in other countries that buy goods produced in the United States.
11. What do you think will be the effect on the markets for used homes and apartments if there is a reduction in expected capital gains from owning a new home? The shift in the supply curve came from an increase in the cost of credit. Where might the increase in the cost of credit come from?
12. Think about your hometown as an economy. What does it import (i.e., what goods and services does it purchase from outside the town)? What does it export (i.e., what goods and services are produced in the town and sold outside it)? What about the street you live on—what are its imports and exports?
13. Using supply and demand, explain how an increase in Chinese demand for Australian butter might be one of the factors causing the Australian dollar to appreciate. How might this affect the labor markets in Australia?
14. If oil prices increase, what will this do to the demand for apartments and houses in warm climates? What will happen to housing prices in cold climates? Use supply and demand to illustrate.
Economics Detective
1. Find three news articles that discuss the financial crisis. Which markets are discussed in these articles? Can you use a supply-and-demand picture to help you make sense of anything that is discussed in the articles you find?
2. Find one example of another country where there was a major decrease in housing prices, as in the United States and England. Find another country where housing prices did not seem to be affected.
Spreadsheet Exercise
1. Using a spreadsheet, construct a version of Table 19.2.1 "Market Equilibrium: An Example" assuming that $market\ demand\ =\ 50 − 0.005 \times price.$
Fill in all the prices (in thousands) from 1,000 to 100,000. What is the equilibrium price and quantity in the market? How would you explain the difference between this equilibrium and the one displayed in Table 19.2.1 "Market Equilibrium: An Example"? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/19%3A_The_Interconnected_Economy/19.06%3A_End-of-Chapter_Material.txt |
We begin this chapter with five stories from around the world.
The United Kingdom
The following is a BBC report on Polish immigration to the United Kingdom.
So You’re Polish and Want a Job…
If there was ever any doubt that the UK is in the grips of an extraordinary revolution, then hunt out the migrant worker recruitment fairs that are starting to spring up.
Last month, thousands of young Polish workers turned up at the third recruitment fair hosted by Polish Express, the London-based newspaper for the diaspora, […]
As they queued to enter the hall that was filled to its legal safety capacity, they scribbled away at resumes, going over their pitch time and time again.
Most were in their mid-20s. Some had only recently arrived, having stuffed a few belongings into a backpack, bought a one-way no-frills airline ticket. […]
[A] willingness to do jobs that employers say British workers don’t want, was at the heart of the boom, said Bob Owen of Polcat, a Doncaster safety training firm targeting the Polish employees market.
“I must admit it, I have never seen a workforce like the Poles,” said Mr Owen. “They want to work, you can see it in their eyes. But here’s the thing—they’re not in competition with the British workforce—they are finding ways of fulfilling a need that just wasn’t being met and that’s why they are being welcomed.”
[…]See Dominic Casiani, “So You’re Polish and You Want a Job,” BBC News, September 25, 2006, accessed June 28, 2011, http://news.bbc.co.uk/1/hi/uk/5376602.stm.
United Arab Emirates
Figure 20.1.1 is a screenshot from a Dubai government website that promotes business and tourism in Dubai.See “Dubai for Business,” Government of Dubai: Department of Tourism and Commerce Marketing, accessed July 27, 2011, http://www.dubaitourism.ae/definitely-dubai/dubai-business. It details many different ways in which Dubai is a desirable place for businesses to locate. For example, the website contains the following:
Pro-Business Environment
Dubai offers incoming business all the advantages of a highly developed economy. Its infrastructure and services match the highest international standards, facilitating efficiency, quality, and service. Among the benefits are:
• Free enterprise system.
• Highly developed transport infrastructure.
• State-of-the-art telecommunications.
• Sophisticated financial and services sector.
• Top international exhibition and conference venue.
• High quality office and residential accommodation.
• Reliable power, utilities, etc.
• First class hotels, hospitals, schools, and shops.
• Cosmopolitan lifestyle.
The website goes on to talk about benefits such as the absence of corporate or income taxes, the absence of trade barriers, competitive labor and energy costs, and so on.
Vietnam
The following is an extract from the Taipei Times, April 9, 2007.
Compal Eyes Vietnam for Factory
Compal Electronics Inc, the world’s second-largest laptop contract computer maker, is considering building a new factory in Vietnam.
Compal could join the growing number of Taiwanese electronic companies investing in Vietnam—such as component maker Hon Hai Precision Industry Co—in pursuit of more cost-effective manufacturing sites outside China.
[…]
Compal forecast last month that its shipments of notebook computers would expand around 38 percent to 20 million units this year, from 14.5 million units last year. The company currently makes 24 million computers a year at its factories in Kunshan, China.
Compal, which supplies computers to Dell Inc and other big brands, could lack the capacity to match customers’ demand next year if its shipments increase any faster,…
Lower wages and better preferential tax breaks promised by the Vietnamese government could be prime factors for choosing Vietnam, Compal chairman Rock Hsu said earlier this year.
[…]See “Compal Eyes Vietnam for Factory, Taipei Times, April 9, 2007, accessed June 28, 2011, www.taipeitimes.com/News/biz/print/2007/04/09/2003355949. We have corrected a minor grammatical error in the article.
Niger
In Niger, West Africa, the World Bank is funding a \$300 million project to improve education: “The Basic Education Project for Niger’s objectives are: (i) to increase enrollment and completion in basic education programs and (ii) to improve management at all levels by improving the use of existing resources, focusing on rural areas to achieve greater equity and poverty reduction in the medium to long term.”For more details, see World Bank, “Basic Education Project” World Bank, accessed June 28, 2011, web.worldbank.org/external/projects/main?page PK=64283627&piPK=73230&theSitePK=40941&menuPK=228424&Projectid=P061209. The World Bank website explains that the goals of the project are to improve access to primary education (including adult literacy), improve the quality of primary and secondary education, and improve the management capability of the Ministry of Education.
United States
President Obama recently established the President’s Council on Jobs and Competitiveness, which is charged, among other things, with reporting “directly to the President on the design, implementation, and evaluation of policies to promote the growth of the American economy, enhance the skills and education of Americans, maintain a stable and sound financial and banking system, create stable jobs for American workers, and improve the long term prosperity and competitiveness of the American people.”See “President’s Council on Jobs and Competitiveness: About the Council,” accessed July 27, 2011, www.whitehouse.gov/administration/advisory-boards/jobs-council/about. In his concern with competitiveness, President Obama follows directly in the footsteps of President George W. Bush, who, in 2006, established the American Competitiveness Initiative to Encourage American Innovation and Strengthen Our Nation’s Ability to Compete in the Global Economy.George W. Bush, “State of the Union: American Competitiveness Initiative,” White House Office of Communications, January 31, 2006, accessed June 28, 2011, www2.ed.gov/about/inits/ed/competitiveness/sou-competitiveness.pdf.
At first reading, these five stories seem to have little to do with each other. There is no obvious connection between the actions of the World Bank in Niger and Taiwanese computer manufacturers in Vietnam or between the marketing of Dubai and the arrival of Polish migrants in the United Kingdom. Yet they are indeed all connected. Think for a moment about the consequences of the following:
• An influx of workers to the United Kingdom
• A superior business environment in Dubai
• Improved education in Niger
• A new factory opening in Vietnam
• An improved banking system in the United States
Of course, each story has many different implications. But they have something fundamental in common: every single one of them will increase the real gross domestic product (real GDP) of the country in question. They all therefore shed light on one of the most fundamental questions in macroeconomics:
What determines a country’s real GDP?
As we tackle this question, we will see that it is indeed connected to our stories of Dubai, the United Kingdom, Niger, Vietnam, and the United States.
Our stories have something else in common as well. In each case, they concern not only the country in isolation but also how it interacts with the rest of the world. The funds for Niger’s education program are coming from other countries (via the World Bank). The US policy is designed to ensure that America is “leading the global competition that will determine our success in the 21st century.”“Obama Presses for an Economy in ‘Overdrive’: Will Jobs Soon Follow?,” PBS NewsHour, January 21, 2011, accessed August 22, 2011, www.pbs.org/newshour/bb/business/jan-june11/obamabusiness_01-21.html. Dubai is trying to attract investment from other countries. The workers in the United Kingdom are coming from Poland. The factory in Vietnam is being built so that a Taiwanese company can supply other manufacturers throughout the world.
Road Map
Real GDP is the broadest measure that we have of the amount of economic activity in an economy. In this chapter, we investigate the supply of real GDP in an economy. Firms in an economy create goods and services by transforming inputs into outputs. For example, think about the manufacture of a pizza. It begins with a recipe—a set of instructions. A chef following this recipe might require 30 minutes of labor time to make the dough and assemble the toppings and then might need 15 minutes use of a pizza oven to cook the pizza. The inputs here are as follows: the pizza oven, the labor time, the skills of the chef, and the recipe. Given 15 minutes of capital time, 30 minutes of labor time, a skilled chef, and the instructions, we can make one pizza.
In macroeconomics, we work with the analogous idea that explains how the total production in an economy depends on the available inputs. We first explain the relationship between the available inputs in the economy and the amount of real GDP that the economy can produce. Then we look at all the individual inputs in turn. If we can explain what determines the amount of each input in an economy and if we know the link from inputs to real GDP, then we can determine the level of real GDP. Finally, we look at a technique that allows us to quantify the relationship between inputs and output. Specifically, we look at how increases in different inputs translate into increases in overall GDP. Using this technique, we can see which inputs are particularly important. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/20%3A_Globalization_and_Competitiveness/20.01%3A_Five_Stories.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What determines the production capabilities of an economy?
2. What is the marginal product of an input?
3. How is competitiveness related to the aggregate production function?
Economists analyze production in an economy by analogy to the production of output by a firm. Just as a firm takes inputs and transforms them into output, so also does the economy as a whole. We summarize the production capabilities of an economy with an aggregate production function.
The Aggregate Production Function
Physical capital refers to goods—such as factory buildings, machinery, and 18-wheel trucks—that have two essential features. First, capital goods are used in the production of other goods. The production of physical capital does not increase our well-being in and of itself. It allows us to produce more goods in the future, which permits us to enjoy more consumption at some future date. Second, capital goods are long lasting, which means we accumulate a capital stock over time. Capital goods are thus distinct from intermediate goods, which are fully used up in the production process.
The capital stock of an economy is the total amount of physical capital in the economy. As well as factories and machines, the capital stock includes physical infrastructure—road networks, airports, telecommunications networks, and the like. These are capital goods that are available for multiple firms to use. Sometimes these goods are supplied by governments (roads, for example); sometimes they are provided by private firms (cellular telephone networks are an example). For brevity, we often simply refer to “capital” rather than “physical capital.” When you see the word capital appearing on its own in this book you should always understand it to mean physical capital.
Labor hours are the total number of hours worked in an economy. This depends on the size of the workforce and on how many hours are worked by each individual.We use the term workforce rather than labor force deliberately because the term labor force has a precise definition—those who are unemployed as well as those who are working. We want to include only those who are working because they are the ones supplying the labor hours that go into the production function. Chapter 23 "Jobs in the Macroeconomy" discusses this distinction in more detail.
Human capital is the term that economists use for the skills and training of an economy’s workforce. It includes both formal education and on-the-job training. It likewise includes technical skills, such as those of a plumber, an electrician, or a software designer, and managerial skills, such as leadership and people management.
Knowledge is the information that is contained in books, software, or blueprints. It encompasses basic mathematics, such as calculus and the Pythagorean theorem, as well as more specific pieces of knowledge, such as the map of the human genome, the formula for Coca-Cola, or the instructions for building a space shuttle.
Natural resources include land; oil and coal reserves; and other valuable resources, such as precious metals.
Toolkit: Section 31.26 "The Aggregate Production Function"
The aggregate production function describes how aggregate output (real gross domestic product [real GDP]) in an economy depends on available inputs. The most important inputs are as follows:
• Physical capital: machines, production facilities, and so forth used in production
• Labor: the number of hours that are worked in the entire economy
• Human capital: the skills and education embodied in the work force of the economy
• Knowledge: the blueprints that describe the production process
• Natural resources: oil, coal, and other mineral deposits; agricultural and forest lands; and other resources
• Social infrastructure: the general business climate, the legal environment, and any relevant features of the culture
Output increases whenever there is an increase in one of these inputs, all else being the same.
Social infrastructure refers to the legal, political, social, and cultural frameworks that exist in an economy. An economy with good social infrastructure is relatively free of corruption, has a functional and reliable legal system, and so on. Also included in social infrastructure are any relevant cultural variables. For example, it is sometimes argued that some societies are—for whatever reason—more entrepreneurial than others. As another example, the number of different languages that are spoken in a country influences GDP.
We show the production function schematically in Figure 20.2.1 "The Aggregate Production Function".
Figure \(1\): The Aggregate Production Function
The aggregate production function combines an economy’s physical capital stock, labor hours, human capital, knowledge, natural resources, and social infrastructure to produce output (real GDP).
The idea of the production function is simple: if we put more in, we get more out.
• With more physical capital, we can produce more output. If you want to dig a foundation for a house, you will be more productive with a backhoe than a shovel; if you want to deliver documents from Chicago to St. Louis, you will be more productive using a truck than a bicycle.
• With more labor hours, we can produce more output. If there are more workers in an economy, or if they work longer hours, the economy will produce more real GDP.
• With more education and skills, we can produce more output. Skilled workers can produce more from an hour’s work than unskilled workers can produce.
• With more knowledge, we can produce more output. Inventions and innovations make an economy more productive.
• With more natural resources, we can produce more output. For example, if an economy discovers additional oil reserves, it can produce more with given labor and capital than can economies without such resources. Of course, this input more often decreases rather than increases over time, as economies use up their existing stocks of natural resources.
• With better institutions, we can produce more output. Economies in which it is easy to establish businesses, where corruption is limited, and where the laws are reliable get more out of their workers and capital.
We call the extra output that we get from one more unit of an input, holding all other inputs fixed, the marginal product of that input. For example, the extra output we obtain from one more unit of capital is the marginal product of capital, the extra output we get from one more unit of labor is the marginal product of labor, and so on.
Physical capital and labor hours are relatively straightforward to understand and measure. To measure labor hours, we simply count the number of workers and the number of hours worked by an average worker. Output increases if we have more workers or if they work longer hours. For simplicity, we imagine that all workers are identical. Aggregate differences in the type and the quality of labor are captured in our human capital variable. For physical capital, we similarly imagine that there are a number of identical machines (pizza ovens). Then, just as we measure labor as the number of worker hours, so also we could measure capital by the total number of machine hours.If this were literally true, we could measure capital stock by simply counting the number of machines in an economy. In reality, however, the measurement of capital stock is trickier. Researchers must add together the value of all the different pieces of capital in an economy. In practice, capital stock is usually measured indirectly by looking at the flow of additions to capital stock. We can produce more output by having more machines or by using each machine more intensively.
The other inputs that we listed—human capital, knowledge, social infrastructure, and natural resources—are trickier to define and much harder to quantify. Economists have used measures of educational attainment (e.g., the fraction of the population that completes high school) to compare human capital across countries.We use an index of human capital in Chapter 21 "Global Prosperity and Global Poverty". There are likewise some data that provide some indication of knowledge and social infrastructure—such as spending on research and development (R&D) and survey measures of perceived corruption.
The measurement of natural resources is problematic for different reasons. Land is evidently an input to production: factories must be put somewhere, and agriculture requires fields and orchards, so the value of land can be measured in principle. But what about reserves of oil or underground stocks of coal, uranium, or gold? First, such reserves or stocks contribute to real GDP only if they are extracted from the earth. An untapped oil field is part of a nation’s wealth but makes no contribution to current production. Second, it is very hard to measure such stocks, even in principle. For example, the amount of available oil reserves in an economy depends on mining and drilling technologies. Oil that could not have been extracted two decades ago is now available; it is likely that future advances in drilling techniques will further increase available reserves in the economy.
We simply accept that, as a practical matter, we cannot directly measure an economy’s knowledge, social infrastructure, and natural resources. As we see later in this chapter, however, there is a technique for indirectly measuring the combined influence of these inputs.
One thing might strike you as odd. Our description of production does not include as inputs the raw materials that go into production. The production process for a typical firm takes raw materials and transforms them into something more valuable. For example, a pizza restaurant buys flour, tomatoes, pepperoni, electricity, and so on, and transforms them into pizzas. The aggregate production function measures not the total value of these pizzas but the extra value that is added through the process of production. This equals the value of the pizzas minus the value of the raw materials. We take this approach to avoid double counting and be consistent with the way real GDP is actually measured.Reserves of natural resources are not counted as raw materials. The output of the mining sector is the value of the resources that have been extracted from the earth.
A Numerical Example of a Production Function
Table 20.2.1 "A Numerical Example of a Production Function" gives a numerical example of a production function. The first column lists the amount of output that can be produced from the inputs listed in the following columns.
Row Output Capital Labor Other Inputs
Increasing Capital
A 100 1 1 100
B 126 2 1 100
C 144 3 1 100
D 159 4 1 100
Increasing Labor
E 100 1 1 100
F 159 1 2 100
G 208 1 3 100
H 252 1 4 100
Increasing Other Inputs
I 100 1 1 100
J 110 1 1 110
K 120 1 1 120
L 130 1 1 130
Table \(1\): A Numerical Example of a Production Function
If you compare row A and row B of Table 20.2.1 "A Numerical Example of a Production Function", you can see that an increase in capital (from 1 unit to 2 units) leads to an increase in output (from 100 units to 126 units). Notice that, in these two rows, all other inputs are unchanged. Going from row B to row C, capital increases by another unit, and output increases from 126 to 144. And going from row C to row D, capital increases from 3 to 4 and output increases from 144 to 159. We see that increases in the amount of capital lead to increases in output. In other words, the marginal product of capital is positive.
Similarly, if you compare rows E–H of Table 20.2.1 "A Numerical Example of a Production Function", you can see that the marginal product of labor is positive. As labor increases from 1 to 4 units, and we hold all other inputs fixed, output increases from 100 to 252 units. Finally, rows I to L show that increases in other inputs, holding fixed the amount of capital and labor, likewise leads to an increase in output.
Figure 20.2.2 "A Graphical Illustration of the Aggregate Production Function" illustrates the production function from Table 20.2.1 "A Numerical Example of a Production Function". Part (a) shows what happens when we increase capital, holding all other inputs fixed. That is, it illustrates rows A–D of Table 20.2.1 "A Numerical Example of a Production Function". Part (b) shows what happens when we increase labor, holding all other inputs fixed. That is, it illustrates rows E–H of Table 20.2.1 "A Numerical Example of a Production Function".
The aggregate production function shows how the amount of output depends on different inputs. Increases in the amount of physical capital (a) or the number of labor hours (b)—all else being the same—lead to increases in output.
Diminishing Marginal Product
You may have noticed another feature of the production function from Figure 20.2.2 "A Graphical Illustration of the Aggregate Production Function" and Table 20.2.1 "A Numerical Example of a Production Function". Look at what happens as the amount of capital increases. Output increases, as we already noted—but by smaller and smaller amounts. Going from 1 unit of capital to 2 yields 26 extra units of output (= 126 − 100). Going from 2 to 3 units of capital yields 18 extra units of output (= 144 − 126). And going from 3 to 4 yields 15 extra units of output (= 159 − 144). The same is true of labor: each additional unit of labor yields less and less additional output. Graphically, we can see that the production function becomes more and more flat as we increase either capital or labor. Economists say that the production function we have drawn exhibits diminishing marginal product.
The more physical capital we have, the less additional output we obtain from additional physical capital. As we have more and more capital, other things being equal, additions to our capital stock contribute less and less to output. Economists call this idea diminishing marginal product of capital.
The more labor we have, the less additional output we obtain from additional labor. Analogously, this is called diminishing marginal product of labor. As we have more and more labor, we find that additions to our workforce contribute less and less to output.
Diminishing marginal products are a plausible feature for our production function. They are easiest to understand at the level of an individual firm. Suppose you are gradually introducing new state-of-the-art computers into a business. To start, you would want to give these new machines to the people who could get the most benefit from them—perhaps the scientists and engineers who are working in R&D. Then you might want to give computers to those working on production and logistics. These people would see a smaller increase in productivity. After that, you might give them to those working in the accounting department, who would see a still smaller increase in productivity. Only after those people have been equipped with new computers would you want to start supplying secretarial and administrative staff. And you might save the chief executive officer (CEO) until last.
The best order in which to supply people would, of course, depend on the business. The important point is that you should at all times give computers to those who would benefit from them the most in terms of increased productivity. As the technology penetrates the business, there is less and less additional gain from each new computer.
Diminishing marginal product of labor is also plausible. As firms hire more and more labor—holding fixed the amount of capital and other inputs—we expect that each hour of work will yield less in terms of output. Think of a production process—say, the manufacture of pizzas. Imagine that we have a fixed capital stock (a restaurant with a fixed number of pizza ovens). If we have only a few workers, then we get a lot of extra pizza from a little bit of extra work. As we increase the number of workers, however, we start to find that they begin to get in each others’ way. Moreover, we realize that the amount of pizza we can produce is also limited by the number of pizza ovens we have. Both of these mean that as we increase the hours worked, we should expect to see each additional hour contributing less and less in terms of additional output.
In contrast to capital and labor, we do not necessarily assume that there are diminishing returns to human capital, knowledge, natural resources, or social infrastructure. One reason is that we do not have a natural or obvious measure for human capital or technology, whereas we do for labor and capital (hours of work and capital usage).
Globalization and Competitiveness: A First Look
Over the last several decades, a host of technological developments has reduced the cost of moving both physical things and intangible information around the world. The lettuce on a sandwich sold in London may well have been flown in from Kenya. A banker in Zurich can transfer funds to a bank in Pretoria with a click of a mouse. People routinely travel to foreign countries for vacation or work. A lawyer in New York can provide advice to a client in Beijing without leaving her office. These are examples of globalization—the increasing ability of goods, capital, labor, and information to flow among countries.
One consequence of globalization is that firms in different countries compete with each other to a much greater degree than in the past. In the 1920s and 1930s, the automobiles produced by Ford Motor Company were almost exclusively sold in the United States, while those produced by Daimler-Benz were sold in Europe. Today, Ford and DaimlerChrysler (formed after the merger of Chrysler and Daimler-Benz in 1998) compete directly for customers in both Europe and the United States—and, of course, they also compete with Japanese manufacturers, Korean manufacturers, and others.
Competition between firms is a familiar idea. Key to this idea of competition is that one firm typically gains at the expense of another. If you buy a hamburger from Burger King instead of McDonald’s, then Burger King is gaining at McDonald’s expense: it is getting the dollars that would instead have gone to McDonald’s. The more successful firm will typically see its production, revenues, and profits all growing.
It is tempting to think that, in a globalized world, nations compete in much the same way that firms compete—to think that one nation’s success must come at another’s expense. Such a view is superficially appealing but incorrect. Suppose, for example, that South Korea becomes better at producing computers. What does this imply for the United States? It does make life harder for US computer manufacturers like Dell Inc. But, at the same time, it means that there is more real income being generated in South Korea, some of which will be spent on US goods. It also means that the cheaper and/or better computers produced in South Korea will be available for US consumers and producers. In fact, we expect growth in South Korea to be beneficial for the United States. We should welcome the success of other countries, not worry about it.
What is the difference between our McDonald’s-Burger King example and our computer example? If lots of people switched to McDonald’s from Burger King, then McDonald’s would become less profitable. It would, in the end, become a smaller company: it would lay off workers, close restaurants, and so on. A company that is unable to compete at all will eventually go bankrupt. But if South Korea becomes better at making computers, the United States doesn’t go bankrupt or even become a significantly smaller economy. It has the same resources (labor, capital, human capital, and technology) as before. Even if Dell closes factories and lays off workers, those workers will then be available for other firms in the economy to hire instead. Other areas of the economy will expand even as Dell contracts.
In that case, do countries compete at all? And if so, then how? The Dubai government’s website that we showed at the beginning of this chapter provides a clue. The website sings the praises of the Emirate as a place for international firms to establish businesses. Dubai is trying to entice firms to set up operations there: in economic language, it wants to attract capital and skilled labor. Dubai is not alone. Many countries engage in similar advertising to attract business. And it is not only countries: regions, such as US states or even cities, deliberately enact policies to influence business location.
Dubai is trying to gain more resources to put into its aggregate production function. If Dubai can attract more capital and skilled labor, then it can produce more output. If it is successful, the extra physical and human capital will lead to Dubai becoming a more prosperous economy.
In the era of globalization, inputs can move from country to country. Labor can move from Poland to the United Kingdom or from Mexico to the United States, for example. Capital can also move. At the beginning of this chapter, we quoted from an article explaining that a Taiwanese manufacturer was planning to open a factory in Vietnam, drawn by low wages and preferential tax treatment. This, then, is the sense in which countries compete with each other—they compete to attract inputs, particularly capital. Competitiveness refers to the ability of an economy to attract physical capital.
We have more to say about this later. But we should clear up one common misconception from the beginning. Competing for capital does not mean “competing for jobs.” People worried about globalization often think that if a Taiwanese factory opens a factory in Vietnam instead of at home, there will be higher unemployment in Taiwan. But the number of jobs—and, more generally, the level of employment and unemployment—in an economy does not depend on the amount of available capital. Chapter 23 "Jobs in the Macroeconomy" and Chapter 25 "Understanding the Fed" explain what determines these variables. This does not mean that factory closures are benign. They can be very bad news for the individual workers who are laid off and must seek other jobs. And movements of capital across borders can—as we explain later—have implications for the quality of available jobs and the wages that they pay. But they do not determine the number of jobs available.
Key Takeaways
• The production capabilities of an economy are described by the aggregate production function, characterizing how the factors of production, such as capital, labor, and technology, are combined to produce real GDP.
• In the aggregate production function, the marginal product is the extra amount of real GDP obtained by adding an extra unit of an input.
• One measure of competitiveness is the ability of an economy to attract inputs for the production function, particularly capital.
Exercises
1. Earlier, we observed that our news stories were about the following:
• Improved education in Niger
• A new factory opening in Vietnam
• A superior business environment in Dubai
• An influx of workers to the United Kingdom
• A better banking system in the United States
Which input to the production function is being increased in each case?
2. Building on part (b) of Figure 20.2.2 "A Graphical Illustration of the Aggregate Production Function", draw an aggregate production function that does not exhibit diminishing marginal product of labor. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/20%3A_Globalization_and_Competitiveness/20.02%3A_The_Production_of_Real_GDP.txt |
learing objectives
After you have read this section, you should be able to answer the following questions:
1. What determines the amount of labor in the aggregate production function?
2. What determines the patterns of labor migration?
3. Why do real wages differ across countries?
The aggregate production function tells us how much output we get from the inputs that we have available. Our next task is to explain how much of each input goes into this production function. When we have done this, we will have explained the level of real gross domestic product (real GDP). We begin with labor because it is the most familiar—almost everyone has had the experience of selling labor services.
The Labor Market
Figure 20.3.1 "Equilibrium in the Labor Market" shows a diagram for the labor market. In this picture, we draw the supply of labor by households and the demand for labor by firms. The price on the vertical axis is the real wage. The real wage is just the nominal wage (the wage in dollars) divided by the price level. It tells us the amount that you can consume (measured as the number of units of real GDP that you get) if you sell one hour of your time.
Toolkit: Section 31.3 "The Labor Market" and Section 31.8 "Correcting for Inflation"
When we adjust the nominal wage in this way, we are “correcting for inflation.” The toolkit gives more information. You can also review the labor market in the toolkit.
Figure \(1\): Equilibrium in the Labor Market
Equilibrium in the labor market occurs where the number of hours of labor supplied by households equals the number of hours of labor demanded by firms.
The upward-sloping labor supply curve comes from both an increase in hours worked by each employed worker and an increase in the number of employed workers.We discuss labor supply in more detail in Chapter 27 "Income Taxes". The downward-sloping labor demand curve comes from the decision rule of firms: each firm purchases additional hours of labor up to the point where the extra output that it obtains from that labor equals the cost of that labor. The extra output that can be produced from one more hour of work is—by definition—the marginal product of labor, and the cost of labor, measured in terms of output, is the real wage. Therefore firms hire labor up to the point where the marginal product of labor equals the real wage.
The marginal product of labor also depends on the other inputs available in an economy. An economy with more physical or human capital, for example, is one in which workers will be more productive. Increases in other inputs shift the labor demand curve rightward.
The point where the labor supply and labor demand curves meet is the point of equilibrium in the labor market. At the equilibrium real wage, the number of hours that workers want to work exactly matches the number of hours that firms wish to use. Figure 20.3.1 "Equilibrium in the Labor Market" shows that equilibrium in the labor market tells us two things: the real wage in the economy and how many hours of work go into the aggregate production function.
The Mobility of Labor
In November 2004, the median hourly wage in Florida was \$12.50. In Washington State, it was \$16.07. On average, in other words, wages were almost 30 percent higher in the Northwest compared to the Southeast. To take a more specific example, the median wage for health-care support occupations (dental assistants, pharmacy aides, hospital orderlies, etc.) was \$8.14 in Mississippi and \$12.81 in Massachusetts. Dental assistants who moved from Baton Rouge to Boston could expect to see about a 50 percent increase in their hourly wage.“Occupational Employment Statistics,” Bureau of Labor Statistics, accessed June 29, 2011, http://www.bls.gov/oes/current/oessrcst.htm.
People in the United States are free to move from state to state, and many people do indeed move from one state to another every year. People move for many reasons: to go to college, join a girlfriend or boyfriend, or move to the place where they have always dreamed of living (such as New York; Los Angeles; or Burr Ridge, Illinois). People also move to take up new jobs, and one of the things that induces them to take one job rather than another is the wage that it pays. Different wages in different places therefore affect the patterns of migration across the United States.
Figure 20.3.2 "Labor Markets in Florida and Washington State" shows the labor markets in Florida and Washington State for November 2004. The cost of living was different in those two states but, to keep our story simple, we ignore these differences. That is, we assume that there is no difference in the price level in the two states. If we set 2004 as the base year, the price level is 1. This means that the real wage is the same as the nominal wage. A more careful analysis would correct for differences in state taxes and the cost of living.
These diagrams show the labor markets in (a) Florida and (b) Washington State. Real wages are higher in Washington State than in Florida.
Part (a) of Figure 20.3.2 "Labor Markets in Florida and Washington State" shows the labor market in Florida. The equilibrium wage is \$12.50, and the equilibrium level of employment is 1,200 million hours. This is roughly calibrated to the actual experience in Florida, where total employment in 2004 was just under 7.5 million individuals. Part (b) of Figure 20.3.2 "Labor Markets in Florida and Washington State" shows Washington State, where the equilibrium wage is \$16.07, and employment is 400 million hours.
We expect that the higher wages in Washington State would attract people to move from Florida to Washington State. Workers would migrate from Florida to Washington State, causing the labor supply curve to shift leftward in Florida and rightward in Washington State. As a consequence, wages would increase in Florida and decrease in Washington State. Figure 20.3.3 "Migration from Florida to Washington State" shows what would happen if the only thing people cared about was wages: migration would stop only when wages were equal in both states. Employment would be lower in Florida and higher in Washington State. (The exact number of people who moved and the new equilibrium wage would depend on the slopes of the supply and demand curves in both labor markets.)
Workers move from Florida to Washington State in search of higher wages. Labor supply decreases in Florida and increases in Washington State.
If wages were the only factor affecting people’s decisions, migration would completely equalize real wages across the different state economies. In fact, we do not expect wages to become exactly equal in Florida, Washington State, and the other 48 states of the Union. Differences in both state taxes and the cost of living in different states and cities lead to persistent differences in wages. Some places are less attractive to live than others, so people will need to be paid more to induce them to live there. Our example nevertheless illustrates a key economic principle: people respond to incentives. Individual decisions about where to live respond to differences in real wages. Labor tends to migrate to where it can earn the highest return.
International Migration
People migrate between different US states because of wage differences. In China and other developing economies, many workers migrate from rural areas to urban areas, again in search of better wages. The same forces operate across international borders. Workers seek to emigrate from countries where their wages are low and move to countries that pay higher wages. Sometimes, this movement is actively encouraged. Some countries attract immigrant workers—particularly rich economies that want to attract relatively unskilled workers to perform low-paying and unattractive jobs.
However, there are many more barriers to movement among countries compared to movement within countries. Some are legal barriers. Most countries strictly limit the immigration that they permit. In the United States, a physical barrier has been constructed along some of the US-Mexican border to prevent illegal immigration from Mexico to the United States. Some countries also make emigration very difficult.
Even when legal impediments to migration are absent, there are cultural and language barriers. European Union citizens are legally free to live and work anywhere in the countries of the Union, and we saw at the beginning of this chapter that many young Polish workers take advantage of this by moving to the United Kingdom in search of work. But such examples notwithstanding, most European workers remain in the country of their birth. Migration from Portugal to Finland is very limited, for example, despite the higher wages paid in Finland. A Portuguese worker who wants to move to Finland must learn to cope with a completely different language and culture, not to mention a much colder climate.
To summarize, while we do see some movement of labor across national borders, people remain, for the most part, in the country in which they were born. When we are analyzing national economies, the main determinant of labor hours is, in the end, the number of people in the economy and the number of hours that they choose to work. International migration plays a limited role.
We can also turn this argument on its head. We observe huge differences in real wages in different economies. If people were truly able and willing to migrate across economies, we would expect most of those differences to disappear. So we can conclude that there must be substantial barriers to migration.
Population Growth and Other Demographic Changes
Over long periods of time, the amount of labor in the production function is affected by changes in population and other demographic changes. As a country’s population increases, it has more workers to “plug in” to the aggregate production function. Changes in the age structure of the population also have an effect. Much of the developed world has an aging population, meaning that the fraction of the population that is working is decreasing.We discuss some implications of this in Chapter 28 "Social Security".
Changes in social norms can also affect the amount of labor that goes into the production function. For example, child labor is now uncommon, whereas a century ago it was much more usual. Another example is the increase in women’s participation in the labor force over the last half century, both in the United States and other countries. Public health matters as well. In some countries of the world, particularly in Africa, the HIV/AIDS crisis is having devastating effects. Quite apart from the human misery that the disease causes, the epidemic means that there is less labor available. The problem is particularly acute because working-age individuals are disproportionately affected.
In an introductory economics textbook such as this one, we do not seek to explain such social changes. To be sure, these changes are studied by economists, as well as by sociologists and other researchers. But here we investigate the effects rather than the causes of such social changes.
Explaining International Differences in the Real Wage
Real wages differ markedly across countries: the typical worker in Australia is paid much more than the typical worker in Bolivia, for example. Suppose that we compare two countries, and we find that real wages are higher in one country (country A) than in the other (country B). This tells us that the marginal product of labor is higher in country A than in country B. There are two basic reasons why this might be true:
1. Hours worked are fewer in country A than in country B.
2. Other inputs are larger in country A than in country B.
Figure 20.3.4 "Why Real Wages May Be Different in Different Countries" illustrates these possibilities. Part (a) compares two countries that are identical except that less labor is supplied to the market in country A. In country A, the real wage is higher, and the equilibrium number of hours is lower. In part (b), the two countries have identical labor supplies, but one or more of the other inputs (physical capital, human capital, knowledge, social infrastructure, or natural resources) is higher in country A. This means that the labor demand curve in country A is further to the right, so the real wage is higher, and the equilibrium number of hours is also higher.
Real wages are higher in country A than in country B either because of lower labor supply in country A (a) or greater labor demand in country A (b).
The real wage is an indicator of societal welfare because it tells us about the living standards of the typical worker. From the perspective of workers, increases in other inputs—such as capital stock or an economy’s human capital—are desirable because they increase the marginal product of labor and hence the real wage.
Thus, when the World Bank helps to fund education in Niger, it is helping to increase GDP by increasing the amount of human capital in the production function. Furthermore, this increased GDP will appear in the form of higher wages and living standards in the economy. Conversely, if a food processing company decides to close a factory in England, capital stock in England decreases, and output and real wages decrease.
Key Takeaways
• The quantity of labor in the aggregate production function is determined in the labor market.
• All else being the same, labor will migrate to the place with the highest real wage.
• Differences in real wages across economies reflect differences in the marginal product of labor due to differences in the number of hours worked, technology, and capital stocks.
Exercises
1. To determine the patterns of labor migration, should we look at nominal or real wages? Should we look at wages before or after taxes?
2. Building on Figure 20.3.4 "Why Real Wages May Be Different in Different Countries", suppose that country A had fewer workers than country B but more capital. Would the real wage be higher or lower in country A than country B? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/20%3A_Globalization_and_Competitiveness/20.03%3A_Labor_in_the_Aggregate_Production_Function.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What determines the movement of investment in a country?
2. How does the capital stock of a country change?
3. What determines the movement of capital across countries?
Many of the arguments that we have just made about labor have analogies when we think about capital. Just as the amount of labor in an economy depends on the size of the workforce, so the amount of capital depends on the capital stock. Just as the amount of labor depends on how many hours each individual works, so the amount of capital depends on the utilization rate of capital.
Capital utilization is the rate at which the existing capital stock is used. For example, if a manufacturing firm runs its production lines 24 hours per day, 7 days per week, then its capital utilization rate is very high.
Just as labor can migrate from country to country, so also capital may cross national borders. In the short run, the total amount of capital in an economy is more or less fixed. We cannot make a significant change to the capital stock in short periods of time. In the longer run, however, the capital stock changes because some of the real gross domestic product (real GDP) produced each year takes the form of new capital goods—new factories, machines, computers, and so on. Economists call these new capital goods investment.
Toolkit: Section 31.27 "The Circular Flow of Income"
Investment is one of the components of overall GDP.
The Circular Flow: The Financial Sector
We can use the circular flow to help us understand how much investment there is in an economy. Figure 20.4.1 "The Flows In and Out of the Financial Sector" reviews the four flows of dollars in and out of the financial sector. The circular flow is introduced in Chapter 18 "The State of the Economy". We elaborate on it in Chapter 19 "The Interconnected Economy", Chapter 22 "The Great Depression", Chapter 27 "Income Taxes", and Chapter 29 "Balancing the Budget".
1. Households put their savings into the financial sector. Any income that households receive today but wish to put aside for the future is sent to the financial markets. Although individual households both save and borrow, there is almost always more saving than borrowing, so, on net, there is a flow of dollars from the household sector into the financial markets (private savings).
2. There is a flow of dollars between the financial sector and the government sector. This flow can go in either direction. Figure 20.4.1 "The Flows In and Out of the Financial Sector" is drawn for the case where the government is borrowing (there is a government deficit), so the financial markets send money to the government sector. In the case of a government surplus, the flow goes in the other direction. The national savings of an economy are the savings carried out by the private and government sectors taken together: \[national\ savings\ =\ private\ savings\ +\ government\ surplus\]
or
\[national\ savings\ =\ private\ savings\ −\ government\ deficit.\]
1. There is a flow of dollars between the financial sector and the foreign sector. This flow can also go in either direction. When our economy exports more than it imports, we are sending more goods and services to other countries than they are sending to us. This means that there is a flow of dollars from the economy as foreigners buy dollars so that they can make these purchases. It also means that we are lending to other countries: we are sending more goods and services to other countries now in the understanding that we will receive goods and services from them at some point in the future. By contrast, when our economy imports more than it exports, we are receiving more goods and services from other countries than we are sending to them. We are then borrowing from other countries, and there is a flow of dollars into the economy. Figure 20.4.1 "The Flows In and Out of the Financial Sector" illustrates the case of borrowing from other countries.
2. There is a flow of dollars from the financial sector into the firm sector. These are the funds that are available to firms for investment purposes.
The flows in and out of the financial sector must balance, which tells us that investment is financed by national savings plus borrowing from abroad.
The total flows in and out of the financial sector must balance. Because of this, as we see from Figure 20.4.1 "The Flows In and Out of the Financial Sector", there are two sources of funding for new physical capital: savings generated in the domestic economy and borrowing from abroad.
\[investment\ =\ national\ savings\ +\ borrowing\ from\ other\ countries.\]
Or, in the case where we are lending to other countries,
\[investment\ =\ national\ savings\ −\ lending\ to\ other\ countries.\]
Changes in the Capital Stock
Capital goods don’t last forever. Machines break down and wear out. Technologies become obsolete: a personal computer (PC) built in 1988 might still work today, but it won’t be much use to you unless you are willing to use badly outdated software and have access to old-fashioned 5.25-inch floppy disks. Buildings fall down—or at least require maintenance and repair.
Depreciation is the term economists give to the amount of the capital stock that an economy loses each year due to wear and tear. Different types of capital goods depreciate at different rates. Buildings might stay standing for 50 or 100 years; machine tools on a production line might last for 20 years; an 18-wheel truck might last for 10 years; a PC might be usable for 5 years. In macroeconomics, we do not worry too much about these differences and often just suppose that all capital goods are the same.
The overall capital stock increases if there is enough investment to replace the worn out capital and still contribute some extra. The overall change in the capital stock is equal to new investment minus depreciation:
change in capital stock = investment − depreciation of existing capital stock.
Investment and depreciation are the flows that lead to changes in the stock of physical capital over time. We show this schematically in Figure 20.4.2 "The Accumulation of Capital". Notice that capital stock could actually become smaller from one year to the next, if investment were insufficient to cover the depreciation of existing capital.
Figure \(2\): The Accumulation of Capital
Every year, some capital stock is lost to depreciation, as buildings fall down and machines break down. Each year there is also investment in new capital goods.
The Mobility of Capital
Can physical capital move from place to place? A first guess might be no. Although some capital goods, such as computers, can be transported, most capital goods are fixed in place. Factories are not easily moved from one place to another.
New capital, however, can be located anywhere. When Toyota decides to build a new factory, it could put it in Japan, the United States, Italy, Vietnam, or Brazil. Even if existing capital stocks are not very mobile, investment is. In the long run, firms can decide to close operations in one country and open in another. To understand how much capital a country has, therefore, we must recognize that investment in one country may come from elsewhere in the world.
Just as workers go in search of high wages, so the owners of capital seek to find the places where capital will have the highest return. We already know that the real wage is a measure of the marginal product of labor. Similarly, the real return on investment is the marginal product of capital (more precisely, the marginal product of capital adjusted for depreciation). Remember that the marginal product of capital is defined as the amount of extra output generated by an extra unit of capital. The owners of capital look to put their capital in countries where its marginal product is high.
Earlier, we saw two reasons why the marginal product of labor (and thus the real wage) might be higher in one country rather than another. There are likewise two reasons why the marginal product of capital might be higher in one country (A) rather than in another country (B). Holding all else the same, the marginal product of capital will be higher in country A if
• The capital stock is smaller in country A than in country B.
• The stock of other inputs is larger in country A than in country B.
These two factors determine the return on investment in a country. The benefits of acquiring more capital are higher in a country that has relatively little capital than in a country that has a lot of capital. This is because new capital can be allocated to projects that yield a lot of extra output, but as the country acquires more and more capital, such projects become harder and harder to find. Conversely, a country that has more of the other inputs in the production function will have a higher marginal product of capital.
Countries with a lot of labor, other things being equal, will be able to get more out of a given piece of machinery—because each piece of machinery can be combined with more labor time. As a simple example, think about taxis. In a capital-rich country, there may be only one driver for every taxi. In a poorer country, two or three drivers often share a single vehicle, so that vehicle spends much more time on the road. The return on capital—other things being equal—is higher in countries with a lot of labor and not very much capital to share around. Such countries are typically relatively poor, suggesting that poor countries should attract investment funds from elsewhere. In other words, basic economics suggests that if the return on investment is indeed higher in poor countries, investment funds should flow to those countries.
We certainly do see individual examples of such flows. The story at the beginning of this chapter about a Taiwanese company establishing a factory in Vietnam is one example. The following quotation from a British trade publication describes another.
Less than two months into 2006 and the UK’s grocery manufacturing industry is already notching up a growing list of casualties: Leaf UK is considering whether to close its factory in Stockport; Elizabeth Shaw is shutting a plant in Bristol; Arla Foods UK is pulling out of a site at Uckfield; Richmond Foods is ending production in Bude; and Hill Station is shutting a site in Cheadle.
[…]
The stories behind these closures are all very different. But two common trends emerge. First, suppliers are being forced to step up the pace of consolidation as retailer power grows and that means more facilities are being rationalised. Second, production is being shifted offshore as grocery suppliers take advantage of lower-cost facilities.“Shutting Up Shop,” The Grocer, February 25, 2006, accessed June 28, 2011, www.coadc.com/grt_article_6.htm. The Grocer is a trade publication for the grocery industry in the United Kingdom.
This excerpt observes that food processing that used to be carried out in Britain is being shifted to poorer Eastern European countries, such as Poland. When factories close in Britain and open in Poland, it is as if physical capital—factories and machines—is moving from Britain to other countries.
If the amount of capital (relative to labor) were the only factor determining investment, we would expect to see massive amounts of lending going from rich countries to poor countries. Yet we do not see this. The rich United States, in fact, borrows substantially from other countries. The stock of other inputs—human capital, knowledge, social infrastructure, and natural resources—also matters. If workers are more skilled (possess more human capital) or if an economy has superior social infrastructure, it can obtain more output from a given amount of physical capital. The fact that the United States has more of these inputs helps to explain why investors perceive the marginal product of capital to be high in the United States.
Earlier we explained that even though migration could in principle even out wages in different economies, labor is, in fact, not very mobile across national boundaries. Capital is relatively mobile, however, and the mobility of capital will also tend to equalize wages. If young Polish workers move from Poland to England, real wages will tend to increase in Poland and decrease in England. If grocery manufacturers move production from England to Poland, then real wages will likewise tend to increase in Poland and decrease in England.
In fact, imagine that two countries have different amounts of physical capital and labor, but the same amount of all other inputs. If physical capital moves freely to where it earns the highest return, then both countries will end up with the same marginal product of capital and the same marginal product of labor. The movement of capital substitutes for labor migration and leads to the same result of equal real wages. This is a striking result.
The result is only this stark if the two countries have identical human capital, knowledge, social infrastructure, and natural resources.There are, not surprisingly, other, more technical, assumptions that matter as well. Perhaps the most important is that the production function should indeed display diminishing marginal product of capital, as we have assumed in this chapter. If other inputs differ, then the mobility of capital will still affect wages, but wages will remain higher in the economy with more of other inputs. If workers in one country have higher human capital, then they will earn higher wages even if capital can flow freely between countries. But the underlying message is the same: globalization, be it in the form of people migrating from one country to another or capital moving across national borders, should tend to make the world a more equal place.
Key Takeaways
• As an accounting identity, the amount of investment is equal to the national savings of a country plus the amount it borrows from abroad.
• The capital stock of a country changes over time due to investment and depreciation of the existing capital stock.
• Differences in the marginal product of capital lead to movements of capital across countries.
Exercises
1. Can investment ever be negative at a factory? In a country?
2. Explain why the movement of capital across two countries will have an effect on the real wages of workers in the two countries. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/20%3A_Globalization_and_Competitiveness/20.04%3A_Physical_Capital_in_the_Aggregate_Production_Function.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. How does the amount of human capital in a country change over time?
2. How is knowledge created?
3. How do property rights influence the aggregate production function?
We have less to say about the other inputs into the aggregate production function, so we group them together.
Human Capital
Education makes the most important contribution to human capital in an economy. Kindergarteners learning to count are acquiring human capital, as are high-school students learning algebra, undergraduate students learning calculus, and experienced workers studying for an MBA. People also acquire human capital on the job—either as a result of explicit company training programs or simply because of practice and experience (sometimes called “learning by doing”).
The education policy of national governments therefore plays a big part in determining how much human capital there is in a country. In the United States and Europe, education is typically compulsory up to age 15 or 16. In other countries, the school-leaving age is lower: 10 in Bangladesh, 11 in Iran, and 13 in Honduras, for example. In still other countries, education is not compulsory at all.“At What Age…? Comparative Table,” Right to Education Project, accessed June 28, 2011, http://www.right-to-education.org/node/279. One of the aims of the American Competitiveness Initiative, mentioned at the beginning of this chapter, was to “provide American children with a strong foundation in math and science.”
There are many similarities between human capital and physical capital. Human capital, like physical capital, is accumulated through a process of investment. Basic education is an investment made by parents and governments. University education is an investment made by individuals and households. When you go to college, you give up time that you could have spent working or having fun. This is one cost of education. The other cost is the expense of tuition. The gain from education—the return on your investment—is that sometime in the future you will be more productive and earn more income. An individual decision to go to college is based on an evaluation of the costs (such as tuition and foregone time) and the benefits (such as higher salary after graduation and the joy of studying fascinating subjects like economics).
Firms also invest in human capital. They seek to increase the productivity of their workers by in-house training or by sending workers to external training courses. Large firms typically devote substantial resources to the training and development of their employees. Some of the skills that workers acquire are transferable to other firms if the worker moves to another job. For example, workers who have attended a training course on accounting would be able to use the knowledge they acquired from that course at many different firms. Other skills are specific to a particular firm (such as knowing exactly where to hit a particular machine with a hammer when it jams).
Human capital, like physical capital, can depreciate. People forget things that they learned, or their knowledge becomes obsolete. VisiCalc was once a leading spreadsheet software, so people skilled in its use had valuable human capital; yet knowledge of this program is of little use today. Human capital that is specific to a particular firm is particularly prone to depreciation because it becomes worthless if the worker leaves or if the firm goes out of business. One reason why factory closures—such as those in the food retailing sector in the United Kingdom—arouse such concern is that laid-off workers may see their useful human capital decline and end up with lower paying jobs as a result.
While there are similarities between physical and human capital, there are also differences. Most importantly, human capital is trapped inside people. Economists say that such skills are “embodied” in the labor force. You cannot sell the human capital that you own without selling your own labor time as well. The implication for government policy is that importing human capital means importing people. Dubai is trying to attract human capital—so it advertises the things that make the country attractive to individuals who own that human capital. Thus their website speaks of the “cosmopolitan lifestyle” in Dubai, together with the quality of the hospitals, schools, shops, and so on.
Knowledge
Many large firms contain research and development (R&D) divisions. Employees in these divisions engage in product development and process development. Product development consists of developing new products and improving a firm’s existing products. Process development consists of finding improvements in a firm’s operations and methods of manufacture to reduce the costs of production.
An example of product development is the development and testing of a new pharmaceutical compound to treat cancer. An example of process development is the way in which transportation firms now use global positioning systems (GPSs) to better manage the movements of their trucks. In either case, firms invest today in the hope of gains in the future from lower production costs and better products.
Knowledge of this kind is also created by independent research laboratories, universities, think tanks, and other such institutions. In many cases, governments subsidize these institutions: policymakers actively intervene to encourage the production of new knowledge. Governments get involved because new knowledge can benefit lots of different firms in an economy. Think of how the invention of electric power, the internal combustion engine, the microchip, or the Internet benefits almost every firm in the economy today.
Economists say that basic knowledge is a nonrival. A good is nonrival if one person’s consumption of that good does not prevent others from also consuming it. A good is rival if one person’s consumption prevents others from also consuming it. The fact that one marketing manager is using economic theory to set a profit-maximizing price doesn’t prevent another manager in a different firm from using the same piece of knowledge. (Contrast this with, say, a can of Coca-Cola: if one person drinks it, no one else can drink it.)
Knowledge is also often nonexcludable. A nonexcludable good is one for which it is impossible to selectively deny access. In other words, it is not possible to let some people consume a good while preventing others from consuming it. An excludable good is one to which we can selectively allow or deny access. Once a piece of knowledge is out in the world, it is difficult to prevent others from obtaining access to it. Nobody has patents on basic economic principles of price setting.
Together, these two properties of knowledge mean that a discoverer or inventor of new knowledge may not get all, or even most, of the benefits of that knowledge. As a result, there is insufficient incentive for individuals and firms to try to create new knowledge.
Social Infrastructure
Social infrastructure is a catchall term for the general business environment within a country. Is the country relatively free of corruption? Does it possess a good legal system that protects property rights? In general, is the economy conducive to the establishment and operation of business?
Economists have found that social infrastructure is a critical input into the aggregate production function. Why does it matter so much? When a firm in the United States or another advanced country builds a factory, there is an expectation of revenues generated by this investment that will make the investment profitable. The owners of the firm expect to obtain the profits generated by the activities in that plant. They also expect that the firm has the right to sell the plant should it wish to do so. The firm’s owners may confront uncertainty over the profitability of the plant—the product manufactured there might not sell, or the firm’s managers might miscalculate the costs of production. But it is clear who owns the plant and has the rights to the profits that it generates.
If the owners of firms are unsure if they will obtain these profits, however, they have less incentive to ensure that firms are well managed, and indeed they have less incentive to establish firms in the first place. Output in an economy is then lower. Governments take many actions that influence whether owners will indeed receive the profits from their firms. First, in most countries, governments tax the profits of firms. High tax rates reduce the return on investment. Uncertainty in tax rates also matters because it effectively lowers the return on investment activities. Economists have found that countries with high political turnover tend to be relatively slow growing. One key reason is that frequent changes in political power lead to uncertainty about tax rates.
Governments can also enact more drastic policies. The most extreme example of a policy that affects the return on investment is called expropriation—the taking of property by the government without adequate compensation. Although both domestically owned and foreign-owned firms could be subject to expropriation, expropriation is more often about the confiscation of the assets of foreign investors. The World Bank has an entire division dedicated to settling disputes over expropriation.It is called the International Centre for Settlement of Investment Disputes ( icsid.worldbank.org/ICSID/Index.jsp). For example, it is arbitrating on a \$10 million dispute between a Cypriot investment firm and the government of Turkey: in 2003 the Turkish government seized without compensation the assets of two hydroelectric utilities that were majority owned by the Cypriot firm. Such settlements can take a long time; at the time of this writing (mid-2011), the dispute has not yet been settled.
There are also more subtle challenges to the rights of foreign investors. Governments may limit the amount of profits that foreign companies can distribute to their shareholders. Governments may limit currency exchanges so that profits cannot be converted from local currencies into dollars or euros. Or governments may establish regulations on foreign-owned firms that increase the cost of doing business. All such actions reduce the attractiveness of countries as places for foreign investors to put their funds.
Economists group these examples under the heading of property rights. An individual (or institution) has property rights over a resource if, by law, that individual can make all decisions regarding the use of the resource. The return on investment is higher when property rights are protected. In economies without well-established property rights, the anticipated rate of return on investment must be higher to induce firms and households to absorb the investment risks they face.
As a consequence, countries with superior social infrastructure are places where firms will prefer to do business. Conversely, countries that have worse infrastructure are less attractive and will tend to have a lower output. On the website for Dubai at the beginning of the chapter, we see that Dubai touts its free enterprise system, for example. (Dubai’s website reveals that physical infrastructure, which is part of the Emirate’s capital stock, also plays a critical role: the website touts the superior transport, financial, and telecommunications infrastructure to be found in Dubai.) As another example, Singapore has a project known as Intelligent Nation 2015 that aims to “fuel creativity and innovation among businesses and individuals”“Singapore: An Intelligent Nation, A Global City, powered by Infocomm,” iN2015, accessed June 29, 2011, www.ida.gov.sg/About%20us/20100611122436.aspx. through improved information technology, including making the entire country Wi-Fi enabled.
An illustration of the importance of social infrastructure comes from the vastly different economic performance of artificially divided economies. At the time that North Korea and South Korea were divided, the two countries were in very similar economic circumstances. Obviously, they did not differ markedly in terms of culture or language. Yet South Korea went on to be one of the big economic success stories of the past few decades, while North Korea is now one of the poorest countries in the world. The experience of East Germany and West Germany is similar: East Germany stagnated under communism, while West Germany prospered.
Natural Resources
There is less to say about what determines the amount of natural resources in the production function. The natural resources available to a country are largely accidents of geography. The United States is fortunate to have high-quality agricultural land, as well as valuable deposits of oil, coal, natural gas, and other minerals. South Africa has deposits of gold and diamonds. Saudi Arabia, Iraq, Kuwait, the United Arab Emirates, and other Middle Eastern countries have large reserves of oil. The United Kingdom and Norway have access to oil and natural gas from the North Sea. For every country, we can list its valuable natural resources.
Natural resources are divided into those that are renewable and those that are nonrenewable. A renewable resource is a resource that regenerates over time. A nonrenewable (exhaustible) resource is one that does not regenerate over time. Forests are an example of a renewable resource: with proper management, forests can be maintained over time by judicious logging and replanting. Solar and wind energy are renewable resources. Coal, oil, and minerals are nonrenewable; diamonds taken from the ground can never be replaced.
It is difficult to measure the natural resources that are available to an economy. The availability of oil and mineral reserves is dependent on the technologies for extraction. These technologies have developed rapidly over time. The economic value of these resources, meanwhile, depends on their price in the marketplace. If the price of oil decreases, the value of untapped oil fields decreases as well.
Economists and others sometimes use real gross domestic product (real GDP) as an indicator of economic welfare. One problem with real GDP as an indicator of economic welfare is that it fails to take into account declines in the stock of natural resources. In Chapter 18 "The State of the Economy", we note several of these. If the stock of natural resources is viewed—as it should be—as part of the wealth of a country, then depreciation of that stock should be viewed as a loss in income. (The same argument, incidentally, applies to depreciation of a country’s physical capital stock. Real GDP also does not take this into account. However, national accounts do report other statistics that adjust for the depreciation of physical capital, whereas they do not report any adjustment for natural resource depletion.)
Key Takeaways
• The human capital of a country can be accumulated by education, the training of workers, and immigration of workers into that country.
• Knowledge about new products and new processes is created by R&D activities within firms, universities, and government agencies.
• Property rights influence the amount of capital in the aggregate production function. In an economy where property rights are not well defined, there is a lower incentive to invest and hence less capital.
Exercises
1. How does on-the-job experience affect the human capital of an economy?
2. Why is it difficult to measure the natural resources available in an economy? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/20%3A_Globalization_and_Competitiveness/20.05%3A_Section_5-.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is growth accounting?
2. What are the different time horizons that we use in economics?
We have inventoried the factors that contribute to gross domestic product (GDP). The next step is to understand how much each factor contributes. If an economy wants to increase its GDP, is it better off trying to boost domestic savings, attract more capital from other countries, improve its infrastructure, or what? To answer such questions, we introduce a new tool that links the growth rate of output to the growth rate of the different inputs to the production function.
Toolkit: Section 31.21 "Growth Rates"
A growth rate is the percentage change in a variable from one year to the next. For example, the growth rate of real GDP is defined as
You can learn more about growth rates in the toolkit.
Some of the inputs to the production function—most notably knowledge, social infrastructure, and natural resources—are very difficult to measure individually. Economists typically group these inputs together into technology, as shown in Figure 20.6.1 "The Aggregate Production Function". The term is something of a misnomer because it includes not only technological factors but also social infrastructure, natural resources, and indeed anything that affects real GDP but is not captured by other inputs.
The aggregate production function combines an economy’s physical capital stock, labor hours, human capital, and technology (knowledge, natural resources, and social infrastructure) to produce output (real GDP).
The technique for explaining output growth in terms of the growth of inputs is called growth accounting.
Toolkit: Section 31.28 "Growth Accounting"
Growth accounting tells us how changes in real GDP in an economy are due to changes in available inputs. Under reasonably general circumstances, the change in output in an economy can be written as follows:
$output\ growth\ rate = a \times\ capital\ stock\ growth\ rate + [(1 − a) times\ labor\ hours\ growth\ rate] + [(1 − a) times\ human \ capital\ growth\ rate] + technology\ growth\ rate.$
In this equation, a is just a number. Growth rates can be positive or negative, so we can use the equation to analyze decreases and increases in GDP.
We can measure the growth in output, capital stock, and labor hours using easily available economic data. The growth rate of human capital is trickier to measure, although we can use information on schooling and literacy rates to estimate this number. We also have a way of measuring a. The technical details are not important here, but a good measure of (1 − a) is simply total payments to labor in the economy (that is, the total of wages and other compensation) as a fraction of overall GDP. For most economies, a is in the range of about 1/3 to 1/2.
For the United States, the number a is about 1/3. The growth rate of output is therefore given as follows:
Because we can measure everything in this equation except growth in technology, we can use the equation to determine what the growth rate of technology must be. If we rearrange, we get the following:
To emphasize again, the powerful part of this equation is that we can use observed growth in labor, capital, human capital, and output to infer the growth rate of technology—something that is impossible to measure directly.
Growth Accounting in Action
Table 20.6.1 "Some Examples of Growth Accounting Calculations*" provides information on output growth, capital growth, labor growth, and technology growth. The calculations assume that a = 1/3. In the first row, for example, we see that
$growth\ in\ technology\ =\ 5.5 − [(1/3) \times 6.0] − [(2/3) \times (2.0 + 1.0)]= 5.5 − 2.0 − 2.0= 1.5.$
Year Output Growth Capital Growth Labor Growth Human Capital Growth Technology Growth
2010 5.5 6.0 2.0 1.0 1.0
2011 2.0 3.0 1.5 0 0
2012 6.5 4.5 1.0 0.5
2013 1.5 0 0 2.2
2014 4.4 3.3 0 1.3
$^{*}$The figures in each column are percentage growth rates.
Table $1$: Some Examples of Growth Accounting Calculations $^{*}$
Growth accounting is an extremely useful tool because it helps us diagnose the causes of economic success and failure. We can look at successful growing economies and find out if they are growing because they have more capital, labor, or skills or because they have improved their technological know-how. Likewise, we can look at economies in which output has fallen and find out whether declines in capital, labor, or technology are responsible.We use this tool in Chapter 22 "The Great Depression" to study the behavior of the US economy in the 1920s and 1930s.
Researchers have found that different countries and regions of the world have vastly varying experiences when viewed through the lens of growth accounting. A World Bank study found that, in developing regions of the world, capital accumulation was a key contributor to output growth, accounting for almost two-thirds of total growth in Africa, Latin America, East Asia, and Southeast Asia.The study covered the period 1960–1987. See World Bank, World Development Report 1991: The Challenge of Development, vol. 1, p. 45, June 30, 1991, accessed August 22, 2011, econ.worldbank.org/external/default/main?pagePK=64165259&theSitePK=478060&pi PK=64165421&menuPK=64166093&entityID=000009265_3981005112648. Technology and human capital growth played a surprisingly small role in these regions, contributing nothing at all to economic growth in Africa and Latin America, for example.
The Short Run, the Long Run, and the Very Long Run
Growth accounting focuses on how inputs—and hence output—change over time. We use the tool both to look at changes in an economy over short time periods—say, from one month to the next—and also over very long time periods—say, over decades. We are limited only by the data that we have available to us. It is sometimes useful to distinguish three different time horizons.
1. The short run refers to a period of time that we would typically measure in months. If something has only a short-run effect on an economy, the effect will vanish within months or a few years at most.
2. The long run refers to periods of time that are better measured in years. If something will happen in the long run, we might have to wait for two, three, or more years before it happens.
3. The very long run refers to periods of time that are best measured in decades.
These definitions of the short, long, and very long runs are not and cannot be very exact. In the context of particular chapters, however, we give more precise definitions to these ideas.For example, Chapter 25 "Understanding the Fed" explains the adjustment of prices in an economy. In that chapter, we define the short run as the time horizon in which prices are “sticky”—not all prices have adjusted fully—whereas the long run refers to a period where all prices have fully adjusted. Meanwhile, Chapter 21 "Global Prosperity and Global Poverty" uses the very long run to refer to a situation where output and the physical capital stock grow at the same rate. Figure 20.6.2 "The Different Time Horizons in Economics" summarizes the main influences on the inputs to the production function in the short run, the long run, and the very long run.
Look first at physical capital—the first row in Figure 20.6.2 "The Different Time Horizons in Economics". In the short run, the amount of physical capital in the economy is more or less fixed. There are a certain number of machines, buildings, and so on, and we cannot make big changes in this capital stock. One thing that firms can do in the short run is to change capital utilization—shutting down a production line if they want to produce less output or running extra shifts if they want more output. Once we move to the long run and very long run, capital mobility and capital accumulation become important.
Look next at labor. In the short run, the amount of labor in the production function depends primarily on how much labor firms want to hire (labor demand) and how much people want to work (labor supply). As we move to the long run, migration of labor becomes significant as well: workers sometimes move from one country to another in search of better jobs. And, in the very long run, population growth and other demographic changes (the aging of the population, the increased entry of women into the labor force, etc.) start to matter.
Human capital can be increased in the long run (and also in the short run to some extent) by training. The most important changes in human capital come in the very long run, however, through improved education.
There is not very much that can be done to change a country’s technology in the short run. In the long run, less technologically advanced countries can import better technologies from other countries. In practice, this often happens as a result of a multinational firm establishing operations in a developing country. For example, if Dell Inc. establishes a factory in Mexico, then it effectively transfers some know-how to the Mexican economy. This is known as technology transfer, the movement of knowledge and advanced production techniques across national borders.
In the long run and very long run, technology advances through innovation and the hard work of research and development (R&D) that—hopefully—gives us new inventions. In the very long run, countries may be able to improve their institutions and thus create better social infrastructure. In the very long run, declines in natural resources also become significant.
Key Takeaways
• Growth accounting is a tool to decompose economic growth into components of input growth and technological progress.
• In economics, we study changes in GDP over very different time horizons. We look at short-run changes due mainly to changes in hours worked and the utilization of capital stock. We look at long-run changes due to changes in the amount of available labor and capital in an economy. And we look at very-long-run changes due to the accumulation of physical and human capital and changes in social infrastructure and other aspects of technology.
Exercises
1. Rewrite the growth accounting equation for the case where a = 1/4.
2. Using the growth accounting equation, fill in the missing numbers in Table 20.6.1 "Some Examples of Growth Accounting Calculations$^{*}$". | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/20%3A_Globalization_and_Competitiveness/20.06%3A_Accounting_for_Changes_in_GDP.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. How is competitiveness measured?
2. What are some of the policies governments use to influence their competitiveness?
At the beginning of this chapter, we noted that both President George W. Bush and President Obama have emphasized policies to improve the competitiveness of the United States. Such interest in national competitiveness is not restricted to the United States.It is perhaps more pronounced in the United States than in other countries. A Google search on October 17, 2011 reveals that the string “Keep America Competitive” has almost twice as many hits as the string “Keep Canada Competitive” and more than three times as many hits as “Keep Britain Competitive.” In their “Lisbon Agenda” of 2000, the heads of European countries stated an aim of making the European Union “the most competitive and dynamic knowledge-driven economy by 2010.”See “Lisbon Agenda,” EurActive, May 21, 2007, accessed July 27, 2011, www.euractiv.com/en/future-eu/lisbon-agenda/article-117510.
Competitiveness: Another Look
Various organizations produce rankings of the competitiveness of countries. For example, IMD, a business school in Switzerland, produces a World Competitiveness Yearbook (WCY) every year.See “World Competitiveness Center,” IMD, accessed August 22, 2011, http://www.imd.org/research/centers/wcc/index.cfm. The World Economic Forum (WEF) produces an annual Global Competitiveness Report.See “Global Competitiveness Report,” World Economic Forum, accessed June 29, 2011, www.weforum.org/s?s=global+competitiveness. In 2010, the WEF judged Switzerland to be the most competitive economy in the world, followed by the United States and Singapore. According to IMD, the top three were Hong Kong, the United States, and Singapore. These rankings are covered extensively in the business press, and there is also a market for them—WCY resources cost over \$1,000. Business and governments purchase these reports each year. National competitiveness is big business.
In their bid to measure competitiveness, the WEF and the WCY look at a combination of “hard” economic data and surveys of businesspeople. Each looks at hundreds of measures in their respective attempts to measure national competitiveness. If these two institutions are to be believed, national competitiveness is a very complicated animal indeed. Although we do not want to go through their measures in detail, a few themes emerge.
• Both the WEF and the WCY look at measures of human capital, such as the number of people enrolled in tertiary education.
• Technology and technological infrastructure feature prominently in both lists of data. The WEF and the WCY look at measures such as the penetration of computers, the Internet, and mobile phones and the granting of patents.
• The quality of public institutions and the prevalence of corruption feature prominently in both lists. Here, the WEF relies on survey data on corruption, bribes, and the extent to which the legal system is fair and transparent. The WCY includes survey information on management practices and “attitudes and values.”
Thus the items that we have identified as components of social infrastructure and human capital are included as key determinants of competitiveness. (Technological infrastructure is difficult to classify and measure. In part, it is captured by measures of capital stock because knowledge can be embodied in the capital stock.)
Countries that do better in terms of these rankings will tend to have higher levels of output because these are all inputs into the aggregate production function. The competitiveness of a country is not a matter of how much output it produces, however; we already have a perfectly good measure of that, called real gross domestic product (real GDP). Instead, competitiveness is the ability to attract foreign capital. If countries do not have enough domestic savings to fund investment, then they need to obtain capital from other countries. The amount of capital in the world is limited, so countries compete for this capital by trying to make their economies attractive places to invest. More human capital, better knowledge, or superior social infrastructure all serve to increase the return on investment. If workers are more skilled, then extra capital will generate more output. If firms have better processes in place, then extra capital will generate more output. If a country is free of corruption, then extra capital will generate more output.
This suggests that one good yet simple indicator of national competitiveness is the marginal product of capital. Country A is more competitive than country B if capital investment in country A is more productive than in country B. More exactly, a country is more competitive if it has a higher marginal product of capital.
Globalization: Another Look
Whenever a good or service is produced and sold, economic value is created. The amount of value is given by the difference between the value to the buyer and the value to the seller. For example, suppose a toy car is produced in a factory in Kansas at a cost of \$5. Imagine that a potential buyer in California values the car at \$20—that is, she is willing to pay up to this amount for the toy. Then the value created if the buyer and seller trade is \(\$20 − \$5 = \$15.\)
In a globalized world, toy cars can be transported around the world. This means two things. First, goods can go to where buyers value them the most. There might be a buyer in Germany who values the car at \$25. If he buys the car, then the trade creates \$20 worth of value (\(= \$25 − \$5\)). Second, goods can be manufactured where production costs are lowest. Perhaps the toy car can be manufactured in China for \$2. If the toy is produced in China and sold in Germany, then the total value created by the trade increases to \$23 (\(= \$25 − \$2\)). Globalization thus contributes to a more efficient global economy because goods—and many services—can be shipped around the world to create more value. They can be produced where it is most efficient to produce them and sold where they are valued the most.
We have also seen that capital (and to a lesser extent labor) moves around the world. Capital moves to competitive economies—that is, to the places where its marginal product is highest. This again contributes to economic efficiency because it means that we (that is, the world as a whole) get more output from a given amount of capital input.
This brief description paints a rosy picture of globalization as a force that makes the world a more productive place. Yet globalization has vehement critics. Protesters have taken to the streets around the world to complain about it. And the recent era of globalization has seen mixed results in terms of economic success. Some economies—particularly in East Asia—have exploited the opportunities of globalization to their advantage. But other countries—most notably in sub-Saharan Africa—remain stuck in poverty.
So what is our story missing? What is wrong with the idea that the free movement of goods and capital can encourage prosperity everywhere? There are some reasons why we should temper our optimism about the process of globalization, including the following:
• There are winners and losers. There is a strong presumption from economic theory that globalization will increase overall economic efficiency, but there is no guarantee that everyone will gain. Investors are winners from globalization because they can send their funds to wherever capital earns the highest return. Workers in countries that attract capital will, in general, be winners because they will obtain higher real wages. However, workers in countries that lose capital lose from globalization: they see their real wages decrease. In our example, the buyers of toys in California and Germany benefit from the fact that toys are cheaper and available in greater variety. But the toy manufacturer in Kansas loses out because it cannot compete with the cheaper product from China. The factory may close, and its workers may be forced to look for other—perhaps less attractive—jobs.
• The playing field is not level. In an introductory economics book, we do not have room to review the details of trade agreements throughout the world. But one trenchant criticism of globalization is that developed countries have maintained high tariffs and subsidies even as they have encouraged poorer countries to eliminate such measures. As a result, the benefits of globalization have been almost entirely absent for some of the poorest countries in the world. Moreover, rich countries have disproportionate control over some of the key international institutions: the managing director of the International Monetary Fund (IMF) is traditionally a European; the president of the World Bank is appointed by the United States.
• One size may not fit all. International institutions such as the IMF and the World Bank typically advocate similar policies for all countries. In fact, different policies might be appropriate for different countries. For example, these organizations argued that countries should allow free movement of capital across their borders. We have seen that there is a strong argument for allowing capital to go in search of the highest return. But not all capital flows take the form of building new factories. Sometimes, the movement of capital consists of only very fast transfers of money in and out of countries, based on guesses about movements in interest rates and exchange rates. These flows of money can be a source of instability in a country. There is increasing recognition that, sometimes at least, it is better to place some limits on such speculative capital movements.
Most economists are convinced that the benefits of globalization are enough to outweigh these concerns. Many—perhaps most—are also convinced that, if globalization is to live up to its promise for the world, it needs to be managed better than it has been in the past.
Policies to Increase Competitiveness and Real Wages
We know that if an economy increases its labor input, other things being equal, the marginal product of labor (and hence the real wage) decreases. If an economy increases its physical capital stock, meanwhile, then the marginal product of capital (and hence the economy’s competitiveness) decreases.
There is a critical tension between competitiveness and real wages. Suppose for a moment that human capital and technology are unchanging. Then an economy in which real wages are increasing must also be an economy that is becoming less competitive. Conversely, the only way in which an economy can become more competitive is by seeing its real wages decrease.
High real wages make a country less attractive for businesses—after all, firms choose where to locate in an attempt to make as much profit as possible, so, other things being equal, they prefer to be in low-wage economies. Indeed, the WEF and the WCY both use labor costs as one of their indicators of competitiveness. Our article about Compal locating in Vietnam likewise cited low wages as an attraction of the country.
But we must not be misled by this. High real wages signal prosperity in a country. Low real wages, even if they make an economy competitive and help to attract capital, are not in themselves desirable. After all, the point of attracting capital in the first place is to increase economic well-being. As an example, China has been quite successful at attracting capital, in large part because of low real wages. As the country has become more prosperous, real wages have risen. A Business Week article, commenting on the increasing wages in the country, observed the following: “The wage issue has started to affect how companies operate in China. U.S. corporations and their suppliers are starting to rethink where to locate facilities, whether deeper into the interior (where salaries and land values are smaller), or even farther afield, to lower-cost countries such as Vietnam or Indonesia. Already, higher labor costs are beginning to price some manufacturers out of more developed Chinese cities such as Shanghai and Suzhou.”“How Rising Wages Are Changing the Game in China,” Bloomberg BusinessWeek, March 27, 2006, accessed June 29, 2011, http://www.businessweek.com/magazine/content/06_13/b3977049.htm. In other words, increasing real wages are making China less competitive. But this tells us that China is getting richer, and workers in China are able to enjoy improvements in their standard of living. This is a good thing, not a problem.
What we really want are policies that will increase both competitiveness and real wages at the same time. The only way to do this is by increasing the stocks of human capital, knowledge, and social infrastructure (there is little a country can do to increase its stock of natural resources). There are no easy or quick ways to increase any of these. Still, important policy options include the following:
• Invest in education and training. Overall economic performance depends to a great degree on the education and skills of the workforce. This is one reason why countries throughout the world recognize the need to provide basic education to their citizens. It is worthwhile for countries to build up their stock of human capital just as it is worthwhile for them to build up their stocks of physical capital.
• Invest in research and development (R&D). The overall knowledge in an economy is advanced by new inventions and innovations. The romantic vision of invention is that some brilliant person comes up with a completely new idea. There are celebrated examples of this throughout human history, starting perhaps with the cave dweller who had the idea of cracking a nut with a stone and including the individual insights of scientists like Louis Pasteur, Marie Curie, and Albert Einstein. But the reality of invention in the modern economy is more mundane. Inventions and innovations today almost always originate from teams of researchers—sometimes in universities or think tanks or sometimes in the R&D departments of firms. Governments often judge it worthwhile to subsidize such research to help increase the stock of knowledge. R&D expenditures in the United States and other rich countries are substantial; in the United States they amount to about 2 percent of GDP.
• Encourage technology transfer. Firms in developed countries tend to have access to state-of-the-art knowledge and techniques. To increase their stock of knowledge, such countries must advance the overall knowledge of the world. For poorer countries in the world, however, there is another possibility. Factories in poor countries typically do not use the most advanced production techniques or have the most modern machinery. These countries can improve their stock of knowledge by importing the latest techniques from other countries. In practice, governments often do this by encouraging multinational firms from rich countries to build factories in their countries. Technology transfer within a country is also important. Researchers have found that, even with a country, there can be big differences in the productivity of different factories within an industry.See Chang-Tai Hsieh and Peter Klenow, “Misallocation and Manufacturing TFP in China and India,” The Quarterly Journal of Economics CXXIV, no. 4, November 2009, accessed June 28, 2011, http://klenow.com/MMTFP.pdf. So countries may be able to increase real GDP by providing incentives for knowledge sharing across plants.
• Invest in social infrastructure. Improvements in social infrastructure are hard to implement. A government, no matter how well intentioned, cannot eliminate corruption overnight. Nor can it instantly establish a reliable legal system that will uphold contracts and protect property rights. (Even if a country could do so, it would still take considerable time for international investors to gain confidence in the system.) Improving social infrastructure is, for most countries, a struggle for the long haul.
We should ask whether government needs to play a role in any of this. After all, individuals have an incentive to invest in their own education. Many people find it worthwhile to pay for undergraduate or graduate degrees because they know they will get better, higher paying jobs afterward. Similarly, firms have a lot of incentive to carry out R&D because a successful invention will allow them to earn higher profits.
There is no doubt that these private incentives play a big role in encouraging the advancement of knowledge. Still, most economists agree that private incentives are not sufficient. Particularly in poor countries, people may not be able to afford to pay for their own education or be able to borrow for that purpose, even if it would eventually pay off for them to do so.
Because knowledge is nonrival and frequently nonexcludable, not all the benefits from R&D flow to the firms that make the investment. For example, suppose a firm comes up with some new software. Other firms may be able to imitate the idea and capture some of the benefits of the invention. (Although the United States and other countries have patent and copyright laws to help ensure that people and firms can enjoy the benefits of their own inventions, such laws are imperfect, and firms sometimes find that their ideas are copied or stolen.) Private markets will do a poor job of providing nonrival and nonexcludable goods, so there is a potential role for the government.
Similar arguments apply to much social infrastructure. The provision of roads is a classic function of government because they are again (most of the time, at least) nonrival and nonexcludable. And the establishment of a reliable legal system is one of the most basic functions of government.
Key Takeaways
• In some leading studies, the items that we have identified as components of social infrastructure and human capital are included as key determinants of competitiveness. Overall, the marginal product of capital is a good indicator of the competitiveness of a country.
• Governments take actions to increase their competitiveness and the real wages of their workers by encouraging the accumulation of human capital, knowledge, and the transfer of technology.
Exercises
1. Why is GDP not a good measure of competitiveness?
2. How could a policy to increase the inflow of capital lead to a decrease in competitiveness? What does this inflow of capital do to the real wage of workers? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/20%3A_Globalization_and_Competitiveness/20.07%3A_Globalization_and_Competitiveness_Revisited.txt |
In Conclusion
We began the chapter with five stories from all around the world. Let us briefly review these stories, based on what we have learned in this chapter.
Niger
Niger is an extremely poor country. Life expectancy in Niger is 52, the infant mortality rate is over 10 percent, and less than 30 percent of the population can read and write. It is extremely poor because it lacks the key inputs to the production function. It is largely a subsistence agricultural economy: it has relatively little physical capital or human capital, little physical infrastructure, and poor social infrastructure as well. It is a natural target for World Bank help. The particular World Bank project that we cited is aimed at one particular input: its goal is to improve Niger’s human capital.
Vietnam
In a globalized world, savings and investment do not have to be equal in any individual economy. Savers can send their funds almost anywhere in the world in search of a high return on capital. Countries that are competitive, in the sense that they have a high marginal product of capital, will tend to attract such funds. One manifestation of these flows of capital is that multinational companies establish factories where they can produce most cheaply. In the story, we see that Vietnam, a low-wage economy, is attracting capital investment from a Taiwanese company. Capital flows have a similar effect to the migration of labor: when capital flows into a country, it increases the real wage; when capital flows out of a country, real wages decrease. Globalization benefits the world as a whole, but many individual workers may lose out.
United Arab Emirates
The policies of Dubai are straightforward to understand in the framework of this chapter. Dubai is actively trying to import foreign physical capital and human capital. It is encouraging multinational firms to establish operations in the country. This makes sense because, as we now know, increased physical and human capital will both tend to increase the marginal product of labor in Dubai, leading to higher wages and higher prosperity. Dubai’s claims of attractiveness rest largely on its social infrastructure.
The United Kingdom
Migrant workers are a global phenomenon, be they Poles traveling to England, Mexicans moving to the United States, or Filipinos moving to Saudi Arabia. Like the young Poles in this story, they move from country to country in search of higher wages. Worker migration across national boundaries tends to equalize wages in different countries. As workers leave Poland, for example, labor becomes scarcer there, so wages in Poland tend to increase. When they arrive in the United Kingdom, there is more labor supplied to the United Kingdom labor market, so wages there tend to decrease. However, labor migration is still quite limited because (1) countries restrict immigration and (2) most workers still do not want to suffer the upheaval of moving to a different country and culture.
United States
The competitiveness initiatives of President Obama and President George W. Bush are designed to increase both human capital and knowledge within the United States. They include measures to strengthen education (human capital), increase research and development (R&D; knowledge), and encourage entrepreneurship and innovation. We have seen that the idea of competitiveness is subtle: nations do not compete in the same way that countries do. Still, improvements in technology and human capital will tend to increase the marginal product of capital, making the United States a more attractive place for investment. In that sense, they do make the country more competitive.
Key Links
exercises
Output Capital Labor Human Capital Technology
10 1 1 10 10
20 2 2 10 10
20 4 1 10 10
20 1 4 10 10
30 9 1 10 10
30 1 9 10 10
30 3 3 10 10
40 2 8 10 10
40 8 2 10 10
40 4 4 10 10
40 4 4 20 5
40 4 4 5 20
80 4 4 20 20
TABLE \(1\): AN EXAMPLE OF A PRODUCTION FUNCTION
1. By comparing two different rows in the preceding table, show that the marginal product of labor is positive. Make sure you keep all other inputs the same. In other words, find two rows that show that an increase in labor, keeping all other inputs the same, leads to an increase in output.
2. By comparing two different rows in the preceding table, show that the marginal product of human capital is positive. Again, make sure you keep all other inputs the same.
3. By comparing two different rows in the preceding table, show that the marginal product of technology is positive.
4. Does the production function exhibit diminishing marginal product of physical capital? [Hint: if more and more extra capital is needed to generate the same increase in output, then there is diminishing marginal product.]
5. Does the production function exhibit diminishing marginal product of labor?
6. (Difficult) Can you guess what mathematical function we used for the production function?
7. Why are electricians not paid the same amount in Topeka, Kansas, and New York City? Why are electricians not paid the same amount in North Korea and South Korea? Is the explanation the same in both cases?
8. Think about the production function for the university or college where you are studying. What are some of the different inputs that go into it? Classify these inputs as physical capital, human capital, labor, knowledge, natural resources, and social infrastructure. Try to come up with at least one example of each.
9. Suppose government spending is 30, government income from taxes (including transfers) is 50, private saving is 30, and lending to foreign countries is 20. What is national savings? What is investment?
10. Explain how it is possible for investment to be positive yet for the capital stock to fall from one year to the next.
11. Is a fireworks display nonrival? Nonexcludable?
12. Suppose that a country’s capital stock growth rate is 8 percent, the labor hours growth rate is 4 percent, the human capital growth rate is 2 percent, and the technology growth rate is 3 percent. The parameter a is 0.25. What is the output growth rate?
13. Suppose that a country’s capital stock growth rate is 4 percent, the labor hours growth rate is 3 percent, the human capital growth rate is 1 percent, and the output growth rate is 5 percent. The parameter a is 0.5. What is the technology growth rate?
14. Explain why a decrease in a country’s competitiveness can be a sign that the country is becoming more prosperous.
15. Firms are sometimes willing to pay for training courses for their workers. Other things being equal, do you think a firm would prefer to pay for one of its employees to do a general management course or a course that trains the employee in the use of software designed specifically for the firm? Explain.
Economics Detective
1. Go to the website of the Bureau of Labor Statistics ( http://www.bls.gov). Find the median hourly wage in the state in which you live. (If you do not live in the United States, pick a state at random.)
1. How does it compare to the median hourly wage for the country as a whole?
2. Which is higher in your state—the median wage or the mean wage? Can you explain why?
2. Find an example of a competitiveness initiative in some country other than the United States. How will the proposed policies help to attract capital? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/20%3A_Globalization_and_Competitiveness/20.08%3A_End-of-Chapter_Material.txt |
[…]
I thought about my new friend Mariya, her life and daily routine. She was married before I had my driver’s license. She pounded millet all day, sweating yet smiling. She hauled water from the well. She cooked. She birthed child after child. There was no end to the manual labor her life required. I liked to watch her. It was fascinating. But if hers was my life, I’d probably jump into that well.
I’ve always thought what life each soul is assigned to is a game of chance. I couldn’t help but to wonder what would have become of me had the powers that be had shaken those dice one more time on March 16, 1982, before moving the game piece that sent me to DePaul Hospital in St. Louis, Missouri.
If I had been born into Mariya’s life, would I have been able to hack it? If she had been born into my life, would she have been happier? […]Alexis Wolff, “Village Life—Niger,” February 27, 2005, accessed June 28, 2011, http://www.bootsnall.com/articles/05-02/village-life-niger.html.
In Niger, where Mariya lives, about 1 in 9 children die before their first birthday. Life expectancy at birth is 53 years, and less than 30 percent of the population can read and write. About one-fifth of the population is nomadic. An Oxfam study in 2005 found that nomads had recently lost about 70 percent of their animals, and that “almost one in ten families is surviving on a diet of mainly wild plants, leaves, and grass.”See “The World Factbook,” Central Intelligence Agency, accessed June 28, 2011, www.cia.gov/library/publications/the-world-factbook/index.html; and “Nomadic Way of Life in Niger Threatened by Food Crisis,” Oxfam America, August 16, 2005, accessed June 29, 2011, www.oxfamamerica.org/press/pressreleases/nomadic-way-of-life-in-niger-threatened-by-food-crisis. Real gross domestic product (real GDP) per person in Niger is the equivalent of about \$700 per year.
Call centers are a phenomenon that has taken over the young crowd of metros in India by a storm. Its implications are social, cultural and economic. It is a new society of the young, rich and free, selling the new dream of an independent life to the regular desi.
[…]
[C]heap labor in India owes its origin to the high rate of unemployment here. Hundreds of thousands of graduates are jobless and desperate for work in India.
[…]
Most call center jobs require a basic understanding of computers and a good grasp over English. And the urban youth of India are computer literate graduates with a command over English language. This is the ideal unskilled labor that the call center industry is looking for.
[…]
With its operations mainly during the night, the call centers offer an opportunity for the young to live a perpetual nocturnal life, a saleable idea to the youth. The fascination of the dark and the forbidden, is tremendous for the Indian youth, recently unleashed from the chains of tradition and culture. Because of this fascination, the industry has developed an air of revolution about itself. Not only is it cool to work for call centers, it is radical and revolutionary.
Just like the bikers subculture of the 60s and the flower children of the 70s, these call centerites also have their own lingo and a unique style of existence. Most of them are happy in a well paying monotonous job, reaping the benefits of technology, enjoying a life away from rush hour traffic and local trains. The moolah is good, the work is easy and life is comfortable.“The Indo-American Dream—Coming of Age with Call Center Jobs,” Mumbai Travel & Living Guide, accessed June 28, 2011, www.mumbaisuburbs.com/articles/call-centers-mumbai.html.
Life expectancy in India is 67 years, and the infant mortality rate is about 1 in 20. Real GDP per person is about \$3,500.
More Americans own pets than ever before, and they're spending more money to keep them healthy, according to a survey released today by the American Veterinary Medical Association.
The number of U.S. households with pets climbed 7.6 million, to 59.5% of all homes, up from 58.3% in 2001. By comparison, about 35% of U.S. households have children, the Census Bureau says.
[…]
Pet owners are spending more on medical care. Veterinary expenditures for all pets were estimated at \$24.5 billion in 2006. In inflation-adjusted dollars, Americans spent \$22.4 billion in 2001.
This represents “the high-tech care that pet owners are demanding and willing to pay for,” DeHaven says. “Diseases that once would have been difficult to treat—diabetes, heart disease, cancer—today are very treatable. We’re even putting pacemakers in dogs.”Elizabeth Weiss, “We Really Love—and Spend on—Our Pets,” USA Today, December 11, 2007, accessed July 29, 2011, www.usatoday.com/life/lifestyle/2007-12-10-pet-survey_N.htm#.
In the United States, where spending on veterinary care for pets is considerably more than twice the entire GDP of Niger, the infant mortality rate is about 1 in 170, and life expectancy is about 78. Real GDP per person is more than 10 times greater than in India and almost 70 times greater than in Niger.
These stories are more than anecdotes. They are, in a real sense, representative of these three countries, as we can see by looking at economic data. Figure 21.1.1 "Real GDP per Person in the United States, India, and Niger" shows real GDP per person in India, the United States, and Niger over the 1960–2009 period.Alan Heston, Robert Summers, and Bettina Aten, “Penn World Table Version 6.2,” Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, September 2006, accessed June 29, 2011, pwt.econ.upenn.edu/php_site/pwt_index.php. The data in the Penn World Tables are constructed so that dollar figures for different countries can be legitimately compared. Specifically, the data are constructed on a purchasing power parity basis, meaning that they take into account the different prices of goods and services in different countries and are based on how much can actually be purchased. From part (a) of Figure 21.1.1 "Real GDP per Person in the United States, India, and Niger", we can see that GDP per person in the United States has grown substantially. On average, real GDP per person grew at 2 percent per year. Perhaps this doesn’t sound like a lot. Economic growth cumulates over time, however. An annual growth rate of 2 percent means that real GDP per person is about 2.6 times higher than half a century ago. To put it another way, each generation is roughly twice as rich as the previous generation. Although there are periods of high and low (sometimes even negative) growth in GDP per person, these fluctuations are overwhelmed by the overall positive growth in our economy. With this growth come many benefits: higher consumption, more varieties of goods, higher quality goods, better medical care, more enjoyable leisure time, and so on.
Real GDP per person in the United States (a) is substantially larger than (b) real GDP in India and Niger. The growth experiences of the three countries are also very different
Source: Alan Heston, Robert Summers and Bettina Aten, Penn World Table Version 7.0, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, May 2011.
Part (b) of Figure 21.1.1 "Real GDP per Person in the United States, India, and Niger" shows real GDP per person for India and Niger. Notice first that the scale on this graph is very different. In 1960, real GDP per person in the United States was about \$15,000 (measured in year 2005 dollars). In Niger and India, it was about 5 percent of the US figure—about \$700 per person. The second striking feature of this graph is the very different performance of India and Niger. India, like the United States, has grown: GDP per person is much higher at the end of the sample than at the beginning. Indeed, India has grown faster than the United States: the average growth rate over the period was 3.1 percent. Over the last two decades, the difference is even starker: India has grown at about 4.4 percent per year on average. Nevertheless, the United States is still a lot richer than India.
By world standards, India is a long way from being the poorest country. In 1960, Niger was richer than India on a per person basis. But in the following half century, Niger became poorer, not richer. GDP per person decreased by almost 30 percent. India in 2009 was six times richer than Niger. Statistics on GDP are just that—statistics—and it is easy to look at graphs like these and forget that they are telling us about the welfare of human beings. But imagine for a moment that Niger had managed to grow like India, instead of collapsing as it did. People would not be surviving by eating grass, infants would be more likely to grow up to be adults instead of dying of preventable diseases, and children would be learning to read and write.
This is why the study of economic growth matters. And this is why, in this chapter, we take on arguably the most important question in the entire book.
Why are some countries rich and other countries poor?
Along the way, we tackle two other closely related questions. We want to know if the differences in income that we see in the world are likely to persist over time. The experiences of the United States, India, and Niger suggest that this question may not have a simple answer: India has been tending to catch up with the United States, but Niger has been falling further behind. As we seek to answer that question, we will also investigate the ultimate sources of economic growth:
Will poorer countries catch up to richer countries?
Why do countries grow?
Road Map
The big mystery we investigate in this chapter is the vast variation in economic performance from country to country. We want to know why the experiences of the United States, India, and Niger are so different from one another.
We begin this chapter with an extended story. We think about how growth would work in a country with just a single inhabitant. Then we turn to a back-of-the-envelope calculation to understand why countries differ so much in terms of economic performance. To understand these differences, we focus attention on different inputs to the production function, first considering physical capital and then looking at human capital and technology. After that, we develop a complete framework for understanding how and why economies grow in the very long run. Finally, we look at policy and international institutions. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/21%3A_Global_Prosperity_and_Global_Poverty/21.01%3A_Life_Around_the_World.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. How does the capital stock increase?
2. What are the factors that lead to output growth?
3. What are the differences between growth in a closed economy and growth in an open economy?
The macroeconomy is very complicated. Overall economic performance depends on billions of decisions made daily by millions of people. Economists have developed techniques to keep us from being overwhelmed by the sheer scale of the economy and the masses of data that are available to us. One of our favorite devices is to imagine what an economy would look like if it contained only one person. This fiction has two nice features: we do not have to worry about differences among individuals, and we can easily isolate the most important economic decisions. Thinking about the economy as if it were a single person is only a starting point, but it is an extremely useful trick for cutting through all the complexities of, say, a \$12 trillion economy populated by 300 million individuals.
The aggregate production function combines an economy’s physical capital stock, labor hours, human capital, and technology to produce output (real gross domestic product [real GDP]).
Solovenia
Imagine, then, an economy called Solovenia. Solovenia is populated by one individual—we will call him Juan. Juan has access to an aggregate production function. The amount of output (real GDP) that he can produce depends on how large a physical capital stock he owns, how many hours he chooses to work, his human capital, and his technology ( Figure 21.2.1 "The Aggregate Production Function"). Physical capital is the stock of factories and machinery in the economy, while human capital refers to the skills and education of the workforce. Technology is a catchall term for everything else (other than capital, labor, or human capital) that affects output.Physical capital, human capital, and technology are discussed in more detail in Chapter 20 "Globalization and Competitiveness". It includes the following:
• Knowledge. The technological know-how of the economy
• Social infrastructure. The institutions and social structures that allow a country to produce its real GDP
• Natural resources. The land and mineral resources in the country
Toolkit: Section 31.26 "The Aggregate Production Function"
You can review the aggregate production function, including its inputs, in the toolkit.
Much of our focus in this chapter is on how economies build up their stock of physical capital. Figure 21.2.2 "The Aggregate Production Function: Output as a Function of the Physical Capital Stock" shows how output in the aggregate production function depends on the capital stock. Increases in the capital stock lead to more output. If Juan has more tools to work with, then he can produce more goods. However, we usually think that the production function will exhibit diminishing marginal product of capital, which means that a given increase in the capital stock contributes more to output when the capital stock is low than when the capital stock is high. In Figure 21.2.2 "The Aggregate Production Function: Output as a Function of the Physical Capital Stock", we can see this from the fact that the production function gets flatter as the amount of physical capital increases.
Figure \(2\): The Aggregate Production Function: Output as a Function of the Physical Capital Stock
As the amount of physical capital increases, output increases, but at a decreasing rate because of the diminishing marginal product of capital.
Each day Juan chooses how much time to work and how much time to spend in leisure. Other things being equal, we expect that Juan likes to have leisure time. This is not to say that Juan never gets any satisfaction from working. But like most people—even those who enjoy their jobs—he would prefer to work a little bit less and play a little bit more. He cannot spend all his time in leisure, however. He works because he likes to consume. The harder he works, the more real GDP he can produce and consume. Juan’s decision about how many hours to work each day is determined in large part by how productive he can be—that is, how much real GDP he can produce for each hour of leisure time that he gives up.
Juan does not have to consume all the output that he produces; he might save some of it for the future. As well as deciding how much to work, he decides how much to consume and how much to save each day. You have probably made decisions like Juan’s. At some time in your life, you may have worked at a job—perhaps in a fast-food restaurant, a grocery store, or a coffee shop. Perhaps you were paid weekly. Then each week you might have spent all the money you earned on movies, meals out, or clothes. Or—like Juan—you might have decided to spend only some of that money and save some for the future. When you save money instead of spending it, you are choosing to consume goods and services at some future date instead of right now. You may choose to forgo movies and clothes today to save for the purchase of a car or a vacation.
The choice we have just described—consuming versus saving—is one of the most fundamental decisions in macroeconomics. It comes up again and again when we study the macroeconomy. Just as you and Juan make this choice, so does the overall economy. Of course, the economy doesn’t literally make its own decision about how much to save. Instead, the saving decisions of each individual household in the economy determine the overall amount of savings in the economy. And the economy as a whole doesn’t save the way you do—by putting money in a bank. An economy saves by devoting some of its production to capital goods rather than consumer goods. If Juan chooses to produce capital goods, he will have a larger capital stock in the future, which will allow him to be more productive and enjoy higher consumption in the future.
Growth in a Closed Economy
At any given moment, Juan’s ability to produce output is largely determined by his stock of physical capital, his human capital, and the state of technology in Solovenia. But, as time passes, the level of output in Solovenia can change through a variety of mechanisms.
First, the capital stock in Solovenia can grow over time, as shown in Figure 21.2.3. Juan builds up his capital stock by saving. Since Juan is the only inhabitant, the amount he saves is equal to the national savings of Solovenia. It is the difference between his output (real GDP of Solovenia) and the amount he consumes.In a real economy, national savings also include the savings of government: we must add in the government surplus or subtract the government deficit, as appropriate.
Figure \(3\)
Increases in the capital stock lead to increases in output. If the capital stock in Solovenia increases between this year and next year, output also increases. Increases in the capital stock are one source of growth.
The more that Juan saves today, the more he can build up his capital stock, and the higher his future standard of living will be. If Juan chooses to consume less today, he will have a higher living standard in the future. If Juan chooses to consume more today, he must accept that this means less consumption in the future. Economies, like individuals, can choose between eating their cake now or saving it for the future.
In making this decision, Juan weighs the cost of giving up a little bit of consumption today against the benefit of having a little bit more consumption in the future. The higher the marginal product of capital, the more future benefit he gets from sacrificing consumption today. Other things being equal, a higher marginal product of capital induces Juan to save more. Juan’s choice also depends on how patient or impatient he is. The more patient he is, the more he is willing to give up consumption today to enjoy more consumption in the future.
Increases in the amount of physical capital are one way in which an economy can grow. Another is through increases in human capital and technology. These shift the production function upward, as shown in Figure 21.2.4. Perhaps Juan sometimes has better ideas about how to do things. Perhaps he gets better with practice. Perhaps Juan spends some time trying to come up with better ways of producing things.
Figure \(4\)
Increases in human capital or technology lead to increases in output. Increases in technology, human capital, and the workforce, like increases in the capital stock, are a source of output growth.
Through the accumulation of physical and human capital, and by improving the components of technology such as knowledge and social infrastructure, the output in Solovenia will grow over time. The combined effect of physical capital growth and improvements in technology is shown in Figure 21.2.5.
Increases in capital, human capital, and technology all lead to increases in output. In general, economies grow because of increases in capital, technology, human capital, and the workforce.
Growth in an Open Economy
If Juan does not trade with the rest of the world, his only way to save for the future is by building up his capital stock. In this case, national savings equal investment. An economy that does not trade with other countries is called a closed economy. An economy that trades with other countries is called an open economy. In the modern world, no economy is completely closed, although some economies (such as Belgium) are much more open than others (such as North Korea). The world as a whole is a closed economy, of course.
If Solovenia is an open economy, Juan has other options. He might decide that he can get a better return on his savings by investing in foreign assets (such as Italian real estate, shares of Australian firms, or Korean government bonds). Domestic investment would then be less than national savings. Juan is lending to the rest of the world.
Alternatively, Juan might think that the benefits of investment in his home economy are sufficiently high that he borrows from the rest of the world to finance investment above and beyond the amount of his savings. Domestic investment is then greater than national savings. Of course, if Juan lends to the rest of the world, then he will have extra resources in the future when those loans are repaid. If he borrows from the rest of the world, he will need to pay off that loan at some point in the future.
There may be very good opportunities in an economy that justify a lot of investment. In this case, it is worthwhile for an economy to borrow from other countries to supplement its own savings and build up the capital stock faster. Even though the economy will have to pay off those loans in the future, the benefits from the higher capital stock are worth it.
The circular flow of income shows us how these flows show up in the national accounts. If we are borrowing on net from other countries, there is another source of funds in additional to national savings that can be used for domestic investment. If we are lending on net to other countries, domestic investment is reduced.
Toolkit: Section 31.27 "The Circular Flow of Income"
You can review the circular flow of income in the toolkit.
\[investment\ =\ national\ savings\ +\ borrowing\ from\ other\ countries\]
or
\[investment\ =\ national\ savings\ −\ lending\ to\ other\ countries.\]
Savings and investment in a country are linked, but they are not the same thing. The savings rate tells us how much an economy is setting aside for the future. But when studying the accumulation of capital in an economy, we look at the investment rate rather than the savings rate. Total investment as a fraction of GDP is called the investment rate:
There are marked differences in investment rates in the United States, India, and Niger.
Source: Alan Heston, Robert Summers and Bettina Aten, Penn World Table Version 7.0, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, May 2011.
Figure 21.2.6 "Investment Rates in the United States, India, and Niger" shows investment rates in the United States, India, and Niger from 1960 to 2009. A number of features of this picture are striking:International Monetary Fund, World Economic Outlook Database, April 2011, accessed July 29, 2011, www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx.
• For most of the period, India had a higher investment rate than the other two countries. As we saw earlier, India was also the fastest growing of the three countries. These facts are connected: capital accumulation plays an important role in the growth process.
• The investment rate in the United States has been relatively flat over time, though it has been noticeably lower in recent years.
• Investment rates in Niger have been more volatile than in the other two countries. They were low in the mid 1980s but have increased substantially in recent years.
Low investment rates may be due to low savings rates. They may also reflect relatively low returns to increases in the capital stock in a country. The low investment rate that prevailed for many years in Niger not only reflected a low saving rate but also indicates that something is limiting investment from external sources. For the United States, in contrast, a significant part of the high investment rate is due not to domestic savings but to inflows from other countries.
We know that output per person is a useful indicator of living standards. Increases in output per person generally translate into increases in material standards of living. But to the extent that an economy trades with other countries, the two are not equivalent. If an economy borrows to finance its investment, output per person will exaggerate living standards in the country because it does not take into account outstanding obligations to other countries. If an economy places some of its savings elsewhere, then measures of output per person will understate living standards.The national accounts deal with this issue by distinguishing between GDP, which measures the production that takes place within a country’s borders, and gross national product (GNP), which corrects for income received from or paid to other countries.
Solovenia and Solovakia
Now add another country, Solovakia (with a single inhabitant named Una), and compare it to Solovenia. We can compare Solovenia and Solovakia by investigating which is producing more output per person and why. Imagine, for example, that Solovenia is a relatively poor country, and Solovakia is richer. Using our knowledge of the aggregate production function, we can understand how this difference might arise. It might be because Una has more human capital or knowledge than Juan, or because Una has a larger stock of physical capital.
Another basis for comparison is the rate at which the two economies are growing. If Solovakia is richer, and if it is also growing faster than Solovenia, then the gap between the two countries will become wider over time. We call such a process divergence. Conversely, if Solovenia is growing faster than Solovakia, then the gap between Juan’s and Una’s living standards will become smaller over time. Such a situation, where poorer countries catch up to richer ones, is called convergence.
Why might we see either convergence or divergence? Part of the answer has to do with the marginal product of capital in the two countries. Suppose that Solovakia is richer because it has a larger stock of physical capital than Solovenia. In that case, we expect the marginal product of capital to be larger in Solovenia. Solovenia is a more competitive economy than Solovakia. Juan will want to invest at home, while Una will take some of the output that she produces in Solovakia and invest it in Solovenia. Therefore we expect capital to migrate from Solovakia to Solovenia. As a consequence, it is likely that Solovenia will grow faster than Solovakia, leading to convergence.
Key Takeaways
• The capital stock increases through investment.
• Because physical capital is an input in the aggregate production function, growth in capital stock is one source of output growth. The other sources are the accumulation of human capital and increases in technology.
• In a closed economy, investment equals national savings. In an open economy, investment equals national savings plus inflows of funds from abroad. So in an open economy, growth in the capital stock and hence output growth can be financed both by domestic savings and borrowing from other countries.
Exercises
1. Draw a version of Figure 21.2.2 "The Aggregate Production Function: Output as a Function of the Physical Capital Stock" with labor hours instead of physical capital on the horizontal axis. Explain how the figure illustrates the positive marginal product of labor and diminishing marginal product of labor. How would you illustrate a change in the capital stock using this figure?
2. Explain how an economy can have an investment rate of 10 percent but a savings rate of only 3 percent. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/21%3A_Global_Prosperity_and_Global_Poverty/21.02%3A_The_Single-Person_Economy.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What are the main possible explanations for real GDP differences across countries?
2. How important are differences in technology for explaining differences in real GDP across countries?
We started this chapter with the following question: “Why are some countries rich and other countries poor?” The aggregate production function and the story of Juan help us to understand what determines the amount of output that an economy can produce, taking us the first step toward explaining why some countries are richer than others.
The production function tells us that if we know four things—the size of the workforce, the amount of physical capital, the amount of human capital, and the level of technology—then we know how much output we are producing. When comparing two countries, if we find that one country has more physical capital, more labor, a better educated and trained workforce (that is, more human capital), and superior technology, then we know that country will have more output.
Differences in these inputs are often easy to observe. Large countries obviously have bigger workforces than small countries. Rich countries have more and better capital goods. In the farmlands of France, you see tractors and expensive farm machinery, while you see plows pulled by oxen in Vietnam; in Hong Kong, you see skyscrapers and fancy office buildings, while the tallest building in Burkina Faso is about 12 stories high; in the suburbs of the United States, you see large houses, while you see shacks made of cardboard and corrugated iron in the Philippines. Similarly, rich countries often have well-equipped schools, sophisticated training facilities, and fine universities, whereas poorer countries provide only basic education. We want to be able to say more, however. We would like to know how much these different inputs contribute to overall economic performance.
To get some sense of this, we look at some rough numbers for the United States, India, and Niger. We carried out this exercise using data from 2003, but the fundamental message does not depend on the year that we have chosen; we would get very similar conclusions with data from any recent year. To start, let us look at the different levels of output in these countries. Table 21.3.1 "Real GDP in the United States, India, and Niger" gives real gross domestic product (real GDP) in these countries. Note that we are now looking at the overall level of GDP, rather than GDP per person as we did at the beginning of this chapter. Real GDP in the United States was about \$10.2 trillion. In India, real GDP was about one-third of US GDP: \$3.1 trillion. In Niger, real GDP was under \$10 billion. In other words, the United States produces about 1,000 times as much output as Niger.
Country Real GDP in 2003 (Billions of Year 2000 US Dollars)
United States 10,205
India 3,138
Niger 9
Table \(1\): Real GDP in the United States, India, and Niger
Source: Alan Heston, Robert Summers and Bettina Aten, Penn World Table Version 7.0, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, May 2011.
In the following subsections, we look at how the different inputs contribute to bring about these large differences in output. We go through a series of thought experiments in which we imagine putting the amount of each input available in the United States into the production functions for the Indian and Niger economies.
Differences in the Workforce across Countries
The United States, India, and Niger differ in many ways. One is simply the number of people in each country. The workforce in the United States is about 150 million people. The workforce in India is more than three times greater—about 478 million in 2010—while the workforce in Niger is only about 5 million people. Thus India has much more labor to put into its production function than does Niger.
In Table 21.3.2 "Real GDP in 2003 in the United States, India, and Niger if All Three Countries Had the Same Workforce" we look at what would happen to output in India and Niger if—counterfactually—each had a workforce the size of that in the United States while their other inputs were unchanged. Output in the United States is, of course, unchanged in this experiment. India’s output would decrease to about \$1.4 trillion because they would have a smaller workforce. Niger’s output would increase about tenfold to \$88 trillion. Differences in the workforce obviously matter but do not explain all or even most of the variation across the three countries. Niger’s output would still be less than 1 percent of output in the United States.
Country Real GDP in 2003 (Billions of Year 2000 US Dollars)
United States 10,205
India 1,475
Niger 88
Table \(2\): Real GDP in 2003 in the United States, India, and Niger if All Three Countries Had the Same Workforce
Differences in Physical Capital across Countries
Not surprisingly, the United States also has a much larger capital stock than does Niger. The capital stock in the United States is worth about \$30 trillion. India’s capital stock is about \$3 trillion, and Niger’s capital stock is much, much smaller—about \$9 billion. So what would happen if we also gave India and Niger the same amount of physical capital as the United States? Table 21.3.3 "Real GDP in the United States, India, and Niger if All Three Countries Had the Same Workforce and Physical Capital Stock" shows the answer.
India’s GDP, in this thought experiment, goes back to something close to its actual value of around \$3 trillion. In other words, the extra capital compensates for the smaller workforce. Real GDP in the United States is still more than three times larger than that in India. The extra capital makes a big difference in Niger, increasing its output about ten-fold. Even if Niger had the same size workforce and the same amount of capital as the United States, however, it would still have only a tenth of the amount of output. The other two inputs—human capital and technology—evidently matter as well.
Country Real GDP in 2003 (Billions of Year 2000 US Dollars)
United States 10,205
India 3,054
Niger 1,304
Table \(3\): Real GDP in the United States, India, and Niger if All Three Countries Had the Same Workforce and Physical Capital Stock
Differences in Human Capital across Countries
Differences in education and skills certainly help to explain some of the differences among countries. Researchers have found evidence that measures of educational performance are correlated with GDP per person. The causality almost certainly runs in both directions: education levels are low in Niger because the country is so poor, and the country is poor because education is low.
We can include measures of education and training in an attempt to measure the skills of the workforce. In fact, economists Robert Hall and Chad Jones have constructed a measure that allows us to compare the amount of human capital in different countries.To estimate relative human capital levels in different countries, we use the figures in Robert Hall and Chad Jones, “Why Do Some Countries Produce So Much More Output per Worker Than Others?” Quarterly Journal of Economics 114, no. 1 (1999): 83–116. In Table 21.2.4 "Real GDP in 2003 in the United States, India, and Niger if All Three Countries Had the Same Workforce, Physical Capital Stock, and Human Capital Stock", we bring the human capital level in India and Niger up to the level in the United States and, as before, suppose that all three countries have the same amount of labor and physical capital. Real GDP in India would climb to about \$5.2 trillion, or a little over half the level in United States. Niger’s real GDP would equal about \$2.8 trillion, meaning the increased human capital would more than double Niger’s GDP. However, real GDP in the United States would still be more than three times greater than that of Niger.
Country Real GDP in 2003 (Billions of Year 2000 US Dollars)
United States 10,205
India 5,170
Niger 2,758
Table \(4\): Real GDP in 2003 in the United States, India, and Niger if All Three Countries Had the Same Workforce, Physical Capital Stock, and Human Capital Stock
Differences in Technology across Countries
To summarize, even after we eliminate differences in labor, physical capital, and human capital, much is still left to be explained. According to our production function, the remaining variation is accounted for by differences in technology—our catchall term for everything apart from labor, physical capital, and human capital.
Just as firms accumulate physical capital, they also accumulate knowledge in various ways. Large firms in developed countries develop new knowledge through the activities of their research and development (R&D) divisions.Gains in productivity of this form sometimes end up embodied in capital stock—think of a computer operating system, such as Windows or Linux. Such knowledge increases the value of capital stock and is already captured by looking at the ratio of capital stock to GDP. In poorer countries, firms may access existing knowledge by importing technology from more developed countries.
Differences in knowledge help to explain differences in output per worker. The rich countries of the world tend to have access to state-of-the-art production techniques. We say that they are on the technology frontier; they use the most advanced production technologies available. Factories in poor countries often do not use these production techniques and lack modern machinery. They are inside the technology frontier.
As economists have researched the differences in economic performance in rich and poor countries, they have found that success depends on more than physical capital, human capital, and knowledge. Appropriate institutions—the social infrastructure—also need to be in place. These are institutions that allow people to hold property and write and enforce contracts that ensure they can enjoy the fruits of their investment. Key ingredients are a basic rule of law and a relative lack of corruption. An ability to contract and trade in relatively free markets is also important.
Particularly in more advanced countries, we need the right institutions to encourage technological progress. This is complicated because there is a trade-off between policies to encourage the creation of knowledge and policies to encourage the dissemination of knowledge. Knowledge is typically a nonexcludable good, so individuals and firms are not guaranteed the rights to new knowledge that they create. This reduces the incentive to produce knowledge. To counter this problem, governments establish certain property rights over new knowledge, in the form of patent and copyright laws. Knowledge is also typically a nonrival good, so everyone can, in principle, benefit from a given piece of knowledge. Once new knowledge exists, the best thing to do is to give it away for free. Patent and copyright laws are good for encouraging the development of knowledge but bad for encouraging the dissemination of knowledge. Current debates over intellectual property rights (file sharing, open source, downloading of music, etc.) reflect this trade-off.
Differences in natural resources can also play a role in explaining economic performance. Some countries are lucky enough to possess large amounts of valuable resources. Obvious examples are oil-producing states such as Saudi Arabia, Kuwait, Venezuela, the United States, and the United Kingdom. Yet there are many countries with considerable natural resources that have not enjoyed great prosperity. Niger’s uranium deposits, for example, have not helped that country very much. At the same time, some places with very little in the way of natural resources have been very successful economically: examples include Luxembourg and Hong Kong. Natural resources help, but they are not necessary for economic success, nor do they guarantee it.
Key Takeaways
• Differences in real GDP across countries can come from differences in population, physical capital, human capital, and technology.
• After controlling for differences in labor, physical capital, and human capital, a significant difference in real GDP across countries remains.
Exercises
1. In Table 21.3.2 "Real GDP in 2003 in the United States, India, and Niger if All Three Countries Had the Same Workforce", Table 21.3.3 "Real GDP in the United States, India, and Niger if All Three Countries Had the Same Workforce and Physical Capital Stock", and Table 21.3.4 "Real GDP in 2003 in the United States, India, and Niger if All Three Countries Had the Same Workforce, Physical Capital Stock, and Human Capital Stock", the level of real GDP for the United States is the same as it is in Table 21.3.1 "Real GDP in the United States, India, and Niger". Why is this the case?
2. What kinds of information would help you measure differences in human capital?
3. How can human capital and knowledge flow from one country to another? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/21%3A_Global_Prosperity_and_Global_Poverty/21.03%3A_Four_Reasons_Why_GDP_Varies_across_Countries.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What factors determine the growth rate of the capital stock?
2. Will poorer countries catch up to richer countries because of faster growth of capital stock?
3. What is the evidence on convergence?
4. Why might countries not converge?
Our first task in this chapter was to explain the vast differences in living standards that we observe in the world. We now know that this variation is due to differences in physical capital, human capital, and technology. The rough calculations in 21.2 Section "Four Reasons Why GDP Varies across Countries" tell us that variations in physical capital, human capital, and technology all play a role in explaining differences in economic performance.
Now we consider these inputs separately. In this section, we look at the accumulation of physical capital. In 21.4 Section "Balanced Growth", we look at the role of human capital and technology. Our main aim is to consider one of our two remaining questions:
Will poorer countries catch up to richer countries?
The Growth Rate of the Capital Stock
Capital goods are goods such as factories, machines, and trucks. They are used for the production of other goods and are not completely used up in the production process. Economies build up their capital stocks by devoting some of their gross domestic product (GDP) to new capital goods—that is, investment. As we saw in our discussion of Solovenia in 21.2 Section "Four Reasons Why GDP Varies across Countries", if a country does not interact much with other countries (that is, it is a closed economy) the amount of investment reflects savings within a country. In open economies, the amount of investment reflects the perceived benefits to investment in that country compared to other countries.
Capital goods wear out over time and have to be scrapped and replaced. A simple way to think about this depreciation is to imagine that a fraction of the capital stock wears out every year. A reasonable average depreciation rate for the US economy is 4 or 5 percent. To understand what this means, think about an economy where the capital stock consists of a large number of identical machines. A depreciation rate of 5 percent means that for every 100 machines in the economy, 5 machines must be replaced every year.The depreciation rate can be understood in terms of the average lifetime of a typical machine. For example, a depreciation rate of 5 percent is the same as saying that, on average, machines last for 20 years. To see this, imagine that capital stock is kept constant at 100 machines, and each machine lasts for 20 years. Imagine also that 5 machines are 1 year old, 5 machines are 2 years old, and so forth, with the oldest 5 machines being 20 years old. Each year, these 5 oldest machines would wear out (5 percent depreciation) and have to be replaced by 5 new machines. After a year has passed, the situation will be exactly the same as the previous year: there will be 5 machines that are 1 year old, 5 machines that are 2 years, and so forth. Mathematically, we are saying that the lifetime of a machine = 1/depreciation rate: $20 = 1 / 0.05$.
The depreciation of capital goods reduces the capital stock. The total amount of capital lost to depreciation each year is calculated by multiplying the depreciation rate and the capital stock together. If the capital stock is $30 trillion, for example, and the depreciation rate is 5 percent, then$1.5 trillion ($= 30\ trillion \times 0.05$) worth of capital is lost each year.
The capital stock increases as long as there is enough new investment to replace the worn out capital and still contribute some extra. The overall change in the capital stock is equal to new investment minus depreciation:
$change\ in\ capital\ stock\ =\ new\ investment\ −\ depreciation\ rate\ \times capital\ stock.$
For example, suppose that the current capital stock (measured in trillions of dollars) is 40, and the depreciation rate is 10 percent per year. Then the capital stock after depreciation is $40 − (.1 \times 40) = 40 − 4 = 36.$ Suppose that new investment is $4.8 trillion. Then the new capital stock is 36 + 4.8 = 40.8. In this case, capital stock has increased by$0.8 trillion, or 2 percent.
The equation for the change in the capital stock is one of the fundamental ingredients of economic growth. It tells us that economies build up their capital stock—and therefore their real GDP—by devoting enough output to new investment to both replace worn out capital and then add some more. If we divide both sides of the previous equation by the capital stock, we can obtain the growth rate of the capital stock. (Remember that the growth rate of a variable is the change in the variable divided by its initial level.)
The growth rate of the capital stock depends on three things:
1. The amount of investment. The more investment the economy carries out, the more quickly the capital stock grows.
2. The current capital stock. The larger the capital stock, other things being equal, the lower its growth rate.
3. The depreciation rate. If existing capital wears out faster, the capital stock grows more slowly.
It is intuitive that a higher investment rate increases the growth rate of the capital stock, and a higher depreciation rate decreases the growth rate of the capital stock. It is less obvious why the growth rate of the capital stock is lower when the capital stock is higher. The growth rate measures the change in the capital stock as a percentage of the existing capital stock. A given change in the capital stock results in a smaller growth rate if the existing capital stock is larger. For example, suppose that the current capital stock is 100, and the change in the capital stock is 10. Then the growth rate is 10 percent. But if the current capital stock is 1,000, then the same change of 10 in the capital stock represents only a 1 percent growth rate.
Toolkit: Section 31.21 "Growth Rates"
The toolkit contains more information on how growth rates are calculated.
Why are we so interested in the accumulation of capital? One reason is that poverty of the kind we observe in Niger and elsewhere is a massive problem for the world. About 40 percent of the world’s population—close to 2.5 billion people—live in conditions of poverty. (The World Bank defines poverty as living on less than US$2 per day.) We are not going to solve the problem of mass poverty overnight, so we would like to know whether this gap between the rich and the poor is a permanent feature of the world. It might be that economies will diverge, meaning that the disparities in living standards will get worse and worse, or it might be that they will converge, with poorer countries catching up to richer countries. When comparing two countries, if we find that the poorer economy is growing faster than the richer one, then the two are converging. If we find that the richer country is growing faster than the poorer one, they are diverging. Moreover, if a country has a small capital stock, we know that—other things being equal—it will tend to be a poorer country. If a country has a large capital stock, then—again, other things being equal—it is likely to be a richer country. The question of convergence then becomes: other things being equal, do we expect a country with a small capital stock to grow faster than an economy with a large capital stock? The answer is yes, and the reason is the marginal product of capital. From the production function, the marginal product of capital is large when the capital stock is small. Think again about Juan in Solovenia. A large marginal product of capital means that he can obtain a lot of extra output if he acquires some extra capital. This gives him an incentive to save rather than consume. A large marginal product of capital also means that Juan can attract investment from other countries. A country where the marginal product of capital is high is a competitive economy—one where both domestic savers and foreign savers want to build up the capital stock. The capital stock will grow quickly in such an economy. This is precisely what we saw in the equation for the growth rate of the capital stock: higher investment and a lower capital stock both lead to a larger capital stock growth rate. Both of these imply that a country with a large marginal product of capital will tend to grow fast. We illustrate this idea in Figure 21.4.1 "Convergence through the Accumulation of Capital". Country A has a small capital stock. The aggregate production function tells us that this translates into a large marginal product of capital—the production function is steep. In turn, a large marginal product of capital means that country A will grow quickly. Country B has an identical production function but a larger capital stock, so the marginal product of capital is lower in country B than in country A. There is less incentive to invest, implying that country B, while richer than country A, grows more slowly. Figure 21.4.1 "Convergence through the Accumulation of Capital" also shows that it is possible for a country to have such a large capital stock that it shrinks rather than grows. Country C has so much capital that its marginal product is very low. There is little incentive to build up the capital stock, so the capital stock depreciates faster than it is replaced by new investment. In such an economy, the capital stock and output would decrease over time. Figure $1$: Convergence through the Accumulation of Capital The growth rate of the capital stock depends on the marginal product of capital. Country A has little capital, so the marginal product of capital is large, and the capital stock will grow rapidly. Country B has more capital, so the capital stock grows more slowly. Country C has so much capital that the capital stock decreases. Figure 21.4.1 "Convergence through the Accumulation of Capital" suggests an even stronger conclusion: all three economies will ultimately end up at the same capital stock and the same level of output—complete convergence. This conclusion is half right. If the three economies were identical except for their capital stocks and if there were no growth in human capital and technology, they would indeed converge to exactly the same level of capital stock and output. In 21.4 Section "Balanced Growth", we look at this argument more carefully. First, though, we examine the evidence on convergence. Convergence or Divergence? Two Contrasting Pictures Convergence is a very pretty theory but is it borne out by the evidence? Figure 21.4.2 "Some Evidence of Convergence" shows the growth experience of several countries in the second half of the 20th century. These countries are all members of the Organisation for Economic Co-operation and Development (OECD) and are, relatively speaking, rich.The countries are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Iceland, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Switzerland, and the United States. The median real GDP per capita in 1950 for these countries was about$6,000, in year 1996 dollars. Data for Figure 21.4.2 "Some Evidence of Convergence" and Figure 21.4.3 "Some Evidence of Divergence" come from Alan Heston, Robert Summers, and Bettina Aten, “Penn World Table Version 6.2,” Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, September 2006, accessed June 29, 2011, pwt.econ.upenn.edu/php_site/pwt_index.php. Figure 21.4.2 "Some Evidence of Convergence" shows real GDP per person in these countries relative to the United States (the United States itself is the horizontal line near the top of the figure.) Figure 21.4.2 "Some Evidence of Convergence" does show some evidence of convergence. Countries with higher levels of real GDP person in 1950 tended to grow more slowly than countries with lower levels of real GDP per person. Poorer countries in this group tended to catch up with richer countries.
The growth experience of 16 relatively developed countries, measured as real GDP per person relative to the level in the United States, shows considerable evidence of convergence.
So far so good. But Figure 21.4.3 "Some Evidence of Divergence" shows the growth experience over the same period for a more diverse group of countries. This group is largely composed of poorer countries. The picture here is very different: we do not see convergence. There is no evidence that the poorer countries are growing faster than the richer countries. In some cases, there even appears to be divergence: poor countries growing more slowly than rich countries so that output levels in rich and poor countries move further apart.
In contrast to Figure 21.4.2 "Some Evidence of Convergence", the countries in this sample do not appear to be converging. Many countries that were poor in 1950 were just as poor, relatively speaking, in 2000.
Table 21.4.1 "Evidence from Select Countries" shows more data for some of these countries. It lists the level of initial GDP per person and the average growth rate in GDP per person between the early 1950s and the end of the century. For example, Argentina had real GDP per person of $6,430 in 1950 (in year 1996 dollars) and grew at an average rate of 1.25 percent over the 50-year period. Egypt and South Korea had very close levels of GDP per person in the early 1950s, but growth in South Korea was much higher than that in Egypt: by the year 2000, GDP per person was$15,876 in South Korea but only \$4,184 in Egypt. These two countries very clearly diverged rather than converged. Looking at China, the level of GDP per person in the early 1950s was less than 10 percent that of Argentina. By 2000, GDP per person in China was about 33 percent of that in Argentina.
Country (Starting Year) Real GDP per Capita (Year 1996 US Dollars) Percentage Average Growth Rate to 2000
Argentina (1950) 6,430 1.25
Egypt (1950) 1,371 2.33
China (1952) 584 4.0
South Korea (1953) 1,328 5.5
Table $1$: Evidence from Select Countries
Source: Penn World Tables
Overall, this evidence suggests that our theory can explain the behavior over time of some but not all countries. If we look at relatively rich countries, then we do see evidence of convergence. Across broader groups of countries, we do not see convergence, and we see some evidence of divergence.
Explaining Divergence
Why is it that, contrary to what Figure 21.4.1 "Convergence through the Accumulation of Capital" seems to suggest, not all countries converge? The logic of that picture rests on the diminishing marginal product of capital. If rich countries have lower marginal product of capital than poor countries, then we expect poor countries to catch up. If, for some reason, richer countries sometimes also have a higher marginal product of capital than poorer countries, then the argument for convergence disappears.
Figure 21.4.4 "Divergence Arising from Increasing Marginal Product of Capital" shows an example where the aggregate production function looks a bit different. This production function has a range where increases in capital stock lead to a higher rather than a lower marginal product of capital. That is, for some amounts of capital, we see increasing marginal product of capital rather than diminishing marginal product of capital. In the figure, country A and country B converge, just as in our previous diagram. But country C is rich enough to lie on the other side of the range where there is an increasing marginal product of capital. Country C therefore has a higher marginal product of capital than country B, even though country C is richer. Countries B and C will diverge, rather than converge.
Figure $4$: Divergence Arising from Increasing Marginal Product of Capital
In this diagram, three countries have an aggregate production function that does not always exhibit diminishing marginal product of capital. As a result, the economies need not converge.
Figure 21.4.5 "Divergence Arising from Differences in Technology" shows another reason why a richer country might have a higher marginal product of capital than a smaller country. In Figure 21.4.1 "Convergence through the Accumulation of Capital" we supposed that the three countries had the same production function and differed only in terms of their capital stock. In Figure 21.4.5 "Divergence Arising from Differences in Technology", country B is richer than country A for two reasons: it has more capital and has a superior technology (or more labor or human capital). The higher capital stock, other things being equal, means a lower marginal product of capital in country B. But the superior technology, other things being equal, means a higher marginal product of capital in country B. In the picture we have drawn, the technology effect dominates. Country B has the higher marginal product of capital, so it is the more attractive location for capital—it is more competitive. Because of this, the capital stock increases in country B. Indeed, if the only factor driving investment is the marginal product of capital, then we would expect capital to flow among countries until the marginal product of capital is equal everywhere.We discuss capital migration across countries in more detail in Chapter 20 "Globalization and Competitiveness".
One reason why a richer economy might have better technology is because it has better social infrastructure. In particular, developed economies often have the legal and cultural institutions that preserve property rights. The return on investment is higher, other things being equal, when property rights are protected. In economies with less well-developed institutions, investors need a higher rate of return to compensate them for the additional risk of placing their capital in those countries.
Measuring these aspects of social infrastructure is a challenge. The World Bank has attempted to do so in its 2005 World Development Report.World Bank, World Development Report 2005: A Better Investment Climate for Everyone (New York: World Bank and Oxford University Press, 2004), 8, accessed August 22, 2011, siteresources.worldbank.org/INTWDR2005/Resources/complete_report.pdf. The study looks at various aspects of doing business in 48 countries. The top constraints on investment reported by firms were policy uncertainty, macroeconomic instability, and taxes. Many of the risks of doing business are directly associated with government action in the present and in the future. This is nicely stated in the World Bank report: “Because investment decisions are forward looking, firms’ judgments about the future are critical. Many risks for firms, including uncertain responses by customers and competitors, are a normal part of investment, and firms should bear them. But governments have an important role to play in maintaining a stable and secure environment, including by protecting property rights. Policy uncertainty, macroeconomic instability, and arbitrary regulation can also cloud opportunities and chill incentives to invest. Indeed, policy-related risks are the main concern of firms in developing countries.”World Bank, World Development Report 2005: A Better Investment Climate for Everyone (New York: World Bank and Oxford University Press, 2004), 5, accessed August 22, 2011, siteresources.worldbank.org/INTWDR2005/Resources/complete_report.pdf.
Figure $5$: Divergence Arising from Differences in Technology
In this diagram, country B has a better technology or more human capital than country A. Even though country B has a larger capital stock, it also has a larger marginal product of capital.
Key Takeaways
• Capital stock increases from investment and decreases due to the depreciation of capital stock.
• All else being the same, poorer countries have a lower capital stock and therefore a higher marginal product of capital compared to rich countries. Thus capital accumulation should be faster in poor countries, which will lead to convergence with richer countries.
• The evidence suggests convergence between some but not all economies.
• Divergence of output across countries might come from the presence of an increasing marginal product of capital or from one country having a superior technology to another.
Exercises
1. Suppose we have 100 units of capital stock at the beginning of 2012 and the following table gives the investment for the next 5 years. Suppose the depreciation rate is 5 percent. Fill in the blanks in the table for the years 2012–2017.
Year Capital Stock (Start of Year) Investment Depreciation
2012 100 80
2013 20
2014 50
2015 120
2016 10
2. If one country has a higher level of real GDP than another, does that mean it must have a higher growth rate as well?
3. If citizens of a relatively poor country are educated in a richer country, does this help or hinder convergence? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/21%3A_Global_Prosperity_and_Global_Poverty/21.04%3A_The_Accumulation_of_Physical_Capital.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is balanced growth?
2. Why does balanced growth matter?
3. When will economies converge to a balanced-growth path?
We have seen that the accumulation of capital—other things being equal—leads economies to converge over time. However, we saw that the evidence for such convergence in the data is highly mixed. To understand more about when economies will and will not converge, we need a more complete theory of the sources of economic growth. In this section, we develop such a theory and then use it to look again at the question of convergence. We initially take as given—that is, as exogenous—the growth rates of human capital, the workforce, and the technology.
Growth Accounting
We begin with the tool of growth accounting. The growth accounting equation for our aggregate production function is as follows:Growth accounting is discussed in more detail in Chapter 20 "Globalization and Competitiveness".
$output\ growth\ rate =\ [a \times (capital\ growth\ rate)]+ [(1 − a) \times (workforce\ growth\ rate +\ human\ capital\ growth\ rate)]+ technology\ growth\ rate.$
Toolkit: Section 31.28 "Growth Accounting"
You can review growth accounting in the toolkit.
In this equation, a is just a number. For the US economy, a is approximately equal to 1/3. Remember that output is just another term for real gross domestic product (real GDP).
It turns out that, in the very long run, we expect the capital stock and the level of output to grow at exactly the same rate. We see why later in this section. Such a situation is called balanced growth. When this is true, the growth accounting equation then becomesYou don’t need to worry about the mathematical details, but if you are interested, we obtain this equation by setting the capital growth rate equal to the output growth rate:
$output\ growth\ rate ^{B G} = [a \times (output\ growth\ rate ^{B G})] + [(1 − a) \times (workforce\ growth\ rate +\ human\ capital\ growth\ rate)] +\ technology\ growth\ rate,$
which implies
$(1 − a) \times output\ growth\ rate ^{B G}= [(1 − a) \times (workforce\ growth\ rate\ +\ human\ capital\ growth\ rate)] +\ technology\ growth\ rate.$
Dividing this equation by (1 − a) gives us the equation in the text.
For example, suppose that a = 1/3, the human capital growth rate = 0.01, the technology growth rate = 0.02, and the workforce growth rate = 0.03. Then
The Growth Rate of Output per Worker in a Balanced-Growth Economy
When we are comparing living standards across countries, it is better to adjust for differences in the size of the workforce to obtain output per worker. This is a measure of the overall productivity of an economy—that is, the effectiveness of an economy for producing output. (Of course, output per worker and output per person are very closely related. For the US economy, the workforce is roughly half the total population, so output per person is therefore approximately half as much as output per worker.) The growth rate of output per worker equals the growth rate of output minus the growth rate of the workforce:
This equation tells us that, in the end, the secret to economic growth is the development of knowledge and skills. Invention, innovation, education, training, and improvements in social infrastructure are the drivers of economic growth in the very long run.
Perhaps surprisingly, the growth rate of the capital stock is not a fundamental determinant of the growth rate. When we have balanced growth, the capital stock grows, which contributes to the overall growth of output. But if we ask what determines the overall growth rate in an economy, it is the growth of technology and human capital. The capital stock then adjusts to keep the economy on its balanced-growth path. By the definition of balanced growth, the growth rate of the capital stock is equal to the output growth rate.
This picture shows an example of an economy on a balanced-growth path. Both variables grow at 3 percent per year and the capital stock is always equal to exactly twice the level of GDP.
Figure 21.5.1 "Output and Capital Stock in a Balanced-Growth Economy" illustrates balanced growth. Look first at output. Notice that even though the growth rate of output is constant, the graph is not a straight line. Instead, it curves upward: the change in the level of output increases over time. This is because a growth rate is a percentage change. In our example, output in 2000 is $10 trillion, and the growth rate is 3 percent. From 2000 to 2001, output increases by$300 billion (= $10 trillion × 0.03). By 2050, output is equal to$44 trillion. Between that year and the next, output increases by $1.3 trillion (=$44 trillion × 0.03). Even though the growth rate is the same, the change in the level of output is more than four times as large.
When output and the capital stock grow at the same rate, the ratio of the capital stock to GDP does not change. In Figure 21.5.1 "Output and Capital Stock in a Balanced-Growth Economy", the value of the capital stock is always twice the value of output. The capital stock and real GDP both grow at the same rate (3 percent per year), so the ratio of the capital stock to GDP does not change over time.
Figure $2$
Balanced growth means that the ratio of the capital stock to output does not change. On a balanced-growth path, output and the capital stock grow at the same rate, so the ratio of the capital stock to output is always the same: the growth path of the economy is a straight line from the origin.
Figure 21.5.2 shows what a constant ratio of the capital stock to GDP looks like in our production function diagrams. Along any straight line from the origin, the ratio of the capital stock to output does not change. As a simple example, suppose that (as in Figure 21.5.1 "Output and Capital Stock in a Balanced-Growth Economy") the capital stock is always twice the level of output. This means that output is always half of the capital stock:
$output\ =\ 0.5 \times capital\ stock.$
This is just the equation of a straight line that passes through the origin. In Figure 21.5.2, increases in human capital or technology shift the production function upward. On the balanced-growth path, capital stock grows at exactly the right rate so that the economy grows along a straight line from the origin.
The Transition to Balanced Growth
If an economy is not yet on its balanced-growth path, it will tend to go toward that path. If a country has a small capital stock relative to GDP, then its capital stock will grow faster than real GDP. Countries that are still developing may well be in this position. Countries that are further along in the development process are likely to be (approximately) on their balanced-growth paths. For such countries, the ratio of capital stock to output is unchanging.
Economies that have not yet accumulated enough capital to be on their balanced-growth paths will have a growth rate that equals the balanced-growth rate plus an additional factor due to the growth rate of capital relative to GDP.If you are interested in the mathematical derivation of this equation, you can find it in the toolkit.
The first term is the growth rate along the balanced-growth path. The second term is the additional component to growth that comes about whenever the capital stock is growing faster than output.
Table 21.5.1 "Approaching the Balanced-Growth Path" gives an example of an economy that is approaching a balanced-growth path. Like the economy in Figure 21.5.1 "Output and Capital Stock in a Balanced-Growth Economy", the balanced-growth output growth rate is 3 percent. The workforce grows at 1 percent, so output per worker grows at 2 percent along the balanced-growth path. However, this economy starts off (in the year 2000) with a smaller capital stock than is needed for balanced growth. Looking at the first row of the table, you can see that the capital stock grows at 14.4 percent, while output grows at 6.8 percent. Because capital grows faster than output, there is an additional component to growth, as we have just explained. This contributes an extra 3.8 percentage points to the growth rate, so output per worker grows at 5.8 percent.
As time goes on, the capital stock grows relative to output, and the economy gets closer to the balanced-growth path. As this happens, the additional component of growth becomes smaller. For example, in 2010, the capital stock grows at 6.8 percent, and output grows at 4.3 percent. The growth rate of output per worker is 3.3 percent—2 percentage points being the balanced-growth contribution and 1.3 percent due to the faster growth rate of capital stock compared to output. By 2050, the economy is close to balanced growth: output per worker grows at 2.3 percent, with capital stock growing only a little bit faster than output.
Year Balanced-Growth Output Growth Rate (%) Balanced-Growth Output per Worker Growth Rate (%) Capital Growth Rate (%) Output Growth Rate (%) Output per Worker Growth Rate (%)
2000 3.0 2.0 14.4 6.8 5.8
2005 3.0 2.0 9.3 5.1 4.1
2010 3.0 2.0 6.8 4.3 3.3
2015 3.0 2.0 5.5 3.8 2.8
2020 3.0 2.0 4.7 3.6 2.6
2025 3.0 2.0 4.1 3.4 2.4
2050 3.0 2.0 3.8 3.3 2.3
Table $1$: Approaching the Balanced-Growth Path
Countries that are well below their growth path will see their capital stock grow rapidly relative to GDP. They will experience relatively rapid GDP growth. Countries that are close to their balanced-growth path will see their capital stock grow more slowly relative to GDP and have a GDP growth rate that is only slightly bigger than the balanced-growth rate. Although the economy will eventually reach its balanced-growth value, this adjustment may take decades. For this reason, we say that the economy will achieve balanced growth only in the very long run.To be mathematically precise, the economy gets closer and closer to its balanced-growth path but never quite gets there. Over a period of decades, it gets close enough that it makes no practical difference.
Convergence Revisited
We can now use our theory of balanced growth to make our earlier argument for convergence more precise. Then we consider whether we might also see convergence from changes in human capital and technology.
Convergence in Physical Capital
Imagine that we are comparing two countries that are identical in almost every respect. They both have the same levels of technology and human capital and the same balanced-growth ratio of capital stock to GDP. However, they have different amounts of physical capital. Suppose that one of the countries has a large capital stock (call it the rich country) and the other country has a much smaller capital stock (call it the poor country).
These two economies will initially have different levels of output and living standards. Our model predicts, however, that these differences will be temporary. Both economies will approach the balanced-growth path. The poor country will grow more rapidly because its ratio of capital stock to GDP will be increasing more quickly as it moves toward the balanced-growth path. Over time, we expect to see the poor country catch up to the rich one. We illustrate this in Figure 21.5.3 "Convergence of a Rich Country and a Poor Country".
Consider two economies, identical in all respects except that one has a smaller capital stock than the other. The poorer country accumulates capital faster than the richer country and grows faster.
This is exactly the same mechanism for convergence that we saw before. The country with a smaller capital stock will have a higher marginal product of capital and will grow faster because the country is a more attractive place for investment. Because the poor country accumulates capital more rapidly than the richer country, it will grow faster. The two countries will converge to the same balanced-growth path and to the same level of output per person.
Convergence in Human Capital
So far we have not considered why human capital might change over time. If there are reasons to think that this variable might grow more quickly in poor countries than in rich countries, we have another force that might drive convergence.
In some ways, human capital resembles physical capital. As with the physical capital stock, some accumulation is the result of decisions by governments, and some comes from decisions by private agents. From the government side, it is likely that economies with low levels of human capital might also be economies in which there is a high return to basic education. If literacy rates are low and most children do not receive much education, even straightforward investments in schooling might yield big gains in terms of the ultimate capabilities of the workforce. Governments in poor countries might see big potential gains from investment in education. Private individuals and firms may also perceive that the returns on education are larger in poorer economies. If very few people in the economy have college degrees, an individual might find that a college education yields a very large payoff. By contrast, if the population as a whole is highly educated, it might take a much larger investment to stand out from others.
This discussion is somewhat speculative. Human capital is difficult to measure, and the marginal product of human capital is even harder to quantify. Nevertheless, there are some good reasons to believe that the incentives to invest in human capital are greater in poorer economies. If so, we have another reason to expect convergence.
Convergence in Technology
What about technology? Will it grow faster in poorer economies? The answer depends on which aspect of technology we are talking about.
Differences in knowledge between rich and poor countries are likely to diminish over time. Rich economies are typically close to the technology frontier, meaning that they are using state-of-the-art production techniques. For countries on the technology frontier, growth in knowledge can only come the hard way, through investment in research and development (R&D). Countries inside the technology frontier are typically poorer developing countries. These economies can grow their stock of knowledge simply by importing knowledge from countries at the frontier. Technological advance is much cheaper and easier if you can use others’ inventions and innovations rather than coming up with your own. We therefore expect such countries to have faster growth rates of knowledge. As they become more developed, the growth of knowledge in these economies will slow down to the rate experienced by other countries near the technology frontier. But in the meantime, they will grow faster than rich countries. Technology transfer to developing economies is surely a force leading to convergence of economies.
There is less to say about social infrastructure and natural resources. The amount of natural resources available in an economy is largely due to accidents of history and geography: there is no obvious reason to expect the growth rate of natural resources to be linked to the level of development. Social infrastructure, meanwhile, is a complicated mix of institutions, customs, and other factors. Again, there is no obvious reason to expect social infrastructure to grow more quickly in poorer economies.
Divergence Revisited
Now that we have incorporated human capital and technology into our framework, we can identify some further possible explanations of divergence. Our theory says that economies will converge if they differ only in terms of their initial capital stock. But it is possible that different economies will also have different balanced-growth paths. Figure 21.5.4 "Balanced Growth in Two Countries with Different Ratios of Capital to Output" shows what this looks like. The ratio of capital stock to output in the very long run depends on a number of different factors, including the growth rate of technology and the growth rate of the workforce. If these differ across countries, then their balanced-growth paths will differ as well, and we will not observe convergence.The toolkit presents a complete model of balanced growth, including a formula for the balanced-growth ratio of capital stock to output.
Economies may have different balanced-growth paths. In this example, the ratio of capital stock to output is higher in country A than in country B.
This explanation—and our previous stories of divergence—tells us why different economies will not necessarily end up at exactly the same level of output per worker. But the problem of divergence is in some ways worse than that. Some countries are not only failing to converge but also moving further and further apart. In other words, in some cases, richer economies are growing faster than poorer economies. Indeed, as we saw with Niger, some of the poorest economies in the world have been shrinking rather than growing.
Remember that the growth rate of output per worker on a balanced-growth path is as follows:
We can explain divergence in our framework if human capital or technology is growing more slowly in poor countries than in rich ones. Are there reasons to expect this to be the case? Earlier, we said that countries with low levels of human capital might also be countries where the return to human capital investment was large, which is a force for convergence. We also pointed out, however, that the marginal product of physical capital might be larger in an economy with a superior technology, even if that economy had more capital. The same is true of human capital. Countries can build up their human capital through schooling and training. They can also build up their human capital by attracting skilled workers from other countries. If richer countries are able to attract skilled workers, then we will see divergence rather than convergence. In Chapter 20 "Globalization and Competitiveness", we discuss how economies actively seek to attract human capital.
Turning to technology, divergence in social infrastructure is certainly a possibility. Social infrastructure includes the rule of law, the general business climate, social attitudes toward corruption, the protection of property rights, and many other intangible factors. These influences on economic growth are difficult to define and almost impossible to measure accurately. Yet economists are convinced that successful economies must have a good set of such social institutions. It is likely that it is easier to build and improve such institutions in countries that are relatively prosperous, which would again lead richer countries to grow more rapidly than poorer countries.
Economists have built some of these ideas into the theoretical framework of economic growth. Unfortunately, the models are too complicated for an introductory economics textbook, so we will not go into them in any detail here. We can, however, provide a simple example that conveys the flavor of these more complex ideas. The story goes as follows. We know that workers acquire human capital through education and on-the-job training. Suppose that, when there is more physical capital in the economy (relative to the number of workers), it is easier to acquire human capital. You can study in modern facilities with up-to-date computers. You work with state-of-the-art machinery and become more skilled. In this story, human capital is endogenous: it depends on the amount of physical capital.
To be concrete, imagine that technology is constant, and the amount of human capital is proportional to the amount of physical capital per worker. When we incorporate this assumption into the production function, we end up with a very straightforward relationship:
$output\ =\ B \times physical\ capital,$
where B is just a number.The derivation of this equation is not very difficult; it is explained in the toolkit.
In this economy, the ratio of capital stock to GDP is constant at all times (capital/output = 1/B). This economy is always on a balanced-growth path. Because of this, the growth rate of output equals the growth rate of capital stock:
$output\ growth\ rate\ =\ physical\ capital\ growth\ rate.$
The more important point, though, is that this technology does not exhibit diminishing marginal product of capital. The marginal product of capital is constant: it equals B. If this number were different in different economies, then we would expect to see capital stock flowing from economies where B is small toward economies where B is large. We would see divergence rather than convergence.
The model that we have described in this subsection is simplistic. Its point is simply to show that, if we make human capital endogenous, it is much easier to explain divergence. Economists have built more complicated and realistic models with endogenous human capital and technology that give similar results.
Key Takeaways
• Balanced growth occurs when capital stock grows at the same rate as output. Along a balanced-growth path, the ratio of output to capital stock does not change.
• Balanced growth is important to understand because over long periods of time, we expect economies to reach their balanced-growth path.
• There are reasons to expect at least some convergence in physical capital, human capital, and knowledge. However, there is no strong argument for why we would see convergence in social infrastructure.
Exercises
1. Suppose that an economy has a balanced-growth path where the physical capital stock is three times the level of GDP. If the current capital stock is four times the level of GDP, do you expect capital stock to grow faster or slower than GDP?
2. Suppose we have two economies that are currently identical, except in the first economy a is 0.3 and in the second economy a is 0.5. Will the balanced-growth path be the same in both countries? Which economy will converge more quickly to the balanced-growth path? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/21%3A_Global_Prosperity_and_Global_Poverty/21.05%3A_Balanced_Growth.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What are the main international organizations that help to promote growth?
2. What do these institutions do to achieve their stated goals?
Governments acting alone can do a lot to promote economic growth. We have discussed the importance of protecting property rights and establishing a climate of political stability. These efforts by individual governments are complemented by international actions to promote growth and development in poorer countries. In this section, we describe three powerful and controversial international economic organizations: the World Bank, the International Monetary Fund (IMF), and the World Trade Organization (WTO). We briefly explain what these institutions do and how they go about reaching their goals.The websites of the World Bank, the IMF, and the WTO are, respectively, as follows: http://www.worldbank.org, http://www.imf.org/external/index.htm, and http://www.wto.org.
The World Bank
The World Bank is an international intermediary funded by 184 member countries. Its goal is to provide loans and grants to developing countries with the aim of eliminating poverty by promoting economic growth. Economists working at the World Bank rely on variants of the growth model used in this chapter to understand the growth experiences of different countries and determine the effects of policies in those countries.
The World Bank borrows money on international capital markets and also receives funds directly from member countries. The World Bank is similar to a bank that a household or a firm would approach for a loan to build a factory or a house, except that its borrowers are national governments. It often funds projects that would otherwise not be undertaken. In many cases, these are projects that promote infrastructure, education, health, and so forth. Projects like these may have social benefits yet not be profitable enough for private firms to undertake. Building a road in a rural part of a developing country is not the type of investment project one normally associates with a profit-seeking firm, for example, even though the road may have spurred rural development.
In 2010 the World Bank made about \$45 billion in loan commitments and \$29 billion in loan disbursements.“Annual Report 2010: Financial Information,” World Bank, accessed August 22, 2011, web.worldbank.org/WBSITE/EXTERNAL/EXTABOUTUS/EXTANNREP/ EXTANNREP2010/0,,contentMDK:22626599~menuPK:7115719~pagePK:64168445~piPK:64168309 ~theSitePK:7074179,00.html. At one level, this is evidently substantial—a project worth \$100 million or more can certainly have a large impact on a poor country. At another level, it is not a huge sum of money in the global economy. For comparative purposes, BP set aside over \$40 billion to pay for the cleanup of its 2010 oil spill in the Gulf of Mexico.
1. World Bank projects range broadly. They include funding for infrastructure construction, promoting health care (such as HIV/AIDS programs), promoting education, and so forth. Many of these projects involve the provision of public goods, so they create benefits for society as a whole that exceed the direct return on investment. That is, many of the projects that are funded by national governments in richer countries are funded through the World Bank in developing countries. At the beginning of this chapter, we saw an example of a World Bank project in Niger, which was aimed at increasing human capital in that country. As another example, here is a description of a recent World Bank loan to Guyana to provide water access to the poor.
Guyana: Water Sector Consolidation Project
GRANT AMOUNT: \$12.3 million
PROJECT DESCRIPTION: This project’s main objective is to increase access to safe water among the poor. The project seeks to support the achievement of sustainable universal access to safe and affordable water for the population of Guyana, especially the poor. The project will also help to consolidate the water sector modernization and reform process undertaken by the government with support of the International Development Association (IDA) and other donors in recent years.“Water Sector Consolidation Project,” World Bank, July 12, 2005, accessed June 30, 2011, web.worldbank.org/external/projects/main?pagePK=64283627&piPK=73230& theSitePK=40941&menuPK=228424&Projectid=P088030&cid=3001_72.
The project described here would not likely be a profitable private sector project, but it is important for the development of Guyana. Notice, too, that this loan, like many other World Bank loans, is for the development of infrastructure (roads, bridges, schools, communication systems, etc.). In more developed countries, such projects are usually performed by governments, but in developing countries, these investments are frequently undertaken through the World Bank.
Investment in infrastructure is typically complementary to the accumulation of other physical capital, such as machines and plants. Even though developing countries have relatively low capital stocks, investment in plants and equipment may not be very profitable if basic infrastructure is lacking. There is no point in building a factory if there are no roads to take your goods to market. Investment in infrastructure can increase the marginal product of capital and make other investment more attractive.
The International Monetary Fund
The IMF was established to (among other things) provide short-term support for countries facing financial difficulties. This is explicitly stated in the IMF’s Articles of Agreement: “To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.”“Articles of Agreement of the International Monetary Fund,” International Monetary Fund, February 22, 2010, accessed June 30, 2011, http://www.imf.org/external/pubs/ft/aa/aa01.htm.
A country’s balance of payments has two main components. The first is the trade balance. A balance of payment maladjustment may mean that a country is running persistent trade deficits—that is, its imports are greater than its exports. This means the country is borrowing from other countries and is building up its external debt. The second component of the balance of payments is the interest that a country must pay on its existing external debt. This means that imbalances in the past lead to worse imbalances in the present. Imagine, for example, that Juan in Solovenia borrowed extensively in the past. It is then difficult for him to get out of debt because he has to pay so much interest. Moreover, the amount of external debt in a country cannot grow forever. When countries get into trouble by accumulating large amounts of debt, there is a temptation to default on outstanding debt. A key role of the IMF is to help countries through these difficult episodes.
IMF help has strings attached. A controversial aspect of the IMF’s mode of operation is in the phrase…under adequate safeguards. As part of a deal to provide resources to countries in need of funds, the IMF often makes explicit demands about government fiscal and monetary policies. This is termed IMF “conditionality” and is described by the IMF as follows: “When a country borrows from the IMF, its government agrees to adjust its economic policies to overcome the problems that led it to seek financial aid from the international community. These loan conditions also serve to ensure that the country will be able to repay the Fund so that the resources can be made available to other members in need. In recent years, the IMF has streamlined conditionality in order to promote national ownership of strong and effective policies.”“IMF Conditionality,” International Monetary Fund, March 18, 2011, accessed August 22, 2011, http://www.imf.org/external/np/exr/facts/conditio.htm.
A quick tour of the IMF website ( http://www.imf.org/external/index.htm) provides a lot of information about past and ongoing loans. One example is the ongoing relationship between the IMF and Argentina.The IMF formulates country reports on an annual basis, and these are available on the IMF website. These reports summarize the dealings between individual countries and the IMF. Argentina had reached an agreement with the IMF in September 2003 providing Argentina with access to SDR 8,981 million. SDR means “special drawing right.” It is a unit of account used by the IMF whose value is an average of four key currencies. Its actual value on any given date can be found at www.imf.org/external/np/fin/data/rms_sdrv.aspx. In May 2011, 1 SDR was worth US\$1.59. This agreement with Argentina came after Argentina was unable to meet demands for payment on some of its external debt and after real gross domestic product (real GDP) had fallen by nearly 11 percent in 2002. Agreement with the IMF was not immediate, partly due to the conditionality of a prospective loan. Though agreement was ultimately reached, there were lengthy negotiations regarding the conduct of fiscal and monetary policy in Argentina as a condition for IMF assistance.
The World Trade Organization
The WTO “makes the rules” for international trade. It is a relatively new organization—having been founded in 1995—and has 150 member countries. It arose from earlier trade agreements between countries, most notable the General Agreement on Tariffs and Trade. The WTO website describes the role of the organization as follows:
[…]
Essentially, the WTO is a place where member governments go, to try to sort out the trade problems they face with each other. The first step is to talk. The WTO was born out of negotiations, and everything the WTO does is the result of negotiations. The bulk of the WTO’s current work comes from the 1986–94 negotiations called the Uruguay Round and earlier negotiations under the General Agreement on Tariffs and Trade (GATT). The WTO is currently the host to new negotiations, under the “Doha Development Agenda” launched in 2001.
Where countries have faced trade barriers and wanted them lowered, the negotiations have helped to liberalize trade. But the WTO is not just about liberalizing trade, and in some circumstances its rules support maintaining trade barriers—for example to protect consumers or prevent the spread of disease.
[…]“What Is the World Trade Organization?” World Trade Organization, accessed June 30, 2011, http://www.wto.org/english/thewto_e/whatis_e/tif_e/fact1_e.htm.
The negotiations at the WTO set the ground rules for international trade. Using the mechanisms of the WTO, countries agree on trade policies, such as the levels of tariffs. This is also a forum for designing policies on the protection of intellectual property rights. The WTO also provides a forum for dispute resolution.
Many critics of globalization have focused their attention on the WTO. For example, the nongovernmental organization Global Exchange ( http://www.globalexchange.org) lists 12 “top reasons to oppose the WTO,” including the claims that the WTO is increasing hunger, increasing inequality, trampling human rights, destroying the environment, and killing people through its policies. Critics such as this group argue that the WTO is fundamentally undemocratic, writing the rules so as to favor powerful corporations and rich countries. Defenders of the WTO argue that it gives poorer countries a much greater voice in international economic decision making. They point out, for example, WTO decisions are based on consensus, meaning that all 150 member countries must agree to them.
Key Takeaways
• The World Bank, the IMF, and the WTO are three leading international organizations that help countries in the development process.
• The World Bank funds projects in recipient countries, the IMF provides balance of payments support, and the WTO works to reduce trade barriers.
Exercises
1. In what way does the IMF work to promote convergence across countries?
2. The WTO helps to govern intellectual property rights. What is the impact of those rights on development? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/21%3A_Global_Prosperity_and_Global_Poverty/21.06%3A_The_Role_of_International_Institutions_in_Promoting_Growth.txt |
In Conclusion
We live in a world today that would be unrecognizable and unimaginable to those born two centuries ago. Things we take for granted—jet travel, antibiotics, electricity, the Internet, dentistry—are all products of the extraordinary growth of the last 200 years. Yet despite all our technological advances, billions of people in the world still live in poverty. Although some countries continue to grow rapidly, others stagnate or even go backward. If we could unlock the secrets of economic growth, we would have the means to help people to permanently better lives.
Even as economists emphasize economic growth as a way to combat poverty, noneconomists are often critical of economic growth, pointing out that it comes with costs as well as benefits. For example, as countries become richer, they use more energy and more of the world’s natural resources. Oil reserves are being depleted, and rainforests are disappearing. Growth may lead to increased pollution, such as greenhouse gas emissions that in turn contribute to climate change. These are serious and legitimate concerns. In brief, economists have four main responses.
1. The framework we presented in this chapter does, in fact, capture the effect of declining natural resources. They lead to a slower rate of growth in technology. Indeed, it is possible that declining natural resources could more than offset growth in knowledge and social infrastructure so that the technology growth rate becomes negative. As yet, there is no evidence that this is a significant concern, but—at least until we have a better understanding of the drivers of knowledge and social infrastructure growth—it certainly might become relevant in the future.
2. There are indeed uncompensated side effects of economic growth, such as increased pollution. Economists agree that such effects can be very important. However, they can and should be corrected directly. Curtailing growth is an extremely indirect and inefficient response to its adverse side effects. As Nobel Prize–winner Robert Solow put it, “What no-growth would accomplish, it would do by cutting off your face to spite your nose.”Robert M. Solow, “Is the End of the World at Hand?” Challenge 16, no. 1 (March/April 1973): 39–50. Also available at www.jstor.org/stable/40719094.
3. The evidence reveals that some environmental problems are solved rather than exacerbated by growth. Air pollution is a much more serious problem in the developing countries of the world than in the rich countries of the world. In part this is because a clean environment is a luxury good; people only worry about the state of the environment once their basic needs of food and shelter are addressed.
4. The most serious problems are those where we cannot rely on market mechanisms. If oil becomes scarce, then increases in the price of oil will provide incentives for people to economize on their use of fuel and look for alternative sources of energy. These incentives will at least ease the adjustment of the world economy. But there are no functioning market mechanisms to deal with climate change, for example.
Decades of research by economists have told us that there is no magic bullet, no simple and painless way to encourage economic growth. At the same time, we have learned a great deal about how and why countries grow. We have learned that growth depends on the accumulation of both physical and human capital. We have learned that growth ultimately hinges on the growth of knowledge, highlighting the importance of education, training, and research and development (R&D). And we have learned that good institutions are critical for countries that want to promote economic growth.
We have made progress, but the study of economic growth remains one of the most fascinating and challenging problems in all economics. There is no doubt that economists will continue their search for the elusive secrets of prosperity. As the Nobel Prize–winning economist Robert Lucas observed, “Once one starts to think about [economic growth], it is hard to think about anything else.”
Key Links
exercises
1. Think about your last visit to a shopping center or a large food store in the United States or other developed economy. Which of these goods and services do you think are available in a typical market in Niger? Which were available in the United States 50 years ago? 100 years ago?
2. (Advanced) In the late 1990s, the US government was running a surplus of about 1 percent of gross domestic product (GDP). Current projections show that the government is going to run deficits in excess of 5 percent of GDP in the future. Let us imagine that there are no changes in private saving or in foreign borrowing/lending.The condition that private savings do not change is important. For example, if the government cuts taxes, it is possible that people will predict that taxes will be higher in the future and will increase their savings in anticipation. We will say more about this in Chapter 29 "Balancing the Budget". In this case, the increased deficit translates directly into a decrease in the investment rate. To investigate the implications of such a decrease, suppose that, in the year 2000
investment rate = 0.24,
depreciation rate = 0.085,
and output growth rate = 0.035.
1. What would output per worker equal in 2040 if there had been no change in the investment rate?
2. Suppose that by 2040, improvements in technology and human capital mean that the production function is given by output per worker = 30,000 × capital/output. Suppose also that the economy has reached its new balanced-growth path. What is output per worker in 2040?
3. Now suppose that the increase in the government deficit means that the investment rate decreases to 0.18. What is the new balanced-growth ratio of the capital stock to GDP?
4. Suppose the production function for this economy is output per worker = 15,000 × capital/output. What is output per worker in 2000?
5. On a balanced-growth path, the ratio of capital stock to output is given by the following formula:
Suppose that the economy was on a balanced-growth path in 2000. Calculate the balanced-growth ratio of the capital stock to GDP.
1. Try to estimate approximately how much you spend every day. Be sure to include an amount for rent, utilities, and food. Do you think it would be possible for you to live on \$2 per day?
2. Suppose there are two economies. The first has a current level of real GDP of 100, and the second has a current level of real GDP of 200. The poorer country is forecasted to grow at 10 percent in the coming year, while the richer country is forecasted to grow at 15 percent. If these forecasts are true, what will their levels of real GDP be next year? Is this a case of divergence or convergence?
3. When capital’s share of output (a) is larger, does an economy move to its balanced-growth path more quickly or more slowly? Explain.
4. Suppose that capital’s share of output is 0.5, the human capital growth rate is 2 percent, the technology growth rate is 1 percent, and the workforce is not growing. What is the balanced-growth growth rate of output?
5. Look at Table 21.5.1 "Approaching the Balanced-Growth Path". Explain why the output growth rate decreases over time.
6. (Advanced) Think about Juan in Solovenia. Consider two cases. In the first case, he experiences an increase in his productivity that he knows will last for only one month. In the second, he experiences a permanent increase in his productivity. How do you think his decisions about how hard to work will be different in the two cases?
7. On a balanced-growth path, the ratio of capital stock to output is given by the following formula:
Use the formula for the balanced-growth rate of output to determine how the ratio of capital stock to output depends on the growth rate of the workforce. Does an increase in the growth rate of the workforce lead to an increase or a decrease in the ratio of capital stock to output?
Economics Detective
1. Find savings rates for the United States, India, and Niger and compare these to the investment rates for these countries. What can you say about capital inflows from other countries?
2. Go to the Penn World Tables ( http://datacentre2.chass.utoronto.ca/pwt61). Click on “Alphabetical List of Countries.” Select the United States and two other countries of your choice. Look at the data for real GDP per capita and real GDP per worker. Briefly describe in words what has happened to these two variables over the period for which data are available.
Spreadsheet Exercises
1. Using a spreadsheet, reproduce Figure 21.5.1 "Output and Capital Stock in a Balanced-Growth Economy". Specifically, suppose that GDP starts with the value 10 in the year 2000, and capital stock in the same year has the value 20. Now set the growth rate of each series equal to 3 percent (0.03). What is the capital stock in 2050? What is GDP? Has the ratio of capital stock to GDP stayed constant?
2. Using the same spreadsheet and keeping the growth rate of GDP equal to 3 percent, examine what happens if the growth rate of capital is (a) 1 percent; (b) 5 percent.
3. Suppose that an economy has the following production function:
Suppose that the workforce is growing at 1 percent per year, and human capital is growing at 2 percent per year. (We are assuming technology is constant in this example.) Suppose that we find that the ratio of capital stock to GDP is 4 on all dates and, initially, human capital is 15,000. What are the values for the growth rate of output per worker, the growth rate of output, and the growth rate of capital?
4. By experimenting with a spreadsheet, find out how long it will take for output per worker to double in this example. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/21%3A_Global_Prosperity_and_Global_Poverty/21.07%3A_End-of-Chapter_Material.txt |
Newspaper headlines around the world in 2008 asked whether the world’s economies were heading for another “Great Depression.” Long-past economic history suddenly captured the attention of economists, journalists, and others. But what was this event and why—even though it occurred the best part of a century ago—does it still hold such a prominent place in our economic memories?
In the early 1930s, instead of benefiting from economic growth and improved standards of living, people witnessed a huge decline in the level of economic activity. There was great economic hardship: large numbers of families struggled to obtain even basic food and shelter. Some sense of the desperation during these times can be found in oral histories. Here, for example, is one person’s story of what it was like trying to find a job:
I’d get up at five in the morning and head for the waterfront. Outside the Spreckles Sugar Refinery, outside the gates, there would be a thousand men. You know dang well there’s only three or four jobs. The guy would come out with two little Pinkerton cops: ‘I need two guys for the bull gang. Two guys to go into the hole.’ A thousand men would fight like a pack of Alaskan dogs to get through there. Only four of us would get through. I was too young a punk.See Studs Terkel, Hard Times: An Oral History of the Great Depression (New York: Pantheon Books, 1970), 30.
The personal suffering is less apparent in the figure below, but this picture does reveal the extraordinary nature of those times. It shows real gross domestic product (real GDP) in the United States from 1890 to 1939. Three things stand out. First, the level of economic activity grew substantially during this half century. This is normal: economies typically grow over the long haul, becoming more productive and producing more output. Second, although the level of US economic activity grew substantially over this half century, there were many ups and downs in the economy during the late 19th century and early 20th century. Third—and most important for our purposes—the period from 1929 to 1937 stands out from the rest. This was not a minor blip in economic activity; the US economy suffered a collapse that persisted for many years. At the same time, unemployment climbed to a staggering 25 percent in 1933—one out of four people was unemployed—compared to a rate of only 3.2 percent in 1929.
Real GDP increased considerably between 1890 and 1939, but the Great Depression of the early 1930s is a striking exception.
Source: Data from “What Was the U.S. GDP Then?,” Measuring Worth, accessed August 22, 2011, www.measuringworth.org/datasets/usgdp/result.php.
The United States was not the only country to experience such hard economic times in this period. Many other countries, such as the United Kingdom, Canada, France, Germany, and Italy also saw their economic progress reversed for a period of years. The Great Depression, as this economic cataclysm came to be called, was a shock to the economists of the day. Prior to that time, most economists thought that, though economies might grow fast in some years and decline slightly in others, prolonged unemployment and underutilization of resources was impossible. The Great Depression proved this view to be erroneous and eventually led to a fundamental change in the way in which economists thought about the aggregate economy. The idea that the economy was naturally stable was replaced with a view that severe economic downturns could recur at any time.
Along with this change in thinking about the economy came a change in attitudes toward macroeconomic policy: economists began to believe that the government could play an active role to help stabilize the economy, perhaps by increasing government spending in bad times. Prior to the Great Depression, nobody even thought that the government should try to keep the economy stable. Both Democrats and Republicans in the 1932 election advocated less government spending because government revenues had fallen. Yet, by the end of the 1930s, the United States and other countries had adopted the view that active policy measures were useful or even essential for the proper functioning of economies.
Three-fourths of a century later, these events are part of economic history. Few people still alive experienced those terrible years directly, yet the time remains part of our collective memory. Above all, we need to know what went wrong if we hope to ensure that such punishing times do not come again. Indeed, the world economy recently suffered the most severe recession since the 1930s, and it is unclear at the time of this writing how long or how bad the current crisis will be. The insights of the economists who explained the Great Depression are still at the heart of today’s discussions of economic policy. Understanding what happened to the economy in the 1930s is more than an exercise in economic history; it is essential for understanding modern macroeconomics. We want to know—
What caused the Great Depression?
Road Map
We begin by looking at some facts about the Great Depression and the boom that preceded it. Our goal is to see if we can develop a good explanation of these facts. The most fundamental defining feature of the Great Depression was the large and sustained decrease in real GDP. In the figure below, which shows the circular flow of income, reminds us that real GDP measures both production and spending.
GDP measures the production of an economy and total income in an economy. We can use the terms production, income, spending, and GDP interchangeably.
It follows that during the Great Depression, both output and spending decreased. Perhaps it is the case that production in the economy declined for some reason, and spending decreased as a consequence. Or perhaps spending declined for some reason, and production decreased as a consequence. We examine two approaches to the Great Depression, based on these ideas. One sees the root cause of the Great Depression as a decline in the productive capabilities of the economy, meaning that firms—for some reason—were unable to produce as much as they had before. This then led to decreased spending. The other approach sees the root cause of the Great Depression as a decline in spending, meaning that households and firms—for some reason—decided that they wanted to purchase fewer goods and services. This then led to decreased production.
We look at each explanation in turn. We investigate which inputs contributed the most to the decrease in output and also look at what happened to the different components of spending. This more careful look at the data helps us to evaluate the two competing theories of the Great Depression. We conclude by examining the implications for economic policy and considering what policies were actually conducted at the time of the Great Depression. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/22%3A_The_Great_Depression/22.01%3A_Lessons_from_History.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What are the main facts about the Great Depression?
2. What is puzzling about the Great Depression?
3. What are the two leading strands of thought about the cause of the Great Depression?
We begin with some facts. Table 22.2.1 "Major Macroeconomic Variables, 1920–39*" shows real gross domestic product (real GDP), the unemployment rate, the price level, and the inflation rate from 1920 to 1939 in the United States. Real GDP measures the overall production of the economy, the unemployment rate measures the fraction of the labor force unable to find a job, the price level measures the overall cost of GDP, and the inflation rate is the growth rate of the price level.
Year Real GDP Unemployment Price Level Inflation Rate
1920 606.6 5.2 11.6
1921 585.7 11.7 10.4 −10.3
1922 625.9 6.7 9.8 −5.8
1923 713.0 2.4 9.9 1.0
1924 732.8 5.0 9.9 0.0
1925 748.6 3.2 10.2 3.0
1926 793.9 1.8 10.3 1.0
1927 798.4 3.3 10.4 1.0
1928 812.6 4.2 9.9 −4.8
1929 865.2 3.2 9.9 0.0
1930 790.7 8.9 9.7 −2.0
1931 739.9 16.3 8.8 −9.3
1932 643.7 24.1 8.0 −9.1
1933 635.5 25.2 7.5 −6.3
1934 704.2 22.0 7.8 4.0
1935 766.9 20.3 8.0 2.6
1936 866.6 17.0 8.1 1.3
1937 911.1 14.3 8.4 3.7
1938 879.7 19.1 8.2 −2.4
1939 950.7 17.2 8.1 −1.2
\(^{*}\)GDP is in billions of year 2000 dollars (Bureau of Economic Analysis [BEA]). The unemployment rate is from the US Census Bureau, The Statistical History of the United States: From Colonial Times to the Present (New York: Basic Books, 1976; see also www.census.gov/prod/www/abs/statab.html). The base year for the price index is 2000 (that is, the index equals 100 in that year) and comes from the Bureau of Labor Statistics (BLS; http://www.bls.gov), 2004.
Table \(1\): Major Macroeconomic Variables, 1920–39\(^{*}\)
Looking at these data, we see first that the 1920s were a period of sustained growth, sometimes known as the “roaring twenties.” Real GDP increased each year between 1921 and 1929, with an average growth rate of 4.9 percent per year). Meanwhile the unemployment rate decreased from 6.7 percent in 1922 to 1.8 percent in 1926. Real GDP reached a peak of \$865 billion in 1929. This number is expressed in year 2000 dollars, so we can compare that number easily with current economic data. In particular, if we divide by the population at that time, we find that GDP per person was the equivalent of about \$7,000, in year 2000 terms. Real GDP per person has increased about fivefold since that time.
Toolkit: Section 31.21 "Growth Rates"
You can review growth rates in the toolkit.
The Great Depression began in late 1929 as a recession not unlike those experienced previously—a decrease in GDP from one year to the next was common—but it rapidly blossomed into a four-year reduction in economic activity. By 1933, real GDP had fallen by over 25 percent and was only \$636 billion. At the same time, unemployment increased from around 3 percent to 25 percent. In 1929, jobs were easy to come by. By 1933, they were almost impossible to find. More than a quarter of the people wishing to work were unable to find a job. Countless others, no doubt, had given up even looking for a job and were out of the labor force.
The experience of the 1920s and 1930s tells us that when real GDP increases, unemployment tends to decline and vice versa. We say that unemployment is countercyclical, meaning that it typically moves in the direction opposite to the movement of real GDP. An economic variable is procyclical if it typically moves in the same direction as real GDP, increasing when GDP increases and decreasing when GDP decreases. The countercyclical behavior of unemployment is not something that is peculiar to the Great Depression; it is a relatively robust fact about most economies. It is also quite intuitive: if fewer people are employed, less labor goes into the production function, so we expect output to be lower.
An event occurred in September 1929 that, at least with hindsight, marks a turning point. The stock market, as measured by the Dow Jones Industrial Average, had been increasing until that time but then decreased by 48 percent in less than 2.5 months. The value of the stock market is a measure of the value, in the minds of investors, of all the firms in the economy. Investors suddenly decided that the US economy was worth only half what they had believed three months earlier. It is unlikely that two such dramatic economic events occurred at almost the same time and yet are unconnected. We should not make the claim that the stock market crash caused the Great Depression. But the stock market decrease was correlated with declining output in the early days of the Great Depression. Correlation is distinct from causation. It is possible, for example, that the stock market crash and the Great Depression were both caused by some other event.
Toolkit: Section 31.23 "Correlation and Causality"
Correlation is a statistical measure of how closely two variables are related. If the two variables tend to increase together, we say that they are “positively correlated”; if one increases when the other decreases, then they are “negatively correlated.” If the relationship between the two variables is an exact straight line, we say that they are “perfectly correlated.” The fact that two variables are correlated does not necessarily mean that changes in one variable cause changes in the other. The toolkit contains more information.
Table 22.2.1 "Major Macroeconomic Variables, 1920–39*" also contains information on the price level and the inflation rate. The most striking fact from this table is that the price level declined over this period—on average, goods were considerably cheaper in dollar terms in 1940 than they were in 1920. We see this both from the decrease in the price level and from the fact that the inflation rate was negative in several years (remember that the inflation rate is the growth rate of the price level). If we look at the more recent history of the United States and at most other countries, we rarely observe negative inflation. Decreasing prices are an unusual phenomenon.
Other countries had similar experiences during this time period. Figure 22.2.1 "The Great Depression in Other Countries" shows that France, Germany, and Britain all experienced very poor economic performance in the early 1930s. Output was lower in each country in 1933 compared to four years earlier, and each country also saw a decline in the price level. Many other countries around the world had similar experiences. The Great Depression was a worldwide event.
Figure \(1\): The Great Depression in Other Countries
France, Germany, and Britain also experienced declines in output (a) and prices (b) during the Great Depression. The output data are data for industrial production (manufacturing in the case of the United States), and the price data are wholesale prices.
Source: International Monetary Fund, “World Economic Outlook: Crisis and Recovery,” April 2009, Box 3.1.1, http://www.imf.org/external/pubs/ft/weo/2009/01/c3/Box3_1_1.pdf.
Why this was the case remains one of the puzzles of the period. There were events at the time that had international dimensions, such as concerns about the future of the “gold standard” (which determined the exchange rates between countries) and various policies that disrupted international trade. Still, economists are unconvinced that such factors can explain why the Great Depression occurred in so many countries. Three-fourths of a century later, we still do not have a complete understanding of the Great Depression and are still unsure exactly why it happened. From one perspective this is frustrating, but from another it is exciting: the Great Depression maintains an air of mystery.
Toolkit: Section 31.20 "Foreign Exchange Market"
You can review the meaning and definition of the exchange rate in the toolkit.
The Puzzle of the Great Depression
Try to imagine yourself in the United States or Europe in the early 1930s. You are witnessing immense human misery amid a near meltdown of the economy. Friends and family are losing their jobs and have bleak prospects for new employment. Stores that you had shopped in all your life suddenly go out of business. The bank holding your money has disappeared, taking your savings with it. The government provides no insurance for unemployment, and there is no system of social security to provide support for your elderly relatives.
Economists and government officials at that time were bewildered. The experience in the United States and other countries was difficult to understand. According to the economic theories of the day, it simply was not possible. Policymakers had no idea how to bring about economic recovery. Yet, as you might imagine, there was considerable pressure for the government to do something about the problem. The questions that vexed the policymakers of the day—questions such as “What is happening?” and “What can the government do to help?”—are at the heart of this chapter.
Economists make sense of events like the Great Depression by first accumulating facts and then using frameworks to interpret those facts. We have a considerable advantage relative to economists and politicians at the time. We have the benefit of hindsight: the data we looked at in the previous subsection were not known to the economists of that era. And economic theory has evolved over the last seven decades, giving us better frameworks for analyzing these data.
Earlier, we said there are two possible reasons why output decreased.
1. There was a decrease in production due to a decrease in the available inputs into the aggregate production function. Since there was no massive decrease in the amount of physical capital or the size of the workforce, and people presumably did not suddenly lose all their human capital, this means that the culprit must have been a decrease in technology.
2. There was a decrease in aggregate spending. Households chose to reduce their consumption, firms chose to reduce their investment, and governments chose to reduce their spending. As a consequence, firms scaled back their production.
We look at each of these candidate explanations in turn.
Toolkit: Section 31.26 "The Aggregate Production Function"
You can review the aggregate production function and the inputs that go into it in the toolkit.
Key Takeaways
• During the Great Depression in the United States from 1929 to 1933, real GDP decreased by over 25 percent, the unemployment rate reached 25 percent, and prices decreased by over 9 percent in both 1931 and 1932 and by nearly 25 percent over the entire period.
• The Great Depression remains a puzzle today. Both the source of this large economic downturn and why it lasted for so long remain active areas of research and debate within economics.
• One explanation of the Great Depression rests on a reduction in the ability of the economy to produce goods and services. The second leading explanation focuses on a reduction in the overall demand for goods and services in the economy.
Exercises
1. The notes in Table 22.2.1 "Major Macroeconomic Variables, 1920–39*" state that the base year for the price level is 2000, so the price index has a value of 100 in that year. Approximately how much would you expect to have paid in the year 2000 for something that cost \$2 in the late 1920s?
2. Using Table 22.2.1 "Major Macroeconomic Variables, 1920–39*", how can you see that the unemployment rate is countercyclical? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/22%3A_The_Great_Depression/22.02%3A_What_Happened_during_the_Great_Depression%3F.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is potential output?
2. How could a decrease in potential output create the Great Depression?
3. How does the theory that the Great Depression was caused by a decrease in potential output match the facts?
Our first approach to interpreting the Great Depression focuses on potential output, which is the amount of real gross domestic product (real GDP) an economy produces when the labor market is in equilibrium and capital goods are not lying idle. We start here because this approach corresponds reasonably closely to the economic wisdom of the time.
A Decrease in Technology: The Multiple-Markets Perspective
Comparative statics is a technique that allows us to understand the effects of a decrease in technology in a particular market, such as the market for new homes. In a comparative statics exercise, we look at what happens to endogenous variables (in this case, production and prices of new homes) when we change an exogenous variable (in this case, technology). A decline in technology shifts the market supply curve leftward: at any given price, the decrease in technology means that the firm can produce less output with its available inputs. The result is shown in part (a) of Figure 22.3.1 "An Inward Shift in the Market Supply of Houses" for the housing market: output of new homes decreases and the price of new homes increases.
Toolkit: Section 31.16 "Comparative Statics"
You can review the technique of comparative statics and the definition of endogenous and exogenous variables in the toolkit.
Figure $1$: An Inward Shift in the Market Supply of Houses
(a) A decrease in technology leads to an inward shift of the market supply curve for houses. (b) The labor and other resources that are not being used to produce houses can now be used to produce other goods, such as cars.
If this decline in technology in the housing market were the only change in the economy, what would happen? Construction firms would fire workers because these firms were building fewer new homes. Over time, however, the fired construction workers would find new jobs in other sectors of the economy. The same logic applies to other inputs: capital and other inputs that were being used in the construction industry would be redeployed to other markets. For example, there would be additional labor and other inputs available for automobile production. Part (b) of Figure 22.3.1 "An Inward Shift in the Market Supply of Houses" shows the resulting outward shift in the supply curve for cars. It is difficult to explain the big decrease in output and the high rate of unemployment in the Great Depression through a change in technology in a single market.
Suppose, however, that this change in technology does not happen in just one market but occurs across the entire economy. Then a version of part (a) in Figure 22.3.1 "An Inward Shift in the Market Supply of Houses" would hold for each market in the economy. We would see declines in economic activity across a wide range of markets. Moreover, with declines in so many industries, we would expect to see lower real wages and less employment. The idea that workers could easily move from one industry to another is not as persuasive if the entire economy is hit by an adverse technology shock.
Using Growth Accounting to Understand the Great Depression
We use growth accounting to show how changes in output are driven by changes in the underlying inputs—capital, labor, and technology. Equivalently, we use the technique to give us a measure of the growth rate of technology, given data on the growth rates of output, capital, and labor:
$technology\ growth\ rate\ =\ output\ growth\ rate\ − [a \times capital\ stock\ growth\ rate]− [(1 − a) \times labor\ growth\ rate$.
We have omitted human capital from this growth accounting equation. We do so because, unfortunately, we do not have very good human capital measures for the period of the Great Depression. Human capital typically changes very slowly, so this is not too much of a problem: over a period of a decade, we do not expect big changes in human capital. Any changes in human capital that do occur are included in the catchall “technology” term.
Toolkit: Section 31.28 "Growth Accounting"
You can review the technique of growth accounting in the toolkit.
The key ingredient needed for the growth accounting equation is the number a. It turns out that a good measure of a is the fraction of real GDP that is paid to owners of capital. Roughly speaking, it is the amount of GDP that goes to the profits of firms. Equivalently, (1 − a) is the fraction of GDP that is paid to labor. The circular flow of income reminds us that all income ultimately finds its way back to households in the economy, which is why these two numbers sum to one.
Can Technology Changes Explain the Roaring Twenties?
The economist John Kendrick applied such growth accounting to data from the Great Depression.See John W. Kendrick, Productivity Trends in the United States (Princeton, NJ: Princeton University Press, 1961), particularly Table A-XXII, p. 335, and the discussion of these calculations. Table 22.3.1 "Growth Rates of Real GDP, Labor, Capital, and Technology, 1920–39*" summarizes his findings. Each row in Table 22.3.1 "Growth Rates of Real GDP, Labor, Capital, and Technology, 1920–39*" decomposes output growth into three components. In 1923, for example, output grew at a very high rate of 14.2 percent. This growth in output came from labor growth of 9.9 percent and capital stock growth of 2.0 percent. The remainder, which we interpret as growth in technology, grew at 9.5 percent. By all accounts, 1923 was a good year. The other entries in the table can be read in the same way.
Year Real GDP Labor Capital Technology
1920 0.4 1.4 2.1 −1.2
1921 −3.6 −11.5 1.5 4.0
1922 6.4 8.7 0.7 0.1
1923 14.2 9.9 2.0 9.5
1924 2.0 −3.2 2.6 4.9
1925 3.6 4.0 2.4 0.1
1926 6.2 4.2 3.2 3.4
1927 1.1 −0.2 2.9 0.5
1928 1.0 0.6 2.4 −0.3
1929 6.5 2.2 2.4 5.7
1930 −9.2 −8.1 2.0 −4.8
1931 −7.5 −10.5 0.1 0.4
1932 −14.5 −13.5 −2.2 −5.2
1933 −2.5 −1.0 −3.4 −1.2
1934 9.9 0.4 −2.8 13.7
1935 9.0 5.8 −1.4 6.6
1936 12.8 10.3 0.0 6.8
1937 6.9 5.8 1.4 2.9
1938 −5.5 −9.3 0.9 1.2
1939 9.1 6.2 −0.3 4.6
$^{*}$All entries are annual growth rates calculated using data from John W. Kendrick, Productivity Trends in the United States (Princeton, NJ: Princeton University Press, 1961), Table A-XXII, 335. Following the discussion in Kendrick, the capital share (a) was 0.30 until 1928 and 0.25 thereafter.
Table $1$: Growth Rates of Real GDP, Labor, Capital, and Technology, 1920–39$^{*}$
Real GDP and technology were both growing in most years in the 1920s. In the early 1930s both variables decreased, and both grew again as the economy recovered from the Great Depression. In other words, technology growth and output growth are positively correlated over this period. This suggests the possibility that changes in technology caused the changes in output—always remembering that, as we observed earlier, correlation need not imply a causal relationship. An improvement in technology causes firms to want to produce more. They demand more workers, so employment and real wages increase. The increased output, through the circular flow, means that there is increased income. Households increase both consumption and savings. Higher savings means higher investment, so, over time, the economy accumulates more capital. Exactly the opposite holds if there is a decrease in technology: in this case, employment, consumption, and investment all decrease.
Does this theory fit the facts? For the roaring twenties, we see growth in output, labor, and capital. In addition, there was a positive technology growth rate in almost all the years of the decade. These movements are indeed consistent with the behavior of an economy driven by improvements in technology. Jumping back for a moment to individual markets, improvements in technology shift supply curves rightward. Increased output is therefore accompanied by decreased prices. The aggregate price level is nothing more than a weighted average of individual prices, so price decreases in individual markets translate into a decrease in the overall price level. From Table 22.2.1 "Major Macroeconomic Variables, 1920–39*", the price level actually moved very little between 1922 and 1929, so this fits less well.
Overall, the view that technological progress fueled the growth from 1922 to 1929 seems broadly consistent with the facts. Given the simplicity of the framework that we are using, “broadly consistent” is probably the best it is reasonable to hope for.
Can Technology Changes Explain the Great Depression?
Now let us apply the same logic to the period of the Great Depression. Negative growth in output from 1930 to 1933 was matched by negative growth in labor and technology (except for 1931). The capital stock decreased from 1932 to 1935, reflecting meager investment during this period. When the economy turned around in 1934, technology growth turned up as well.
Imagine that the economy experienced negative technology growth from 1929 to 1933. The reduced productivity of firms leads to a decrease in demand for labor, so real wages and employment decrease. Lower productivity also means that firms did not think it was worthwhile to invest in building new factories and buying new machinery. Both labor and capital inputs into the production function declined. Once technology growth resumed in 1934, the story was reversed: labor and capital inputs increased, and the economy began to grow again. In this view, there was a substantial decline in the production capabilities of the economy, leading to negative growth in output, consumption, and investment. The Great Depression, in this account, was driven by technological regress.
Many economists are skeptical of such an explanation of the Great Depression. They have three criticisms. First, large-scale technological regress is difficult to believe on its face. Did people know an efficient way to manufacture something in 1929 but then forget it in 1930? Even remembering that technology includes social infrastructure, it is hard to imagine any event that would cause a decrease of 3 percent or more in technology—and if such an event did occur, surely we would be able to point to it and identify it.
Second, this explanation claims that labor input decreased because households saw lower real wages and voluntarily chose to consume leisure rather than work. By most measures, though, real wages increased. Moreover, it is difficult to equate a 25 percent unemployment rate, not to mention all the stories of how people could not find work, with a labor market in which households are simply moving along a labor supply curve.
Third, a prominent feature of the Great Depression is the decrease in the price level that occurred from 1929 to 1933. Table 22.2.1 "Major Macroeconomic Variables, 1920–39*" tells us that prices decreased by over 9 percent in both 1931 and 1932. However, a reduction in the level of potential GDP would cause an inward shift of market supply curves and thus an increase, rather than a decrease, in prices.
For most economists, the view of the Great Depression as a shift in technology is not convincing. Something else must have been going on. In particular, the very high unemployment rate strongly suggests that labor markets were malfunctioning. Thus, rather than viewing the large decreases in output in economies around the world as part of the normal functioning of supply and demand in an economy, we should perhaps consider it as evidence that sometimes things can go badly wrong with the economy’s self-correction mechanisms. If we want to explain the Great Depression, we are then obliged—as were the economists at the time—to find a new way of thinking about the economy. It was an economist named John Maynard Keynes who provided such a new approach; in so doing, he gave his name to an entire branch of macroeconomic theory.
Key Takeaways
• Potential output is the amount of real GDP an economy could produce if the labor market is in equilibrium and capital goods are fully utilized.
• A large enough decrease in potential output, say through technological regress, could cause the large decrease in real GDP that occurred during the Great Depression.
• A reduction in potential output would lead to a decrease in real wages and an increase in the price level. Those implications are inconsistent with the facts of the Great Depression years. Further, it is hard to understand how potential output could decrease by the extent needed to match the decrease in real GDP during the Great Depression. Finally, a 25 percent unemployment rate is not consistent with labor market equilibrium.
Exercises
1. Draw the comparative statics picture for the labor market for the situation in which the Great Depression is a consequence of technological regress—that is, negative technology growth. Which curve shifts? Does it shift leftward or rightward?
2. Suppose the supply curve in a market shifts rightward. What must happen to the demand curve if the price in the market does not change? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/22%3A_The_Great_Depression/22.03%3A_The_Great_Depression-_A_Decrease_in_Potential_Output%3F.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What are the main components of aggregate spending?
2. What is the national income identity?
3. What happened to consumption and investment spending during the Great Depression?
4. What is consumption smoothing?
In his analysis of the Great Depression, John Maynard Keynes contrasted his new approach with the prevailing “classical” theory:John Maynard Keynes, The General Theory of Employment, Interest and Money (Orlando: First Harvest/Harcourt, 1964[1936]), 3. “I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case.…Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.” Keynes claimed that there was a fundamental failure in the economic system that prevented markets from fully coordinating activities in the economy. He argued that, as a consequence, the actual output of the economy was not determined by the productive capacity of the economy, and that it was “misleading and disastrous” to think otherwise. In more modern terms, he said that actual output need not always equal potential output but was instead determined by the overall level of spending or demand in the economy.
Keynes provided a competing story of the Great Depression that did not rely on technological regress and in which unemployment truly reflected an inability of households to find work. Keynes gave life to aggregate spending—the total spending by households, firms, and governments—as a determinant of aggregate gross domestic product (GDP). With this new perspective, Keynes also uncovered a way in which government intervention might help the functioning of the economy.
To understand how Keynes approached the puzzle of the Great Depression, we must first look more closely at the components of GDP. Figure 22.4.1 "The Firm Sector in the Circular Flow" shows the circular flow, emphasizing the flows in and out of the firm sector of the economy. Accounting rules tell us that in every sector of the circular flow, the flow of dollars in must equal the flow of dollars out. We know that the total flow of dollars from the firm sector measures the total value of production in the economy. The total flow of dollars into the firm sector equals total expenditures on GDP. The figure therefore illustrates a fundamental relationship in the national accounts.
The flow of dollars into the firm sector equals consumption plus net exports plus investment plus government purchases. The flow of dollars from the firm sector equals total GDP in the economy.
The National Income Identity
The national income identity states that
\[production\ =\ consumption\ +\ investment\ +\ government\ purchases\ +\ net\ exports.\]
Toolkit: Section 31.27 "The Circular Flow of Income"
The toolkit describes the circular flow of income in more detail.
Consumption refers to total consumption spending by households on final goods and services. Consumption is divided into three categories.
1. Services. These are items such as haircuts, restaurant meals, hotel nights, legal services, and movies. There is often no tangible product; the consumer purchases the time and skills of individuals (such as barbers, chefs, and lawyers). Production and consumption of services usually occur together.
2. Nondurable goods. Examples include groceries, clothing, and DVDs—tangible products that (usually) have a fairly limited lifespan (typically less than three years).
3. Durable goods. These are items such as automobiles, “white goods” (washing machines, refrigerators, and other appliances), and computers. They are tangible products that usually have a lifespan of several years.
The distinctions among these categories are not always as clear-cut as the definitions suggest. A good pair of blue jeans might outlast a shoddy dishwasher, even though the jeans are classified as a nondurable good and the dishwasher as a durable good.
Investment is the purchase of new goods that increase the capital stock, allowing us to produce more output in the future. Investment is divided into three categories.
1. Business fixed investment. Purchases of physical capital (plants, machines) for the production of goods and services
2. New residential construction. The building of new homes
3. Inventory investment. Change in inventories of final goods
The economist’s definition of investment is precise and differs from the way we often use the word in everyday speech. Specifically, economists do not use the term to mean the purchase of financial assets, such as stocks and bonds. Most of the time when we talk about investment in this book, we are referring to business fixed investment—the production of new physical capital goods. Inventory investment is a special category of investment that we explain in 22.3 Section "Inventory Investment".
As a rough rule of thumb, consumption spending is carried out by households, and investment spending is carried out by firms. But there is one important exception: new residential construction is included in investment. A new house purchased by a household is treated as investment, not consumption.
Government purchases include all purchases of goods and services by the government. We include in our definition of “government” local as well as national government activity. In the United States, this means that we collapse together federal, state, and local governments for the purpose of our analysis.
This component of spending refers only to purchases of goods and services, not to transfers. So, if the federal government buys aircraft from Boeing or the local police department buys a fleet of Volvos, these are included in government purchases. However, a transfer you receive from the government—say, because you are unemployed and are being paid unemployment insurance—is not counted in GDP. (Of course, if you then use this income to purchase goods and services, that consumption is part of GDP.)
Net exports simply equal exports minus imports. They are included because we must correct for the expenditure flows associated with the rest of the world. Some spending in the economy goes to imported goods, which is not associated with domestic production. We must subtract these imports from total expenditures. Against that, some demand for domestically produced goods comes from other countries. We add these exports to total expenditure.
Inventory Investment
Inventory investment is a relatively minor component of GDP, but we need to understand it in some detail because it plays a key role in the Keynesian approach. When a firm produces output, it does one of two things with it: it either sells it or adds it to inventory. Thus an accounting relationship within a firm is that
\[production\ =\ sales\ +\ changes\ in\ inventory.\]
If a firm produces more than it sells, its stocks of inventories increase. If a firm sells more than it produces, its stocks of inventories decrease. The inventories that a firm holds are counted as part of its capital stock, so any change in firms’ inventories is counted as a component of investment.
Suppose General Motors (GM) produces 10 million cars, anticipating that it will sell them all. Then imagine that demand is lower than expected, so it only sells 9.9 million. The result is that 100,000 cars pile up on GM’s lots, and the GM accountants record this as an addition to inventory. We want GDP to measure both production and spending, but we have 100,000 cars that have been produced but not purchased. The national income accounts get around this problem by effectively pretending that GM bought the cars from itself.
If the cars are then sold in the following year, they will not contribute to GDP in that year—quite properly, since they were not produced that year. The national accounts in the next year will show that 100,000 cars were sold to households, but they will also show that inventories decreased by 100,000 cars. Thus the accounts record expenditures on these cars as part of durable goods consumption, but the accounts also contain an offsetting reduction in inventory investment.
In some cases, firms change their stocks of inventory as a part of their business strategy. More often, changes in inventories occur because a firm did not correctly forecast its sales. Unplanned inventory investment is an increase in inventories that comes about because a firm sells less than it anticipated. Because GM expected to sell all 10 million cars but sold only 9.9 million, GM had 100,000 cars of unplanned inventory investment.
Moreover, GM is likely to react swiftly to this imbalance between its production plans and its sales. When it sees its sales decrease and its inventory increase, it will respond by cutting its production back until it is in line with sales again. Thus, when an individual firm sees inventories increase and sales decrease, it typically scales down production to match the decrease in demand.
Now let us think about how this works at the level of an economy as a whole. Suppose we divide total spending in the economy into unplanned inventory investment and everything else, which we call planned spending.
Toolkit: Section 31.30 "The Aggregate Expenditure Model"
Planned spending is all expenditure in the economy except for unplanned inventory investment:
\[GDP\ =\ planned\ spending\ +\ unplanned\ inventory\ investment.\]
This equation must always hold true because of the rules of national income accounting.
Begin with the situation where there is no unplanned inventory investment—so GDP equals planned spending—and then suppose that planned spending decreases. Firms find that their production is in excess of their sales, so their inventory builds up. As we just argued, they respond by decreasing production so that GDP is again equal to planned spending, and unplanned inventory investment is once again zero. Thus, even though unplanned inventory investment can be nonzero for very short periods of time, we do not expect such a situation to persist. We expect instead that actual output will, in fact, almost always equal planned spending.
What Happened to the Components of GDP during the Great Depression?
Now let us look at how these components of GDP behaved during the 1930s. Table 22.4.1 "Growth Rates of Key Macroeconomic Variables, 1930–39*" presents these data in the form of growth rates. Remember that a positive growth rate means the variable in question increased from one year to the next, while a negative growth rate means it decreased.
Growth Rates 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939
Real GDP −8.6 −6.4 −13.0 −1.3 10.8 8.9 13.0 5.1 −3.4 8.1
Consumption −5.3 −3.1 −8.9 −2.2 7.1 6.1 10.1 3.7 −1.6 5.6
Investment −33.3 −37.2 −69.8 47.5 80.5 85.1 28.2 24.9 −33.9 28.6
Government Purchases 10.2 4.2 −3.3 −3.5 12.8 2.7 16.7 −4.2 7.7 8.8
\(^{*}\)This table shows growth rates in real GDP, consumption, investment, and government purchases. All data are from the National Income and Product Accounts web page, Bureau of Economic Analysis, Department of Commerce ( www.bea.gov/national/nipaweb/index.asp).
Table \(1\): Growth Rates of Key Macroeconomic Variables, 1930–39\(^{*}\)
We see again that real GDP decreased for four years in succession (the growth rates are negative from 1930 to 1933). The decrease in real GDP was accompanied by a decline in consumption and investment: consumption likewise decreased for four successive years, and investment decreased for three successive years. The decline in consumption was not as steep as the decline in real GDP, while the decline in investment was much larger. Were we to drill deeper and look at the components of consumption, we would discover that expenditures on durable goods decreased by 17.6 percent in 1930 and 25.1 percent in 1932, while expenditures on services decreased by only 2.5 percent in 1930 and 6.3 percent in 1932.
Whatever was happening during this period evidently had a much larger influence on firms’ purchases of investment goods, and on households’ spending on cars and other durable goods, than it did on purchases of nondurable goods (such as food) and services (such as haircuts). A similar pattern can be observed in modern economies: consumption is smoother than output, and spending on services is smoother than spending on durables. The reason for this is a phenomenon that economists call consumption smoothing.
Toolkit: Section 31.34 "The Life-Cycle Model of Consumption"
Consumption smoothing is the idea that households like to keep their flow of consumption relatively steady over time. When income is unusually high, the household saves (or pays off existing loans); when income is unusually low, the household borrows (or draws down existing savings). Consumption smoothing is a key ingredient of the life-cycle model of consumption, which is discussed in more detail in the toolkit.
If your company has a good year and you get a big bonus, you will increase consumption spending not only this year but also in future years. To do so, you must save a portion of your bonus to pay for this higher consumption in the future. By the same logic, if your income decreases, your consumption will not decrease as much. People who became unemployed during the Great Depression did not reduce their consumption of services and nondurable goods to zero. Instead, as far as was possible, they drew on their existing savings, borrowed, and postponed purchases of durable goods.
Consumption of durable goods, in other words, resembles investment rather than consumption of nondurable goods and services. This makes sense because durable goods resemble investment goods that are purchased by households. Like investment goods, they yield benefits over some prolonged period of time. As an example, consider automobile purchases during the Great Depression. Although 5.4 million cars were produced in 1929, only 3.4 million were produced in 1930—a reduction of more than 37 percent in a single year. Instead of buying new cars, households simply held onto their existing cars longer. As a consequence of the boom of the 1920s, there were a lot of relatively new cars on the road in 1929: the number of cars less than 3 years old was about 9.5 million. Two years later, this number had fallen to 7.9 million.These figures are from Michael Bernstein, The Great Depression: Delayed Recovery and Economic Change in America, 1929–39 (Cambridge, MA: Cambridge University Press, 1987).
This reduction in activity in the automobile industry was matched by a reduction of inputs into the production process. By early 1933, there were only 4 workers for every 10 who had been employed 4 years previously. Equipment purchases for the transportation sector were so low that capital stock for this sector decreased between 1931 and 1935. In the turmoil of the Great Depression, many small car producers went out of business, leaving a few relatively large companies—such as Ford Motor Company and GM—still in business.
Similar patterns arose as the economy recovered. Investment, in particular, was astonishingly volatile. It decreased by about one-third in 1930 and again in 1931, and by over two-thirds in 1932, but rebounded at an astoundingly high rate after 1933. Consumption, meanwhile, grew at a slower rate than GDP as the economy recovered.
Key Takeaways
• The components of aggregate spending are consumption, investment, government purchases of goods and services, and net exports.
• The national income identity states that real GDP is equal to the sum of the components of aggregate spending.
• During the Great Depression, both consumption spending and investment spending experienced negative growth.
• Households use savings to retain relatively smooth consumption despite fluctuations in their income.
Exercises
1. Explain the difference between investment spending in the national income and product accounts and a decision to buy shares of a company.
2. If someone is unemployed and receives unemployment benefits from a state government, are those funds counted in aggregate expenditure? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/22%3A_The_Great_Depression/22.04%3A_The_Components_of_GDP_during_the_Great_Depression.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. How did the perspective of Keynes differ from the “classical theory” of the macroeconomy?
2. How does a decrease in aggregate spending lead to a reduction in real gross domestic product (real GDP)?
3. Can a decrease in consumption explain the Great Depression?
4. Can a decrease in investment explain the Great Depression?
Now that we understand the components of aggregate spending, we can consider whether a decrease in one or more of these components can explain the Great Depression.
A Decrease in Aggregate Spending: The Multiple-Markets Perspective
Consider, as before, the market for new houses and suppose there is a reduction in spending on houses. Market demand shifts inward, causing a decrease in the price of houses, as shown in Figure 22.5.1 "An Inward Shift in Market Demand for Houses". The lower price means that construction firms choose to build fewer houses; there is a movement along the supply curve.
A decrease in demand for houses leads to a decrease in the price of houses and a lower quantity of houses being produced and sold.
As before, the effects are not confined to the housing market. Construction firms demand less labor, so the wages of these workers decrease. Employment in the construction industry declines, but these workers now seek jobs in other sectors of the economy. The increased supply of labor in these sectors reduces wages and thus makes it more attractive for firms to increase their hiring. Supply curves in other sectors shift rightward. Moreover, the income that was being spent on housing will instead be spent somewhere else in the economy, so we expect to see rightward shifts in demand curves in other sectors as well. In summary, if we are looking at the whole economy, a decrease in spending in one market is not that different from a decrease in technology in one market: we expect a reduction in one sector to lead to expansions in other sectors. The economy still appears to be self-stabilizing.
In this story, as is usual when we use supply and demand, we presumed that prices and wages adjust quickly to bring supply and demand into line. This is critical for the effective functioning of markets: for markets to do a good job of matching up demand and supply, wages and prices must respond rapidly to differences between supply and demand. Flexible prices adjust immediately to shifts in supply and demand curves so that price is always at the point where supply equals demand. If, for example, the quantity of labor supplied exceeds the quantity of labor demanded, flexible wages decrease quickly to bring the labor market back into equilibrium.
Suppose we instead entertain the possibility that wages and prices do not immediately adjust. Sticky prices do not react immediately to shifts in supply and demand curves, and the adjustment to equilibrium can take some time. We defer for the moment the discussion of why prices might be sticky and concentrate instead on the implications of this new idea about how markets work. The easiest way to see the effects of price stickiness is to suppose that prices do not change at all. Figure 22.5.2 "A Shift in Demand for Houses When Prices Are Sticky" shows the impact of a decrease in demand for houses when the price of houses is completely sticky. If you compare Figure 22.5.2 "A Shift in Demand for Houses When Prices Are Sticky" to Figure 22.5.1 "An Inward Shift in Market Demand for Houses", you see that a given shift in demand leads to a larger change in the quantity produced.
If the price in the market is “sticky,” it may not adjust immediately to the change in demand, resulting in a large decrease in the quantity of houses that are produced and sold.
What about the effects on other markets? As before, a decrease in demand for housing will cause construction workers to lose their jobs. If wages are sticky, these workers may become unemployed for a significant period of time. Their income decreases, and they consume fewer goods and services. So, for example, the demand for beef in the economy might decrease because unemployed construction workers buy cheaper meat. This means that the demand for beef shifts inward. The reduction in activity in the construction sector leads to a reduction in activity in the beef sector. And the process does not stop there—the reduced income of cattle farmers and slaughterhouse workers will, in turn, spill over to other sectors.
What has happened to the self-stabilizing economy described earlier? First, sticky wages and prices impede the incentives for workers to flow from one sector to another. If wages are sticky, then the reduction in labor demand in the construction sector does not translate into lower wages. Thus there is no incentive for other sectors to expand. Instead, these other sectors, such as food, see a decrease in demand for their product, which leads them to contract as well. Second, the decrease in income means that it is possible to see decreases in demand across the entire economy. It no longer need be the case that reductions in spending in one area lead to increased spending in other sectors.
The Circular Flow of Income during the Great Depression
So far, we have told this story in terms of individual markets. The circular flow helps us see how these markets come together in the aggregate economy. When we looked at the markets for housing and beef, we saw that a decrease in demand for housing led to a decrease in demand for labor and, hence, to lower labor income. We also saw that as income earned in the housing market decreased, spending decreased in the beef market. Such linkages are at the heart of the circular flow of income. Household spending on goods and services is made possible by a flow of income from firms. Firms’ hiring of labor is made possible by a flow of revenue from households. Keynes argued that this was a delicate process that might be prone to malfunction in a variety of ways.
Households are willing to buy goods and services if they have a reasonable expectation that they can earn income by selling labor. During the Great Depression, however, household expectations were surely quite pessimistic. Individuals without jobs believed that their chances of finding new employment were low. Those lucky enough to be employed knew that they might soon be out of work. Thus households believed it was possible, even likely, that they would receive low levels of income in the future. In response, they cut back their spending.
Meanwhile, the willingness of firms to hire labor depends on their expectation that they can sell the goods they manufacture. When firms anticipate a low level of demand for their products, they do not want to produce much, so they do not need many workers. Current employees are laid off, and there are few new hires.
Through the circular flow, the pessimism of households and the pessimism of firms interact. Firms do not hire workers, so household income is low, and households are right not to spend much. Households do not spend, so demand for goods and services is low, and firms are right not to hire many workers. The pessimistic beliefs of firms and workers become self-fulfilling prophecies.
The Aggregate Expenditure Model
In the remainder of this section, we build a framework around the ideas that we have just put forward. The framework focuses on the determinants of aggregate spending because, in this approach, the output of the economy is determined not by the level of potential output but by the level of total spending. This model is based around the idea of sticky prices—or, more precisely, it tells us what the output of the economy will be, at a given value of the overall price level. Once we understand this, we can add in the effects of changing prices.
Earlier, we introduced the national income identity:
$production\ =\ consumption\ +\ investment\ +\ government\ purchases\ +\ net exports.$
This equation must be true by the way the national income accounts are constructed. That is, it is an accounting identity. We also explained that
$GDP\ =\ planned\ spending\ +\ unplanned\ inventory\ investment.$
It is possible for firms to accumulate or decumulate inventories unintentionally, but such a situation will not persist for long. Firms quickly respond to such imbalances by adjusting their production. The aggregate expenditure model takes the national income identity and adds to it the condition that unplanned inventory investment equals zero—equivalently, gross domestic product (GDP) equals planned spending:
$planned\ spending\ =\ consumption\ +\ investment\ +\ government\ purchases\ +\ net\ exports.$
Another way of saying this is that as long as we interpret investment to include only planned investment, the national income equation is no longer an identity but instead a condition for equilibrium.
The Relationship between Planned Spending and Output
We could now examine all four components of planned spending separately. Different chapters of this book delve deeper into these types of spending. For the moment, however, we group them all together. We focus on the fact that total planned spending depends positively on the level of income and output in an economy, for two main reasons:
1. If households have higher income, they are likely to increase their spending on many goods and services. The relationship between income and consumption is one of the cornerstones of macroeconomics.
2. Firms are likely to decide that higher levels of output—particularly if expected to persist—mean that they should build up their capital stock and thus increase their investment.
Figure $3$: The Planned Spending Line
Planned spending is composed of autonomous spending (the amount of spending when real GDP equals zero) and induced spending (spending resulting from real GDP).
In summary, we conclude that when income increases, planned expenditure also increases. We illustrate this in Figure 22.5.3 "The Planned Spending Line", where we suppose for simplicity that the relationship between planned spending and GDP is a straight line:
$planned\ spending\ =\ autonomous\ spending\ +\ marginal\ propensity\ to\ spend \times GDP.$
Autonomous spending is the intercept of the planned spending line. It is the amount of spending that there would be in an economy if income were zero. It is positive, for two reasons: (1) A household with no income still wants to consume something, so it will either draw on its existing savings or borrow against future income. (2) The government purchases goods and services even if income is zero.
The marginal propensity to spend is the slope of the planned spending line. It tells us how much planned spending increases if there is a $1 increase in income. The marginal propensity to spend is positive: Increases in income lead to increased spending by households and firms. The marginal propensity to spend is less than one, largely because of consumption smoothing by households. If household income increases by$1, households typically consume only a fraction of the increase, saving the remainder to finance future consumption. This equation, together with the condition that GDP equals planned spending, gives us the aggregate expenditure model.
Toolkit: Section 31.30 "The Aggregate Expenditure Model"
The aggregate expenditure model takes as its starting point the fact that GDP measures both total spending and total production. The model focuses on the relationships between output and spending, which we write as follows:
$planned\ spending\ =\ GDP$
and
$planned\ spending\ =\ autonomous\ spending\ +\ marginal\ propensity\ to\ spend \times GDP.$
The model finds the value of output for a given value of the price level. It is then combined with a model of price adjustment to give a complete picture of the economy.
Figure $4$: Equilibrium in the Aggregate Expenditure Model
The aggregate expenditure framework tells us that the economy is in equilibrium when planned spending equals real GDP.
We can solve the two equations to find the values of GDP and planned spending that are consistent with both equations:
We can also take a graphical approach, as shown in Figure 22.5.4 "Equilibrium in the Aggregate Expenditure Model". On the horizontal axis is the level of real GDP, while on the vertical axis is the overall level of (planned) spending in the economy. We graph the two relationships of the aggregate expenditure model. The first line is a 45° line—that is, it is a line with a slope equal to one and passing through the origin. The second is the planned spending line. The point that solves the two equations is the point where the two lines intersect. This diagram is the essence of the aggregate expenditure model of the macroeconomy.
The aggregate expenditure model makes no reference to potential output or the supply side of the economy. The model assumes that the total amount of output produced will always equal the quantity demanded at the given price. You might think that this neglect of the supply side is a weakness of the model, and you would be right. In 22.4 Section "Price Adjustment", when we introduce the adjustment of prices, the significance of potential output becomes clear.
Can a Decrease in Consumption Spending Explain the Great Depression?
We now apply this framework to the Great Depression. The aggregate expenditure approach suggests that output decreased in the Great Depression because aggregate spending decreased. Part (a) of Figure 22.5.5 "A Decrease in Aggregate Expenditures" shows how this process begins: a decrease in autonomous spending shifts the spending line down. The interpretation of such a shift is that, at every level of income, spending is lower. Such a decrease in spending is due to a decrease in (the autonomous component of) consumption, investment, government spending, or net exports (or some combination of these). Part (b) of Figure 22.5.5 "A Decrease in Aggregate Expenditures" shows what happens when the planned spending line shifts downward. The equilibrium level of real GDP decreases. So far, therefore, the aggregate expenditure model seems to work: a decrease in autonomous spending leads to a decrease in real GDP at the given price level. But we need to know why planned spending decreased.
The Keynesian explanation of the Great Depression is that a decrease in autonomous spending caused the planned spending line to shift downward (a) leading to a decrease in the equilibrium level of real GDP (b).
Let us first consider the possibility that a reduction in consumption triggered the Great Depression. Recall that, between September and November 1929, the stock market in the United States crashed. This collapse meant that many households were suddenly less wealthy than they had been previously. A natural response to a decrease in wealth is to decrease consumption; this is known as a wealth effect.
Wealth is distinct from income. Income is a flow: a household’s income is the amount that it receives over a period of time, such as a year. Wealth is a stock: it is the cumulated amount of the household’s savings. Is it plausible that wealth effects could explain a collapse of the magnitude of the Great Depression? To answer this, we need to determine how much real GDP decreases for a given change in autonomous spending.
The Multiplier
Toolkit: Section 31.30 "The Aggregate Expenditure Model"
The solution for output in the aggregate expenditure model can be written in terms of changes as follows:
$change\ in\ GDP\ =\ multiplier \times change\ in\ autonomous\ spending,$
where the multiplier is given by
Suppose that the marginal propensity to spend is 0.8. Then
A given change in autonomous spending will lead to a fivefold change in real GDP. Economists refer to this as a multiplier process. Because (1 − marginal propensity to spend) is less than one, the multiplier is a number greater than one. This means that any change in autonomous spending is multiplied up to result in a larger change in GDP. Even relatively small decreases in spending can end up being damaging to an economy.
The economics behind the multiplier comes from the circular flow of income. Begin with a decrease in autonomous spending. The reduction in spending means less demand for firms’ goods and services. Firms respond by cutting output. (As a reminder, the signal to firms that they should cut their output comes from the fact that they see a buildup of their inventory.) When firms cut their output, they require less labor and pay out less in wages, so household income decreases. This causes households to again cut back on consumption, so spending decreases further. Thus we go round and round the circular flow diagram: decreased spending leads to decreased output, which leads to decreased income, which leads to decreased spending, which leads to decreased output, and so on and so on. The process continues until the reductions in income, output, and consumption in each round are tiny enough to be ignored.
We use the multiplier to carry out comparative static exercises in the aggregate expenditure model. In this case, the endogenous variable is real GDP, and the exogenous variable is autonomous spending. Given a change in autonomous spending, we simply multiply by the multiplier to get the change in real GDP when the price level is fixed. Let us do some back-of-the-envelope comparative static calculations, based on the assumption that the marginal propensity to spend is 0.8, so the multiplier is 5.
Table 22.2.1 "Major Macroeconomic Variables, 1920–39*" tells us that real GDP decreased by approximately $75 billion between 1929 and 1930. With a multiplier of 5, we would need a drop in autonomous spending of$75 billion divided by 5, or $15 billion, to get this large a decrease in GDP. The population of the United States in 1930 was approximately 123 million, so a$15 billion decrease in spending corresponds to about $122 per person. Remember that the figures in Table 22.2.1 "Major Macroeconomic Variables, 1920–39*" are in terms of year 2000 dollars. It certainly seems plausible that households, who had been made significantly poorer by the collapse in the stock market, would have responded by cutting back spending by the equivalent today of a few hundred dollars per year. Our goal, you will remember, is to explain the events of the Great Depression. How are we doing so far? The good news is that we do have a story that explains how output could decrease as precipitously as it did in the Great Depression years: there was a major stock market crash, which made people feel less wealthy, so they decided to consume less and save more. If we look more closely, though, this story still falls short. When we examined the data for the Great Depression, we saw that—while output and consumption both decreased—consumption decreased much less than did output. For example, from 1929 to 1933, real GDP decreased by 26.5 percent, while consumption decreased by 18.2 percent. By contrast, investment (that is, purchases of capital by firms, new home construction, and changes in business inventories) decreased much more than output. In 1932, purchases of new capital were$11 billion (year 2000 dollars), compared to a level of $91 billion in 1929. This is a reduction in real investment of about 82 percent. We must look more closely at investment to see if our theory can also explain the different behavior of consumption and investment. Can a Decrease in Investment Spending Explain the Great Depression? When GDP decreases, there can be an induced decrease in investment: declines in income lead firms to anticipate lower production in the future, meaning they see less of a need to build up their capital stock. But the changes in investment during the Great Depression were very large. Because it is implausible that such large variation was the result of changes in output alone, economists look for additional explanations of why investment decreased so much during the Great Depression. During the Great Depression, the link between savings and investment was disrupted by bank failures. Between 1929 and 1933, a number of US banks went out of business, often taking the savings of households with them. People began to trust banks less, and many households stopped putting their savings into the financial sector. The financial sector is an intermediary between households and firms, matching up the supply of savings from households with the demand for savings by firms. Figure 22.5.6 "The Financial Sector in the Circular Flow of Income" shows the flows in and out of the financial sector. (Our focus here is on the role of this sector in matching savers and investors. As Figure 22.5.6 "The Financial Sector in the Circular Flow of Income" shows, however, funds also flow into (or from) the financial sector from the rest of the world and the government sector.) Financial institutions such as banks act as intermediaries in the circular flow of income. During the Great Depression, many banks failed, disrupting the matching of savings and investment. To understand bank failures in the Great Depression, we need to take a moment to review what banks do. A bank is an institution that accepts money (“bank deposits”) from individuals. It then takes some of that money and puts it into longer-term projects—the construction of an apartment building, for example. The bank in this case issues a long-term loan to the company that plans to construct the new building. At any time, a bank has a portfolio of assets. Some are liquid; they are easily and quickly exchanged for cash. Some are illiquid; they cannot easily be converted into cash. Banks keep some assets in a highly liquid form, such as cash or very short-term loans, and also hold assets that are relatively illiquid, such as a two-year loan to a construction company. At any time, depositors at a bank can choose to withdraw their money. Under normal circumstances, people are happy to leave most of their money in the bank, so only a small fraction of depositors want to withdraw money on any given day. The bank keeps some cash in its vaults to accommodate this demand. But suppose that times are not normal. Suppose that, as was the case during the Great Depression, depositors start to see that other banks are going out of business. Then they may worry that their own bank is also at risk of failing, in which case they will lose their savings. The natural response is to rush to the bank to withdraw money before the bank fails. If a large number of depositors all try to withdraw money at once, the bank will run out of cash and other liquid assets. It will not be able to meet the needs of its depositors. The consequence is a bank run. And if the bank is unable to meet its depositors’ demands, it may be forced out of business altogether. This is known as a bank failure. A striking feature of a bank failure caused by a bank run is that it is a self-fulfilling prophecy: • If everybody believes that the bank is safe, then no one will withdraw money, and the bank will indeed be safe. • If everybody believes that the bank is going to fail, then everyone will try to withdraw money, and the bank will indeed fail. Notice that every individual’s decision about what to do is based on what that individual expects everyone else will do. Figure 22.5.7 "Payoffs in a Bank-Run Game" presents the decisions underlying a bank run in a stylized way. Imagine that you deposit$100 in the bank. The table in the figure shows how much you obtain, depending on your own actions and those of other depositors. You and the other depositors must decide whether to leave your money in the bank (“don’t run”) or try to take your money out of the bank (“run”). If everyone else leaves money in the bank, then you can withdraw your money and get $100 or leave it in the bank and get the$100 plus $10 interest. If others do not run, then it is also best for you not to run. But if everyone else runs on the bank, then you get nothing if you leave your money in the bank, and you can (in this example) recover$20 if you run to the bank along with everyone else. Thus, if you expect others to run on the bank, you should do the same.
This table shows the payoffs in a bank-run game. That is, it shows you what you get back depending on your choice and everybody else’s choice about whether to run on the bank. If everyone else leaves money in the bank, then you should do the same, but if everyone else runs on the bank, you are better running as well.
Economists call this situation a coordination game. In a coordination game, there are multiple equilibria. In this example, there is one equilibrium where there is no run on the bank, and there is another equilibrium where everyone runs to the bank to withdraw funds.
Toolkit: Section 31.18 "Nash Equilibrium"
You can find more details on coordination games in the toolkit.
During the Great Depression, a story such as this played out not only at one bank but at many. Figure 22.5.8 shows what happened in terms of the aggregate expenditure framework. Prior to the Great Depression, the economy was in a “high confidence” equilibrium, in which the banking system was healthy and confidence was high. Then—for some reason—people became nervous about leaving money in banks, and it became much harder for firms to obtain loans. The cost of borrowing—the real interest rate—increased, and investment decreased substantially. The planned spending line shifted downward, and the economy moved to the bad “low confidence” equilibrium. The downward shift in planned spending leads to a decrease in real GDP, given the existing level of prices.
Figure 22.5.8 should look familiar; it is the same as part (b) of Figure 22.5.5 "A Decrease in Aggregate Expenditures". This is because a decrease in autonomous consumption and a decrease in autonomous investment both look the same in the aggregate expenditure model, even though the underlying story is different. Of course, it is also possible that both autonomous consumption and autonomous investment decreased.
Figure $8$
Failures in the financial sector lead to a drop in investment spending. During the Great Depression, a decrease in confidence in the banking system meant that many banks failed, and it became more difficult and expensive for firms to borrow. The planned spending line shifted downward, and real GDP decreased.
To summarize, the banking crisis made households reluctant to put money in the banks, and banks were reluctant to make loans. Two banking measures help us see what was happening. The currency-deposit ratio is the total amount of currency (that is, either banknotes or coins) divided by the total amount of deposits in banks. The loan-deposit ratio is the total amount of loans made by banks divided by the total amount of deposits in banks.
If the currency-deposit ratio is low, households are not holding very much cash but are instead keeping wealth in the form of bank deposits and other assets. The currency-deposit ratio increased from 0.09 in October 1929 to 0.23 in March 1933.See Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), Table B3. This means that households in the economy started holding onto cash rather than depositing it in banks. You can think of the loan-deposit ratio as a measure of the productivity of banks: banks take deposits and convert them into loans for investment. During the Great Depression, the loan-deposit ratio decreased from 0.86 to 0.73.See Ben Bernanke, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” American Economic Review 73 (1983): 257–76, Table 1.
Price Adjustment
The story we have told explains why the economy departs from potential output but says nothing about how (if at all) the economy gets back to potential output. The answer is that prices have a tendency to adjust back toward their equilibrium levels, even if they do not always get there immediately. This is most easily understood by remembering that prices in the economy are, in the end, usually set by firms. When a firm sees a decrease in demand for its product, it does not necessarily decrease its prices immediately. Its decision about what price to choose depends on the prices of its inputs and the prices being set by its competitors. In addition, it depends on not only what those prices are right now but also what the firm expects to happen in the future. Deciding exactly what to do about prices can be a difficult decision for the managers of a firm.
Without analyzing this decision in detail, we can certainly observe that firms often keep prices fixed when demand decreases—at least to begin with. The result looks like that in Figure 22.5.1 "An Inward Shift in Market Demand for Houses". In the face of a prolonged decrease in demand, however, firms will lower prices. Some firms do this relatively quickly; others keep prices unchanged for longer periods. We conclude that prices are sticky; they do not decrease instantly, but they decrease eventually. Chapter 25 "Understanding the Fed" provides more detail about the price-adjustment decisions of firms. For the economy as a whole, this adjustment of prices is represented by a price-adjustment equation.
Toolkit: Section 31.31 "Price Adjustment"
The difference between potential output and actual output is called the output gap:
$output\ gap\ =\ potential\ real\ GDP\ −\ actual\ real\ GDP.$
If an economy is in recession, the output gap is positive. If an economy is in a boom, then the output gap is negative. The inflation rate when an economy is at potential output (that is, when the output gap is zero) is called autonomous inflation. The overall inflation rate depends on both autonomous inflation and the output gap, as shown in the price-adjustment equation:
$inflation\ rate\ =\ autonomous\ inflation\ −\ inflation\ sensitivity \times output\ gap.$
This equation tells us that there are two reasons for increasing prices.
1. Prices increase because autonomous inflation is positive. Even when the economy is at potential output, firms may anticipate that their suppliers or their competitors are likely to increase prices in the future. A natural response is to increase prices, so autonomous inflation is positive.
2. Prices increase because the output gap is negative. The output gap matters because, as GDP increases relative to potential, labor and other inputs become scarcer. Firms see increasing costs and choose to set higher prices as a consequence. The “inflation sensitivity” tells us how responsive the inflation rate is to the output gap.
When real GDP is above potential output, there is upward pressure on prices in the economy. The inflation rate exceeds autonomous inflation. By contrast, when real GDP is below potential, there is downward pressure on prices. The inflation rate is below the autonomous inflation rate. The price-adjustment equation is shown in Figure 22.5.9 "Price Adjustment".
Figure $9$: Price Adjustment
When an economy is in a recession, actual inflation is lower than autonomous inflation. In a boom, inflation is higher than its autonomous level.
We can apply this pricing equation to the Great Depression. Imagine first that autonomous inflation is zero. In this case, prices decrease when output is below potential. From 1929 to 1933, output was surely below potential and, as the equation suggests, this was a period of decreasing prices. After 1933, as the economy rebounded, the increase in the level of economic activity was matched with positive inflation—that is, increasing prices. This turnaround in inflation occurred even though the economy was still operating at a level below potential output. To match this movement in prices, we need to assume that—for some reason that we have not explained—autonomous inflation became positive in this period.
Key Takeaways
• Keynes argued that, at least in the short run, markets were not able to fully coordinate economic activity. His theory gave a prominent role to aggregate spending as a determinant of real GDP.
• Given prices, a reduction in spending will lead to a reduction in the income of workers and owners of capital, which will lead to further reductions in spending. This link between income and spending is highlighted by the circular flow of income and underlies the aggregate expenditure model.
• The stock market crash in 1929 reduced the wealth of many households, and this could have led them to cut consumption. This reduction in aggregate spending, through the multiplier process, could have led to a large reduction in real GDP.
• The reductions in investment in the early 1930s, perhaps coming from instability in the financial system, could lead to a reduction in aggregate spending and, through the multiplier process, a large reduction in real GDP.
Exercises
1. Some researchers have suggested that a reduction in US net exports is another possible cause of the Great Depression. Use the aggregate expenditure model to consider the effects of a reduction in net exports. What happens to real GDP?
2. Suppose autonomous inflation is constant, but real GDP moves around. Would you expect inflation to be procyclical or countercyclical? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/22%3A_The_Great_Depression/22.05%3A_The_Great_Depression-_A_Decrease_in_Aggregate_Spending%3F.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is stabilization policy?
2. What is monetary policy, and how was it used during the Great Depression?
3. What is fiscal policy, and how was it used during the Great Depression?
Understanding why the Great Depression occurred is certainly progress. But policymakers also wanted to know if there was anything that could be done in the face of this economic catastrophe. One of Keynes’ most lasting contributions to economics is that he showed how different kinds of economic policy could be used to assist economies that were stuck in recessions.
When markets are doing a good job of allocating resources, standard economic reasoning suggests that it is better for the government to stay out of the way. But when markets fail to allocate resources well, the government might be able to improve the overall functioning of the economy. The idea that markets left alone would coordinate aggregate economic activity is difficult to defend in the face of 25 percent unemployment of the labor force and a decline in economic activity of nearly 30 percent over a 4-year period. Thus the rationale for government intervention in the aggregate economy is that markets are failing to allocate resources properly, perhaps because prices and wages are sticky.
Policy Remedies
In the wake of the Great Depression, economists started advocating the use of government policy to improve the functioning of the macroeconomy. There are two kinds of government policy. Monetary policy refers to changes in interest rates and other tools that are under the control of the monetary authority of a country (the central bank). Fiscal policy refers to changes in taxation and the level of government purchases; such policies are typically under the control of a country’s lawmakers. Stabilization policy is the general term for the use of monetary and fiscal policies to prevent large fluctuations in real gross domestic product (real GDP).
In the United States, the Federal Reserve Bank controls monetary policy, and fiscal policy is controlled by the president, the Congress, and state governments. In the countries of the European Union, monetary policy is controlled by the European Central Bank, and fiscal policies are controlled by the individual governments of the member countries.
Keynes suggested that the cause of the Great Depression was an unusually low level of aggregate spending. This diagnosis suggests an immediate remedy: use government policies to increase aggregate spending. Because
$change\ in\ GDP\ =\ multiplier \times change\ in\ autonomous\ spending,$
any government policy that increases autonomous spending will, through this equation, also increase GDP. There are many different policies at the disposal of the government, but they are similar at heart. The idea is to stimulate one of the components of aggregate spending—consumption, investment, government purchases, or net exports.
One fiscal policy measure is an increase in government purchases. Suppose the government increases its expenditure—perhaps by hiring more teachers, buying more tanks, or building more roads. This increases autonomous spending and works its way through the economy, just as in our earlier discussion of a decrease in autonomous consumption—except now we are talking about an increase rather than a decrease. If the government spends an extra dollar, this immediately expands income by that dollar. Extra income leads to extra spending, which leads to further increases in output and income. The process continues around and around the circular flow.
Imagine that, as before, the marginal propensity to spend is 0.8, so that the multiplier is 5. If the government increases expenditure on goods and services by $1 billion, overall GDP in the economy will increase by$5 billion. Thus to offset the decrease in real GDP of about $90 billion between 1929 and 1933, assuming a marginal propensity to spend of 0.8, the federal government should have increased government spending by$18 billion. The multiplier is a double-edged sword. It has the bad effect that it can turn small decreases in spending into big decreases in output. But it also means that relatively small changes in government spending can have a big effect on output.
Tax cuts are another way to stimulate the economy. If households have to pay fewer taxes to the government, they are likely to spend more on consumption goods. This form of policy intervention has been used over and over again by governments in the United States and elsewhere. Tax cuts, like government spending, must be paid for. If the government spends more and taxes less, then the government deficit increases. The government must borrow to finance such fiscal policy measures. Chapter 27 "Income Taxes" and Chapter 29 "Balancing the Budget" have more to say about fiscal policy.
The central bank can use monetary policy to affect aggregate spending. Monetary policy operates through changes in interest rates, which are—in the short run at least—under the influence of the central bank. Lower interest rates make it cheaper for firms to borrow, which encourages them to increase investment spending. Lower interest rates likewise mean lower mortgage rates, so households are more likely to buy new homes. Lower interest rates may encourage households to borrow and spend more on other goods. And lower interest rates can even encourage net exports.The link from interest rates to net exports is complicated because it involves changes in exchange rates. You do not need to worry here about how it works. We explain it, together with other details of monetary policy, in Chapter 25 "Understanding the Fed".
Monetary and Fiscal Policies during the Great Depression
We have argued that monetary and fiscal policies could have been used to help the economy out of the Great Depression. But what did policymakers actually do at the time? The answer comes in two parts: at the start of the Great Depression, they did not do much; after 1932, they did rather more.
Both presidential candidates campaigned in favor of conservative fiscal policy in 1932. Here are some excerpts from the party platforms.See John Woolley and Gerhard Peters, The American Presidency Project, accessed June 30, 2011, http://www.presidency.ucsb.edu.
From the Democratic Party platform:
We advocate an immediate and drastic reduction of governmental expenditures by abolishing useless commissions and offices, consolidating departments and bureaus, and eliminating extravagance to accomplish a saving of not less than twenty-five per cent in the cost of the Federal Government. And we call upon the Democratic Party in the states to make a zealous effort to achieve a proportionate result.
We favor maintenance of the national credit by a federal budget annually balanced on the basis of accurate executive estimates within revenues, raised by a system of taxation levied on the principle of ability to pay.“Democratic Party Platform of 1932,” The American Presidency Project, accessed June 30, 2011, http://www.presidency.ucsb.edu/ws/index.php?pid=29595#ax zz1N9yDnpSR.
From the Republican Party platform:
The President’s program contemplates an attack on a broad front, with far-reaching objectives, but entailing no danger to the budget. […]
Constructive plans for financial stabilization cannot be completely organized until our national, State and municipal governments not only balance their budgets but curtail their current expenses as well to a level which can be steadily and economically maintained for some years to come. “Republican Party Platform of 1932,” The American Presidency Project, accessed June 30, 2011, http://www.presidency.ucsb.edu/ws/index.php?pid=29638#axz z1N9yDnpSR.
Both parties were arguing for cuts in government expenditures, not the increases that (with the benefit of hindsight and better theory) we have suggested were needed. Monetary policy was likewise not used to stimulate the economy at this time. It seems unlikely that the fiscal and monetary authorities knew what to do but did nothing. Instead, the tools of economic thought needed to guide policy were simply not sufficiently well developed at the time. In keeping with the prevailing view that the economy was self-correcting, the incumbent Republican president, Herbert Hoover, had insisted that “prosperity is just around the corner.”
The election of Franklin Roosevelt in 1932 was a turning point. After his election, President Roosevelt and his advisors created a series of measures—called the New Deal—that were intended to stabilize the economy. In terms of fiscal policy, the US government moved away from budget balance and adopted a much more aggressive spending policy. Government spending increased from 3.2 percent of real GDP in 1932 to 9.3 percent of GDP by 1936. These spending increases were financed by budget deficits.
Roosevelt also took action to stabilize the banking system, most notably by creating a system of deposit insurance. This policy remains with us today: if you have deposits in a US bank, the federal government insures them. According to the Federal Deposit Insurance Corporation ( http://www.fdic.gov), not a single depositor has lost a cent since the introduction of deposit insurance.The FDIC site ( http://www.fdic.gov) provides a discussion the history of this fund and current activities. The discussion of “Who is the FDIC?” ( http://www.fdic.gov/about/learn/symbol/index.html) is a good place to start. Finally, the 1930s was also the time of the introduction of Social Security and other measures to protect workers. The Social Security Administration ( http://www.ssa.gov) originated in 1935.General information on social security is available at http://www.ssa.gov. The history of the legislation, including various House and Senate Bills, is also available at http://www.ssa.gov/history/history.html. The original act included old-age benefits and the provision of unemployment insurance. The disability part of the program was created in 1956.
The New Deal brought about changes not only in policy but also in attitudes toward policymaking. Gardiner Means, who was an economic adviser to the Roosevelt administration in 1933, said of policymaking at the time:
It was this which produced the yeastiness of experimentation that made the New Deal what it was. A hundred years from now, when historians look back on this, they will say a big corner was turned. People agreed old things didn’t work. What ran through the whole New Deal was finding a way to make things work.
Before that, Hoover would loan money to farmers to keep their mules alive, but wouldn’t loan money to keep their children alive. This was perfectly right within the framework of classical thinking. If an individual couldn’t get enough to eat, it was because he wasn’t on the ball. It was his responsibility. The New Deal said: “Anybody who is unemployed isn’t necessarily unemployed because he is shiftless.” See Studs Terkel, Hard Times: An Oral History of the Great Depression (New York: Pantheon Books, 1970), 247.
Key Takeaways
• Stabilization policy entails the use the monetary and fiscal policy to keep the level of output at potential output.
• Monetary policy is the use of interest rates and other tools, under the control of a country’s central bank, to stabilize the economy. During the Great Depression, monetary policy was not actively used to stabilize the economy. A major component of stabilization after 1932 was restoring confidence in the banking system.
• Fiscal policy is the use of taxes and government spending to stabilize the economy. During the first part of the 1930s, contractionary fiscal policy may have deepened the Great Depression. After 1932, fiscal policy became more expansionary and may have helped to end the Great Depression.
Exercises
1. Suppose the government wants to increase real GDP by \$1,000. Explain why a smaller multiplier implies that the government must increase its spending by more to increase real GDP by this amount.
2. Did the government miss a chance to carry out stabilization policy before 1932? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/22%3A_The_Great_Depression/22.06%3A_Policy_Interventions_and_the_Great_Depression.txt |
In Conclusion
We started this chapter by describing the experience of the economy of the United States and other countries in the 1930s. The catastrophic economic performance of that period was difficult to reconcile with the view of classical economists that markets always worked to coordinate aggregate economic activity. Although technological progress provides a plausible explanation of the roaring twenties, technological regress is much less convincing as a story of the Great Depression. Technological regress also cannot explain the behavior of the price level and real wages during the Great Depression.
The Keynesian view explains the Great Depression as being driven by a decrease in aggregate spending, caused primarily by two factors: household consumption decreased because the stock market crash reduced household wealth, and investment decreased because of disruption of the financial intermediation process and pessimism over the future of the economy. These reductions in spending, through the multiplier, led to large reductions in real output. This story is consistent with the observed reductions in consumption, investment, and real GDP. With sticky prices, these reductions in spending translate into lower real GDP. The simple Keynesian story also has two problems: it can explain increasing prices only by assuming an exogenous increase in autonomous inflation and it provides no explanation of why observed technology decreased in the Great Depression period.
Along with the Keynesian explanation of the Great Depression comes a solution: use government policies to manage aggregate spending. If the aggregate expenditure model were literally true, policymaking would become an exact science: the policymaker would start with a target level of output and then determine the level of, say, government purchases needed to reach that target. As you might imagine, life as an economic policymaker is more complicated. The economists and politicians designing fiscal and monetary policy do not have a perfect picture of the current state of the economy. Moreover, control over policy tools is often inexact, and policy decisions take time.
The Great Depression remains something of a puzzle to macroeconomists. This became very apparent again recently during the so-called Great Recession—the major economic downturn that began in 2008. There are some resemblances between the two episodes, and the experience of the Great Depression certainly influenced some of the monetary policy decisions that were made in recent years. In this chapter, we did not yet consider monetary policy in detail. Chapter 25 "Understanding the Fed", which discusses the conduct of monetary policy, also addresses monetary policy during the Great Depression.
The aggregate expenditure framework is not a very sophisticated theory of the economy. Much work in macroeconomics in the decades since the Great Depression has involved refining the various pieces of the aggregate expenditure model. Economists have developed more rigorous theories of consumption, investment, and price adjustment, for example, in which they emphasize how households and firms base their decisions on expectations about the future. But Keynes’ fundamental insight—that the level of output may sometimes be determined not by the productive capacity of the economy but by the overall level of spending—remains at the heart of macroeconomic research and policymaking today.
Key Links
exercises
1. Consider the bank-run game presented in 22.4 Section "Can a Decrease in Investment Spending Explain the Great Depression?". Discuss in words how you think the introduction of deposit insurance would change the incentives of an individual to run on a bank.
2. If the marginal propensity to spend is 0.6 and autonomous spending decreases by \$500, what is the change in output predicted by the aggregate expenditures model?
3. During the early 1930s, the government was intent on balancing its budget. If this required a reduction in government spending, what do you predict would happen to real GDP?
4. Do you think that labor force participation (that is, the percentage of the population that is actively in the labor force, either working or looking for a job) is procyclical or countercyclical? Why?
5. What is the effect of consumption smoothing on the value of the multiplier?
6. Explain why an increase in the value of the stock market might lead to higher real GDP. [Hint: think about what happens to consumption.]
7. Suppose you plan to meet a friend at a restaurant at 7 p.m. You are worried that she might be late and not show up until 8 p.m. You would prefer to eat at 7 p.m. rather than 8 p.m., but you also would prefer not to have to stand around waiting for your friend for an hour. She has the same tastes as you do. Explain carefully how you and your friend are in a coordination game. Is it an equilibrium for you both to show up at 7 p.m.? Is it an equilibrium for you both to show up at 8 p.m.?
8. Suppose that the inflation rate is very sensitive to the output gap in the economy. What does this imply about how quickly the economy will get back to equilibrium following a shock?
Spreadsheet Exercises
1. Using the data presented in Table 22.2.1 "Major Macroeconomic Variables, 1920–39*", create a spreadsheet to look graphically at the relationship between real GDP, unemployment, and the price level from 1929 to 1933.
2. Redo Table 22.3.1 "Growth Rates of Real GDP, Labor, Capital, and Technology, 1920–39*" assuming that a = 0.3 throughout the period of study. How do the results change?
Economics Detective
1. Consider the town in which you were born. Try to find out what happened there during the Great Depression. Did local businesses close? Were jobs available?
2. Can you find a recent example of a bank run in some country? What happened?
3. Following the financial crisis of 2008, the United States adopted a large fiscal stimulus. Try to find some details of this stimulus. How big was it? What form did it take? How big did policymakers think the multiplier was? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/22%3A_The_Great_Depression/22.07%3A_End-of-Chapter_Material.txt |
In March 2006, students demonstrated on the streets of France.
Violent French Protests: 300 Held
Police detained some 300 people around France after nationwide student marches against a new labor law turned violent, as street cleaners cleared away torched cars Friday and the government braced for more protests.
A quarter of a million people took to the streets in some 200 demonstrations around the country Thursday, in a test of strength between youth and the conservative government of 73-year-old President Jacques Chirac.
Most of the violence—and the arrests—were around the Sorbonne University in Paris, where police fired rubber pellets and tear gas at youths who pelted them with stones and set cars on fire.
[…]
Many trade unionists and students oppose the new youth employment law because it allows new workers under the age of 26 to be dismissed within a two-year trial period.“Violent French Protests: 300 Held,” VOV News, March 18, 2006, accessed August 22, 2011, english.vov.vn/Home/Violent-French-protests-300-held/20063/36835.vov.
If, like most readers of this book, you are a student in the United States, it is unlikely that you have taken part in violent demonstrations about labor policy. It is not that such demonstrations are unheard of. In Madison, Wisconsin, in 2011, there were extended protests concerning proposed changes in public sector contracts. Still, in the United States, it is accepted that the government has a limited influence on contracts between workers and firms. It is part of economic life in the United States that employment is not protected by the government. In Europe, however, many countries have extensive laws on their books that are designed to protect workers. For example, in much of Europe, unemployment insurance is more generous than in the United States. Unemployed people obtain larger benefits and are eligible for these benefits for longer periods of time.
In many European countries, it is also much more difficult to fire workers than it is in the United States. The proposed new job contract that led to the demonstrations in France was intended to reduce the nearly 25 percent unemployment rate of the French youth. Perhaps paradoxically, the contract was designed to make it easier to make young people unemployed. The logic was that firms would be willing to hire more workers if the costs of firing them were lower.
The different systems in the United States and Europe each have their defenders. Supporters of European labor laws point to the greater job security enjoyed by workers in Europe. Supporters of the US system argue that the United States enjoys greater flexibility in the labor market, leading to a more efficient economy with less unemployment. Some feel that the United States should adopt European-style labor protection measures; others feel that Europe would benefit from becoming more like the United States.
In this chapter, we look at the different experiences of Europe and the United States in order to evaluate these different approaches to the labor market. In the end, we want to be able to answer—or at least form intelligent opinions about—the following question:
What are the results of the different labor market policies in the United States and Europe?
This is not just an academic question for discussion in a textbook. In both the United States and Europe, labor market policy is frequently debated. The US Congress has considered various labor policies, such as restrictions on plant closing to protect jobs, requirements that firms offer workers health insurance, requirements that firms include paid sick days in employment contracts, and so on. At the same time, there is considerable discussion in Germany, France, and elsewhere in Europe about the possible benefits of increased labor market flexibility.
Road Map
Employment and unemployment are ideas that most of us are familiar with. You may well have already been employed, at least in a part-time capacity, at some point in your life. It is also possible that you have been unemployed, meaning that you were without a job, but were actively seeking work. Our personal experiences, and those of our parents and friends, help us understand the basics of employment and unemployment.
Even if you have not yet been employed, you will begin searching for a job once you graduate with a college degree. As you surely know, finding a good job is not always easy. You want to find a job that you enjoy, fits your skills, and pays well. It is also not easy for prospective employers: they want to find someone who is suitably skilled, will work well within the firm, and is not too expensive. The challenge is to match workers and jobs: the worker needs to be suited to the job, and the job needs to be suited to the worker.
The process of matching does not happen just once. As time passes, your skills, ambitions, and choice of occupation may change. As time passes, your employer’s needs change. You may wish to move to another city. Your employer may want to move your job to another city. Most people do not spend their entire lives in one job.
A schematic representation of this process is shown in Figure 23.1.1 "Employment Transitions over Your Lifetime". Here you leave college and look for a job. Finding that job is likely to be time-consuming. You will have to contact lots of prospective employers, read newspaper ads, use search engines on the Internet, and, of course, show up for interviews. In the end, you will find your first job and begin your career.
You might stick with this job for a while, but in all likelihood the match between you and your employer will come to an end sooner or later. You may leave the job through your own choice because you are no longer happy with it. Alternatively, you may be forced to leave because your employer no longer has need of you. You then search for another job. When you succeed in finding a new position where your needs and desires align with those of another employer, a new match is formed.
Fifty years or so ago, people often joined companies and stayed with them for life, but this is very unusual today. You are likely to move between jobs several times during your lifetime before your eventual retirement. Sometimes you may be able to move from one job to another without interruption. At other times you will be unemployed between jobs. Throughout your life, you are likely to face periods of anxiety and stress because of the employment uncertainties that you confront:
• How likely is it that you will be able to retain your current job?
• If you lose your job, will you be able to find another job that you like?
• How long will it take to find another job?
• What should you do if you do not like your job?
• How will you support yourself while you are unemployed?
This discussion makes it clear that we cannot analyze labor market policies without understanding the movements in and out of employment and unemployment. But before we can do so, we need to make sure we understand exactly what unemployment is, and what causes it. Thus we begin by carefully defining unemployment.In part, this is a review of material in Chapter 18 "The State of the Economy". There, we explained that the unemployment rate is one possible indicator of the overall health of the economy. We look at the data for Europe and the United States and make sense of this data using economic reasoning. We then turn to an analysis of the matching between workers and jobs and the decisions of individual workers in this process. All this analysis gives us a better understanding of unemployment and, more generally, the operation of labor markets. We conclude by evaluating labor market policies in the United States and Europe. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/23%3A_Jobs_in_the_Macroeconomy/23.01%3A_Taking_to_the_Streets.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is the unemployment rate, and how is it measured?
2. What are the differences and the similarities in unemployment rates in the United States and Europe?
3. If the labor market functions perfectly, what is the rate of unemployment?
4. How does unemployment arise?
We begin by discussing the most commonly watched indicator of the state of the labor market: the unemployment rate. In the United States, the unemployment rate is measured by the Bureau of Labor Statistics (BLS; http://www.bls.gov/cps/home.htm). The BLS looks at the population of individuals of working age who are not in the military. It sorts such people into three separate categories:
1. Employed. Individuals with a job, either full time or part time
2. Unemployed. Individuals who do not currently have a job but are searching for employment
3. Out of the labor force. Individuals who are not employed and not looking for work
Thus
\[civilian\ working\ age\ population\ =\ number\ employed\ + number\ unemployed\ + number\ out\ of\ the\ labor\ force.\]
Those out of the labor force include students, stay-at-home parents, those who are prevented from working by disability, and people who have taken early retirement. The category also includes discouraged workers, those who are deemed to have dropped out of the labor force because they have stopped looking for a job.
The civilian labor force comprises the employed and the unemployed. The unemployment rate is calculated as follows:
and the employment rate is calculated as follows:
In the United States, the definition of “employed” is fairly liberal. To be classified as employed, it is sufficient to have done any work for pay or profit in the previous week. People may even be counted as employed if they did not work during the week—for example, if they were on vacation, out sick, on maternity/paternity leave, or unable to work because of bad weather.
In this chapter, we explore differences in unemployment in the United States and Europe. To do this properly, we need to take care that unemployment is measured in a similar way within the sample of countries. The European Commission defines as unemployed those aged 15 to 74
• who were without work during the reference week, but currently available for work,
• who were either actively seeking work in the past four weeks or who had already found a job to start within the next three months.“Employment and Unemployment (LFS): Definitions,” European Commission, accessed July 31, 2011, epp.eurostat.ec.europa.eu/portal/page/portal/employment_unemployment_lfs/methodology/definitions.
As in the United States, the unemployment rate is the number of people unemployed as a percentage of the labor force, and the labor force is the total number of people employed and unemployed.
The European Commission defines as employed those aged 15 to 74
• who during the reference week performed work, even for just one hour a week, for pay, profit or family gain,
• were not at work but had a job or business from which they were temporarily absent because of, e.g., illness, holidays, industrial dispute or education and training.“Employment and Unemployment (LFS): Definitions,” European Commission, accessed July 31, 2011, epp.eurostat.ec.europa.eu/portal/page/portal/employment_unemployment_lfs/methodology/definitions.
These descriptions reveal that the definitions used in Europe are broadly similar to those in the United States, meaning that we can legitimately compare employment and unemployment rates in the two regions.
National and local governments help people cope with the risk that they might lose their jobs. In the United States and many other countries, unemployed people are typically eligible to receive payments from the government, called unemployment insurance, for some period of time after losing their jobs. Some governments help the unemployed find jobs and may even provide financial support to help people retrain and obtain marketable skills.
Unemployment in the United States and Europe
Figure 23.2.1 "Unemployment Rates in France, the United States, and the Euro Area, 1985-2011" shows quarterly unemployment rates for the United States, France, and Europe as a whole. In the late 1980s, unemployment fell in both the United States and France, although the US unemployment rate was about two percentage points lower than the French rate. The 1990s were a different story. Unemployment rates increased in both countries at the beginning of the decade. Thereafter, the unemployment rate decreased in the United States, but it continued to increase in France for about half of the decade and decreased only near the end of century. From the early 1990s up to about 2008, the unemployment rate in Europe was substantially higher than that in the United States. The pattern for Europe as a whole closely matches the pattern for France, although unemployment in France is typically a little higher than the European average.
The crisis of 2008, however, led to a dramatic rise in the unemployment rate in the United States. At the end of 2007, the US unemployment rate was just under 5 percent. Two years later, at the start of 2010, the rate was over 10 percent. Unemployment also rose in Europe, but to nothing like the same degree. In early 2011, US and European unemployment rates were almost identical.
One other feature of the data is noticeable: there is a regular seasonal pattern in the data. For example, in the United States, unemployment is almost always higher in the first quarter of the year than it is in the preceding or following quarter. This is because some sectors of the economy are heavily affected by seasonal patterns. For example, stores may hire extra people during the Christmas holiday period, while construction firms may employ fewer people during the winter months. Sometimes, data such as these are “seasonally adjusted” to remove these effects.
Figure \(1\): Unemployment Rates in France, the United States, and the Euro Area, 1985-2011
Source: OECD, “Statistics Portal: Labour,”
www.oecd.org/topicstatsportal/0,2647,en_2825_495670_1_1_1_1_1,00.html#499797.
The French labor law reforms with which we began the chapter were aimed at young workers, so let us also look specifically at the unemployment experience of this group. Between 2000 and 2010, the unemployment rate in France for the age group 20–24 ranged between 17 and 21 percent, with an average of 18.6 percent. In the United States, in contrast, for the same period and the same group of workers, the unemployment rate averaged 10 percent. The figures on youth unemployment come from “Statistics Portal: Labour,” OECD, www.oecd.org/topicstatsportal/0,2647,en_2825_495670_1_1_1_1_1,00.html#499797. In both countries, the unemployment rate is higher for younger workers than the overall unemployment rate.
Although there are some similarities between France and the United States, there is also a clear puzzle: unemployment, for both the overall population and young workers, was, until very recently, much higher in France. We need to understand the source of this difference before we can evaluate different policy remedies.
The Labor Market
Unemployment suggests a mismatch between supply and demand. People who are unemployed want to have a job but are unable to find one. In economic language, they are willing to supply labor but cannot find a firm that demands their labor. The most natural starting point for an economic analysis of unemployment is therefore the labor market.
Toolkit: Section 31.3 "The Labor Market"
The labor market brings together the supply of labor by households and the demand for labor by firms. You can review the labor market in the toolkit.
Figure \(2\): Labor Market
The labor market is depicted in Figure 23.2.2 "Labor Market". “Price” on the vertical axis is the real wage, which is the nominal wage divided by the price level. It tells us how much you can obtain in terms of real goods and services if you sell an hour of your time. Recalling that the price level can be thought of as the price of a unit of the real gross domestic product (real GDP), you can equivalently think of the real wage as the value of your time measured in units of real GDP.
At a higher real wage, households supply more labor. There are two reasons for this. First, a higher real wage means that, for the sacrifice of an hour of time, households can obtain more goods and services than before. Households are therefore induced to substitute away from leisure to work and ultimately consume more. Second, as the wage increases, more individuals join the labor force and find a job. Embedded in the upward-sloping labor supply curve is both an increase in hours worked by each employed worker and an increase in the number of employed workers.
At a higher real wage, firms demand fewer labor hours. A higher real wage means that labor time is more expensive than before, so each individual firm demands less labor and produces less output. The point where the labor supply and demand curves meet is the equilibrium in the labor market. At the equilibrium real wage, the number of hours that workers choose to work exactly matches the number of hours that firms choose to hire.
Supply and demand in the labor market determine the real wage and the level of employment. Variations in either labor supply or labor demand show up as shifts in the curves. If we want to talk about unemployment, however, the labor market diagram presents us with a problem. The idea of a market is that the price adjusts to reach equilibrium—the point where supply equals demand. In the labor market, this means the real wage should adjust to its equilibrium value so that there is no mismatch of supply and demand. Everyone who wants to supply labor at the equilibrium wage finds that their labor is demanded—in other words, everyone who is looking for a job is able to find one.
Remember the definition of unemployment: it is people who are not working but who are looking for a job. The supply-and-demand framework has the implication that there should be no unemployment at all. Everyone who wants to work is employed; the only people without jobs are those who do not want to work.
Theories of Unemployment
So where do we go from here? One natural approach is to start from Figure 23.2.2 "Labor Market" but look for circumstances in which we would see unemployment. Figure 23.2.3 "Unemployment in the Labor Market" shows us that there will be unemployment if the real wage in the market is too high—that is, above the equilibrium real wage. In this case, the amount of labor that workers want to sell is greater than the amount that firms want to buy. Some workers will want a job at this wage but be unable to find one. They will be unemployed.
If the real wage is sticky, it may be higher than the equilibrium real wage, meaning that some workers who want to work are unable to find a job.
Figure 23.2.3 "Unemployment in the Labor Market" shows us what the labor market must look like for there to be unemployment, but it is hardly an explanation of unemployment. Economists typically expect markets to look like Figure 23.2.2 "Labor Market", not Figure 23.2.3 "Unemployment in the Labor Market". That is, they think that the price in a market—in this case, the real wage—adjusts quickly to ensure that supply equals demand. If we want to explain unemployment with a picture like Figure 23.2.3 "Unemployment in the Labor Market", we also need some story of why real wages might be sticky, so they remain above the equilibrium wage.
Inflexible Real Wages
Over the years, economists have offered several stories about why wages might be inflexible.
• One story is that the wage is not allowed to decrease by law. Many economies have minimum wage laws on their books. This could explain some unemployment. A difficulty with this explanation is that the minimum wage affects only low-income workers. Most workers in the economy actually earn a wage above the legal minimum and are unaffected by minimum-wage legislation.
• Another possibility is that firms find it difficult to adjust wages downward. The market for people’s time is not like the market for bread. Pay cuts are very visible to workers and are likely to meet a great deal of resistance. If a firm tries to cut wages, it is likely to find that its workers become demotivated and that its best workers start looking for jobs at other firms.
Both of these stories are really explanations of why nominal wages may be unable to adjust. Figure 23.2.3 "Unemployment in the Labor Market" has the real wage on the axis. Remember that the real wage is calculated as follows:
Minimum wage laws specify a fixed minimum nominal wage. Even if the nominal wage is fixed, the real wage decreases when the price level increases. It follows that rigidities in the nominal wage translate into rigidities in the real wage only if the price level is also sticky.
Prices in an economy may indeed be sticky in the short run, so sticky wages and prices do provide one explanation for short periods of unemployment. Such unemployment is sometimes called cyclical unemployment. In the long run, however, we would expect the labor market to return to an equilibrium with zero unemployment. Cyclical unemployment is the component of unemployment that depends on the business cycle. During a recession, cyclical unemployment is relatively high. In periods of economic expansion, cyclical unemployment is low or nonexistent. But we always observe some unemployment, which tells us that sticky nominal wages and prices cannot be the whole story.
Figure 23.2.3 "Unemployment in the Labor Market" tells us that the only way to get persistent unemployment in this framework is for the real wage to be permanently above the equilibrium wage. We need to find some reason why market forces will not cause the real wage to adjust to the point where demand equals supply.
One possible story introduces labor unions into the picture. Unions give some market power to workers. Just as we sometimes think about firms having market power, meaning that they have some control over the prices that they set, so we can think about a union having some control over the wage that workers are paid. If there were just a single union representing all workers, then it could choose the real wage, much as monopoly firms choose their price. Firms would then hire as many hours as they wanted at that wage. Generally, unionized workers are paid more than the wage at which supply equals demand, just as in Figure 23.2.3 "Unemployment in the Labor Market". The union accepts some unemployment but believes that the higher wage more than compensates. A problem with this story is that, like the minimum wage, it is relevant only for a relatively small number of workers. In the United States in particular, only a small fraction of the workforce is unionized.
Another story goes by the name of efficiency wages. The idea here is that firms have an incentive to pay a wage above the equilibrium. Workers who are paid higher wages may feel better about their jobs and be more motivated to work hard. Firms may also find it easier to recruit good workers when they pay well and find it easier to keep the workers that they already have. The extra productivity and lower hiring and firing costs may more than compensate the firm for the higher wage that it is paying.
Inside the Labor Market
So far, we have come up with four possible stories about unemployment. Can these theories help to explain differences between Europe and the United States?
First, it is generally the case that minimum wages are more generous in Europe than in the United States, so it is certainly possible that higher minimum wages in Europe contribute to higher levels of unemployment there. Second, there is some evidence that nominal wages are in some sense “stickier” in Europe than in the United States. Third, we can observe that unions are generally more prevalent and more powerful in Europe than in the United States. Thus some of the stories that we have told are potentially helpful in explaining differences between the United States and Europe.
However, all these theories are silent about the underlying movement of workers from employment to unemployment and back again. Figure 23.2.3 "Unemployment in the Labor Market" paints a static picture of a world that is in fact dynamic and fluid. There is no means in the framework to explore the role of unemployment insurance and other policies that differ across Europe and the United States. In addition, market forces may work differently in the labor market. In Figure 23.2.3 "Unemployment in the Labor Market", there are more workers wanting to work than there are jobs offered by firms. The standard story of market adjustment is that workers willing to work for a lower wage would approach a firm, offer to undercut the wage of an existing worker, and be immediately hired as a replacement. This is not how hiring and firing usually works in the labor market. Firms have a relationship with their existing workers; they know if their workers are competent, hardworking, and reliable. Firms will not readily replace them with unknown quantities, even for a lower wage.
For these reasons, researchers in labor economics think that Figure 23.2.3 "Unemployment in the Labor Market" is too simple a framework to explain the realities of modern labor markets. Instead, they frequently turn to a different framework more suited to thinking about labor market flows.
Key Takeaways
• The unemployment rate is the fraction of the civilian labor force looking for a job but currently not employed. The BLS in the United States produces this number on a monthly basis.
• During the early part of the 1980s, the unemployment experiences in the United States and Europe were similar. Up until 2008, the unemployment rate in Europe had been significantly higher than the unemployment rate in the United States. Very recently, however, the US unemployment rate climbed to European levels.
• In a perfectly functioning labor market, the unemployment rate would be zero.
• Possible explanations of unemployment include rigidities in wages, the market power of unions, and incentive effects.
check your understanding
1. Explain in your own words why the standard supply-and-demand framework predicts zero unemployment when it is applied to the labor market.
2. What wage is determined in labor market equilibrium—the real wage or the nominal wage? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/23%3A_Jobs_in_the_Macroeconomy/23.02%3A_Unemployment.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What key features of labor markets does the static model of labor supply and labor demand fail to capture?
2. What are some of the key facts about worker labor market flows?
3. What is search theory, and how is it useful for understanding labor market outcomes?
4. What are the efficiency gains from flexible labor markets?
The labor market is a highly dynamic place. Workers are constantly moving from job to job, in and out of the workforce, or from employment to unemployment and vice versa. Large firms devote substantial resources to human resource management in general and hiring and firing in particular. By contrast, Figure 23.2.3 "Unemployment in the Labor Market" is static because it shows the labor market at a moment in time. Our understanding of the labor market—and, by extension, employment and unemployment—is badly incomplete unless we look more carefully at the movement of workers. Further, when workers and firms meet, they do not take as given a market wage but instead typically engage in some form of bargaining over the terms of employment.
This vision of a dynamic labor market with bargaining is much closer to the reality of labor relations than is the model of labor supply and demand. To better understand the determinants of employment and unemployment, we therefore turn to labor market flows. We begin with some more facts, again contrasting the experience of Europe with that of the United States, and then develop a framework that allows us to think explicitly about the dynamic labor market.
Facts
Our starting point is the classification of individuals in the civilian working age population. Recall that economic statistics place them as one of the following: employed, unemployed, or not in the labor force. Imagine taking a snapshot of the US economy each month. For a given month, you would be able to count the number of people employed, unemployed, and out of the labor force. We could call these the stocks of each kind of individual.
Figure \(1\): Worker Stocks in the United States
Figure 23.3.1 "Worker Stocks in the United States" shows the number of people between 16 and 64 years old in the United States in three different “states”—employment, unemployment, and out of the labor force—over the period 1996–2003.These data come from a study using a monthly survey conducted by the Bureau of Labor Statistics (BLS) called the Current Population Survey and were compiled by Stephen J. Davis, R. Jason Faberman, and John Haltiwanger. The numbers here come from S. Davis, R. J. Faberman, and J. Haltiwanger, “The Flow Approach to Labor Market: New Data Sources and Micro-Macro Links” NBER Working Paper #12167, April 2006, accessed June 30, 2011, http://www.nber.org/papers/w12167. On average, there were 122 million people employed, 6.2 million unemployed, and 59.3 million considered out of the labor force. Adding these numbers together, there were 187.5 million working-age individuals, of whom 128.2 million were in the labor force. The average unemployment rate was 4.8 percent over this period, and the employment rate was 95.2 percent. Notice, though, that many individuals are out of the labor force: only 65 percent of the population is employed.
Figure 23.3.1 "Worker Stocks in the United States" shows an average over many months, but you could also look at how these numbers change from month to month. Even more informatively, you could count the number of people who were employed in two consecutive months. This would tell you the likelihood of being employed two months in a row. These calculations for the US economy are summarized in Figure 23.3.2 "Worker Flows in the United States".
Look, for example, at the arrows associated with the box labeled unemployed. There are two arrows coming in: one from the employed box and one from the out-of-the-labor-force box. There are two arrows going out: one to the employed box and one to the out-of-the-labor-force box. Each of these four arrows has a percentage attached, indicating the fraction of people going from one box to another. Thus, on average, 28.3 percent of the unemployed people in one month are employed in the next and 23.3 percent leave the labor force. The remaining 48.4 percent stay in the group of unemployed.
The numbers in the figure are averages over a long period. Such flows change over the course of the year due to seasonal effects. Around Christmas, for example, it may be easier for an unemployed worker to find a job selling merchandise in a retail shop. These flows also change depending on the ups and downs of the aggregate economy.
Do European countries exhibit similar patterns? Portugal makes for a good comparison with the United States because the unemployment rates in the two countries were broadly similar over most of the last two decades. Yet Portugal has very strong employment protection laws, to the point where they are enshrined in the Portuguese Constitution: “Article 53,” Portugal-Constitution, adopted April 2, 1976, accessed June 30, 2011, http://www.servat.unibe.ch/icl/po00000_.html#A053_.
Article 53 Job Security
The right of workers to job security is safeguarded. Dismissals without just cause or for political or ideological reasons are forbidden.
A study that compared the labor markets in Portugal and the United States uncovered the following facts: See Olivier Blanchard and Pedro Portugal, “What Hides Behind an Unemployment Rate: Comparing Portuguese and U.S. Labor Markets,” American Economic Review 91, no. 1, (2001), 187–207.
• The flows into unemployment from employment and the flows from employment to unemployment are much lower in Portugal compared to the United States.
• Average unemployment duration in Portugal is about three times that of the United States.
• Job protection is very high in Portugal relative to the United States.
Even though Portugal and the United States have similar overall unemployment rates, the underlying flows are quite different in the two countries. Flows between employment and unemployment—and vice versa—are much smaller in Portugal. This means that if you lose your job, it is likely to take a long time to find a new one. If you have a job, you are likely to keep it for a long time. As we would expect from this, people typically spend much longer periods of time in unemployment in Portugal than they do in the United States.
If we compare the United States with Europe more generally, we see similar patterns. In 2010, the average unemployment duration for workers ages 15–24 was about 10.6 months in Europe but only 5.9 months for the United States. For workers in the 25–54 age group, the duration was higher in both Europe (13.7 months) and the United States (8.2 months) than for younger workers. See “Unemployment Duration,” Online OECD Employment database, accessed June 30, 2011, http://www.oecd.org/document/34/0,3746,en_2649_33927_40917154_1_1_1_1,00.html#uduration. Recall that in 2010, Europe and the United States had similar rates of unemployment. Employment duration, however, is still much higher in Europe than the United States. In both places, older workers tend to be unemployed for longer periods than younger workers. But European workers are typically unemployed for much longer periods of time than US workers. These figures come from “Average Duration of Unemployment,” OECD, accessed June 30, 2011, stats.oecd.org/Index.aspx?DataSetCode=AVD_DUR.
The Organisation for Economic Co-operation and Development (OECD) conducted a large study on the employment protection legislation in a variety of developed countries. The main study (OECD Employment Outlook for 2004, http://www.oecd.org/document/62/0,3746,en_2649_33927_31935102 _1_1_1_1,00.html) created a measure of employment protection and then attempted to relate it to labor market outcomes in different countries. The reasoning we have just presented suggests that in countries with relatively high levels of employment protection, labor markets would be much more sluggish.
Formulating a comprehensive measure of employment protection is not easy. In principle, the idea is to measure the costs of firing workers and various regulations of employment. Examples would include requirements on advance notice of layoffs and the size of severance payments that firms are obliged to pay. In some countries, a firm must go to court to lay off workers. For temporary workers, there are specific restrictions placed on this form of contract, as in the discussion of France that opened this chapter. In reality, these costs are difficult to detect and convert to a single measure. The OECD findings should be interpreted with these challenges in mind.
Another OECD publication ( http://www.oecd.org/dataoecd/40/56/36014946.pdf) examines employment protection legislation across OECD countries in 1998 and 2003.This discussion is based on Figure A.6 of OECD, “Annex A: Structural Policy Indicators,” Economic Policy Reforms: Going for Growth, accessed June 30, 2011, http://www.oecd.org/dataoecd/40/56/36014946.pdf. Portugal was the country with the highest level of employment protection legislation, while the United States was the lowest. France was above average, while the United Kingdom and Canada were below average. The OECD analysis highlighted two effects of such legislation on labor market flows:
1. It limits flows from employment into unemployment because it is costly to fire workers.
2. It limits flows from unemployment to employment because firms, when deciding to hire a worker, will realize that they may wish to fire that worker sometime in the future.
The first effect is the more obvious one; indeed, it provides the rationale for employment protection. If it is hard to fire workers, then firms are less likely to do so. The second effect is less obvious and more pernicious. If it is hard to fire workers, then firms become more reluctant to hire workers. Put yourself in the place of a manager wondering whether to make a hire. One concern is that the person you are considering will turn out to be unsuitable, or a bad worker. Another is that conditions in your industry will worsen, so you may not need as many employees. In those circumstances, you want to be able to let the worker go. If you will not be able to do so, you may decide it is safer simply to make do with the workers you already have.
The OECD analysis particularly stressed the effects on the labor market experience of relatively young workers. The report emphasized that stronger legislation is linked to lower employment of young workers. If it is costly to sever a relationship, then a firm will not give a young worker a chance in a new job. The OECD also noted an important benefit of employment protection legislation: it enhances the willingness of young workers to invest in skills that are productive at their firms. Without a strong attachment to the firm, workers have little incentive to build up skills that are not transferable to other jobs.
Job Creation and Job Destruction
In place of the supply-and-demand diagram, we can think about the decisions that workers and firms make when they are trying to form or break an employment relationship. Individual workers search for available jobs, which are called vacancies. On the other side, vacancies are searching for workers. When a vacancy and a worker are successfully matched, a job is created. When we say that a vacancy is searching for a worker, we, of course, really mean that a firm with a vacancy is seeking to hire a worker. You can think of a firm as being a collection of jobs and vacancies.
Whereas the standard supply-and-demand picture downplays differences among workers and jobs, this “search-and-matching” approach places these differences at the center of the analysis. Workers differ in terms of their abilities and preferences. Jobs differ in terms of their characteristics and requirements. For an economy to function well, we need to somehow do a good job of matching vacancies with workers. When a successful match occurs, we call this “job creation.”
Search theory is a framework for understanding this matching process. Let us think about how this process looks, first from the perspective of the worker and then from the perspective of the firm. Workers care about the various characteristics of their jobs. These characteristics might include how much the job pays, whether it is in a good location, whether it offers good opportunities for advancement, whether it is interesting, whether it is dangerous, and other attributes.
Vacancies are likewise “looking” for certain characteristics of workers, such as how much they cost, what skills they possess, whether they have relevant experience, whether they are hardworking and motivated, whether they are trustworthy, and so on. The firm cares about these characteristics because it cares about profitability: its goal is to make as much profit as possible.
Over time, the quality of the match between a worker and a vacancy may change. A job may become less profitable to the firm and/or less attractive to the worker. To put it another way, the amount of value created by the job may change. The worker may come to dislike particular aspects of the job or may wish to change location for family reasons. The worker may feel that he or she would be better matched with some other firm, perhaps because of changes in his or her skills and experience. From the firm’s side, demand for the firm’s product may decrease, or the firm might shift to a new production technique that requires different skills. If the value created by a job decreases too much, then the firm or the worker may choose to end the relationship, either by the worker’s choice (quitting the job) or the firm’s (firing the worker). This is “job destruction.”
Jobs are created and destroyed all the time in the economy. The flows of workers among jobs and employment states are a key characteristic of the labor market. As these flows occur, workers often spend time unemployed. After a job is destroyed, the worker may spend some time unemployed until he or she finds a job with a different firm.
Labor Flows and Productivity
In a rapidly changing economy, the value of different jobs (worker-firm matches) changes over time. To function efficiently, the labor market needs to be able to accommodate such changes. For this discussion, we will think about efficiency as simply being measured by the productivity of the match between workers and firms. In an efficient match, the worker is productive at the chosen job. For the overall economy, if all matches are efficient, then it is not possible to change the assignment of workers to jobs and produce more output.
Comparative and Absolute Advantage
Let us see how this works in a simple example. Table 23.3.1 "Output Level per Day in Different Jobs" gives an example of an economy with two workers and two jobs. Each entry in the table is the amount of output that a particular worker can produce in each job in one day. For example, worker B can produce 4 units of output in job 2 and 8 units of output in job 1.
Worker Job 1 Job 2
A 9 6
B 8 4
Table \(1\): Output Level per Day in Different Jobs
Before we begin, let us pause for a moment to think about this kind of example. This chapter is motivated by the desire to explain the employment and unemployment experiences of hundreds of millions of workers in the United States and Europe. It may seem ridiculous to think that a story like this—with two workers, two jobs, and some made-up numbers—can tell us anything about employment and unemployment across two continents. Economists often refer to such stories as “toy” models, in explicit recognition of their simplicity. This kind of model is not designed to tell us anything specific about US or European unemployment. The point of this kind of model is to keep our thinking clear. If we cannot understand the workings of a story like this, then we cannot hope to understand the infinitely more complicated real world. At the same time, if we do understand this story, then we begin to get a feel for the forces that operate in the real world.
If we were in charge of this economy, how would we allocate the workers across the jobs? In this case, the answer is easy to determine. If we assign worker A to job 1 and worker B to job 2, then the economy will produce 13 units of output per day. If we assign worker A to job 2 and worker B to job 1, then the economy will produce 14 units of output per day. This is the better option because—in the interest of efficiency—we would like the workers to be assigned to the jobs they do best.
Notice, by the way, that worker A is better than worker B at both jobs. However, worker A is a lot better at job 2 (50 percent more productive) and only a little better at job 1 (12.5 percent more productive). The best assignment of workers is an application of the idea called comparative advantage: each worker does the job at which he or she does best when compared to the other person.
Comparative advantage and absolute advantage are used to compare the productivity of people (countries) in the production of a good or a service. We introduce this tool here assuming there are two people and two goods that they can each produce.
Toolkit: Section 31.13 "Comparative Advantage"
A person has an absolute advantage in the production of a good if that person can produce more of that good in a unit of time than another person can. A person has a comparative advantage in the production of one good if the opportunity cost, measured by the lost output of the other good, is lower for that person than for another.
In our example, worker A has a comparative advantage in job 2, and worker B has a comparative advantage in job 1. We have defined comparative advantage in terms of opportunity cost, so let us go through this carefully and make sure it is clear. The opportunity cost of assigning a worker to one job is the amount of output the worker could have produced in the other job.
We can measure opportunity cost in terms of the output lost from assigning a worker to job 2 instead of job 1. The opportunity cost of assigning worker A to job 2 rather than job 1 is 3 units (9 − 6). The opportunity cost of assigning worker B to job 2 rather than job 1 is 4 units of output (8 − 4). The opportunity cost is higher for worker B, which is another way of saying that worker B has a comparative advantage in job 1. Worker B should be assigned to job 1, and worker A should take on job 2.
We could equally have measured opportunity cost the other way around: as the output lost from assigning a worker to job 1 rather than job 2. The opportunity cost of assigning worker A to job 1 rather than job 2 is −3 units (6 − 9). The opportunity cost of assigning worker A to job 1 rather than job 2 is less, it is −4 units of output (4 − 8). Worker A has the higher opportunity cost (−3 is greater than −4), so we again conclude that worker A should be assigned to job 2.
Changes in Productivity
Suppose that this simple economy is indeed operating efficiently, with worker A in job 2 and worker B in job 1. Then imagine that the productivity of one of these matches changes. For example, suppose that at some point worker B goes on a training course for job 2, so Table 23.3.1 "Output Level per Day in Different Jobs" becomes Table 23.3.2 "Revised Output Level per Hour from Assigning Jobs".
Worker Job 1 Job 2
A 9 6
B 8 7
Table \(2\): Revised Output Level per Hour from Assigning Jobs
If you compare these two tables, you can see that worker B is now more productive than worker A in job 2. Worker A is still better at job 1, as before.
If we want to produce the maximum amount of output in this economy, we now want to switch the workers around: if worker A does job 1 and worker B does job 2, then the economy can produce 16 units of output per day instead of 14.
How might this change happen in practice? Here are three scenarios.
1. Instantaneous reallocation. In this case, the labor market is very fluid. Workers A and B trade places as soon as B becomes more productive. No one is unemployed, and real gross domestic product (real GDP) increases immediately.
2. Stagnant labor market. This scenario is the opposite of the first. Here, there is no reallocation at all. People are stuck in their jobs forever. In this case, worker B remains assigned to job 1, and worker A remains assigned to job 2. Although this was the best assignment of jobs when Table 23.3.1 "Output Level per Day in Different Jobs" described the economy, it is not the best assignment for Table 23.3.2 "Revised Output Level per Hour from Assigning Jobs". Relative to the better assignment, the economy loses 2 units of GDP every day.
3. Frictional unemployment. This scenario lies between these two extremes: workers and firms adjust but not instantaneously. How might workers A and B exchange jobs? One possibility is that worker A is fired from job 2 because the firm wants to attract worker B to the job instead. At the same time, worker B might quit in the hope of getting job 1 when it is vacant. Both workers move from employment into unemployment, as in the arrow from employment to unemployment in Figure 23.3.2 "Worker Flows in the United States".
During the time when workers A and B are unemployed, their production is reduced to zero. So, during the period of adjustment, the economy in the third scenario undergoes a recession. But once adjustments are made, the economy is much more productive than before. Economists refer to the unemployment that occurs when workers are moving between jobs as frictional unemployment.
How do these three scenarios compare? It is evident that fluid labor markets are the ideal scenario. In this situation, there is no lost output due to unemployment, and the economy is always operating in the most efficient manner. The choice between the second and third scenarios is not so clear-cut. In the second scenario, there is no loss of output from unemployment, but the assignment of workers to jobs is not efficient. In the third scenario, the economy eventually gets back to the most efficient assignment of jobs, but at the cost of some lost output and unemployment (and, in the real world, various other costs of transition incurred by workers and firms).
You can think of the time spent in unemployment in the second scenario as a type of investment. The economy forgoes some output in the short run to enjoy a more efficient match of workers and firms in the long run. As with any investment decision, we decide if it is worthwhile by comparing the immediate cost (the first four weeks of lost output) with the discounted present value of the future flow of benefits. Discounted present value is a technique that allows us to add together the value of dollars received at different times.
Toolkit: Section 31.5 "Discounted Present Value"
Discounted present value is a technique for adding together flows at different times. If you are interested in more detail, review the toolkit.
Suppose, for example, that it takes four weeks for the economy to reallocate the jobs in the third scenario. Assuming the workweek has 5 working days, the economy produces 0 output instead of 14 units of output for a total of 20 days. The total amount of lost output is 20 × 14 = 280. Once the workers have found their new jobs, the economy produces 10 more units per week than previously. After 28 weeks, this extra output equals the 280 lost units. If we could just add together output this month and output next month, we could conclude that this investment pays off for the economy after 28 weeks. Because output produced in the future is worth less than output today, it will actually take a bit longer than 28 weeks for the investment to be worthwhile.
Provided that changes to the relative productivity of workers do not occur too frequently, the costs of adjusting the assignment of workers to jobs (the spells of unemployment) will be more than offset by the extra output obtained by putting workers into the right jobs. This is the gain from a fluid labor market, even though the process entails spells of unemployment.
Youth Unemployment
We observed earlier that the unemployment rate for young workers is higher than for older workers, in both France and the United States. We can understand why by thinking about the search and matching process.
When lawyers, doctors, professors, and other professionals change jobs, they typically do so with little or no intervening unemployment. Search and matching is easy because they have visible records, meaning their productivity at a particular job is relatively easy to figure out. In general, the longer someone has been in the workforce, the more information is available to potential new employers. Also, experienced workers have a good understanding of the kinds of job that they like.
Just the opposite is more likely in the labor market for young workers. Firms know relatively little about the young workers they hire. Likewise, young workers, with little employment experience, are likely to be very uncertain about whether or not they will like a new job. The result, at least in the United States, is a lot of turnover for young workers. Young workers sample different jobs in the labor market until they find one suited to their tastes and talents. They take advantage of the fluid nature of the US labor market to search for a good match. The gain is a better fit once they find a job they like. The cost is occasional spells of unemployment.
In Europe, search and matching is much harder. Some young workers are even effectively guaranteed jobs for life by the government from the moment they finish college. By contrast, young workers without jobs find it difficult to obtain employment. Given the lack of fluidity in European labor markets, it is surprising neither that more young workers are unemployed, nor that they stay unemployed for longer periods of time.
The Natural Rate of Unemployment
We expect there to be some frictional unemployment, even in a well-functioning economy. We also know that there is cyclical employment associated with the ups and downs of the business cycle. When cyclical unemployment is zero, we say that the economy is operating at full employment. The natural rate of unemployment is defined as the amount of unemployment we expect in an economy that is operating at full employment—that is, it is the level of unemployment that we expect once we have removed cyclical considerations.
The natural rate of unemployment can seem like an odd concept because it says that it is normal to have unemployment even when the economy is booming. But it makes sense because all economies experience some frictional unemployment as a result of the ongoing process of matching workers with jobs. Government policies that affect the flows in and out of employment lead to changes in the natural rate of unemployment.
key takwaways
• The static model of labor supply and labor demand fails to capture the dynamic nature of the labor market and does not account for job creation and destruction.
• In the United States, labor markets are very fluid. Each month, a significant fraction of workers lose their jobs, and each month a significant fraction of unemployed workers find jobs.
• Search theory provides a framework for understanding the matching of workers and jobs and wage determination through a bargaining process.
• The economy is operating efficiently when workers are assigned to jobs based on comparative advantage. Inflexible labor markets lead to inefficient allocations of workers to jobs.
Exercises
1. Is it best to assign workers to jobs based on absolute advantage or comparative advantage?
2. Why is frictional unemployment not always zero? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/23%3A_Jobs_in_the_Macroeconomy/23.03%3A_Job_and_Worker_Flows.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What are the facts about hours worked across countries?
2. What are the explanations for these differences in hours worked?
The total number of hours worked in an economy depends on both the number of people who are employed and the number of hours worked by each employed person. So far, we have said little or nothing about this second issue. But another significant difference between Europe and the United States is that people work less in Europe than in the United States. If you hear such a statement, perhaps on the radio, you might have some questions about this comparison.
• Does this difference stem from differences in productivity? That is, is it the case that workers in Europe are less productive than workers in the United States, so it is less worthwhile for them to work as much?
• How is the difference measured? For example, suppose we simply divided the number of hours worked in an economy by the total population and found that this number was higher in the United States than in Europe. There are many possible reasons why this might be true. It could be because labor force participation is higher in the United States. Or it could be because the unemployment rate is lower in the United States. Or it could be because the average employed person in Europe works fewer hours than the average employed person in the United States.
Such questions simply mean that we had better be sure that we get our facts straight. We do this in the next part of this chapter. After that, we again turn to some theory to understand what is going on.Discussions of this topic by academics have been prompted by the work of Nobel Prize–winning economist Edward C. Prescott. The following article provides an overview and analysis of the key issues: Edward S. Prescott, “Why Do Americans Work So Much More Than Europeans?” Federal Reserve Bank of Minneapolis Quarterly Review 28, no. 1 (July): 2–13, accessed August 22, 2010, http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=905.
Hours Worked in Europe and the United States
Figure 23.4.1 "Hours in Europe Relative to the United States" and Figure 23.4.2 "Annual Hours in Various Countries" show some basic facts about hours worked in the United States and Europe.Richard Rogerson, “Understanding Differences in Hours Worked,” Review of Economic Dynamics 9 (2006): 365–409. Figure 23.4.1 "Hours in Europe Relative to the United States" shows how hours worked in a number of different European countries compare to hours worked in the United States. More precisely, it shows the total hours worked by individuals between 15 and 64 years old divided by the number of people in that age group. The table does not distinguish by employment status: all working age people are counted, not just employed people.
Three of the largest European countries—France, Germany, and Italy—average less than 75 percent of the hours worked in the United States. Part of this difference is due to longer holidays in Europe, and part is due to the fact that the workweek in Europe is typically shorter. Because the table counts all working age people, the higher unemployment rate in Europe also contributes to the difference.
Figure 23.4.2 "Annual Hours in Various Countries" looks at the hours worked in various countries over the 40 years from 1970 to 2009. The measure of hours is calculated in the same manner as Figure 23.4.1 "Hours in Europe Relative to the United States". Average hours worked have declined significantly in most of these countries. Meanwhile average hours worked in the United States have been more or less flat over these four decades. As a result, hours worked are now significantly higher in the United States than in any of these countries. The data come from OECD (2010), "Hours Worked: Average annual hours actually worked", OECD Employment and Labour Market Statistics (database). doi: 10.1787/data-00303-en (Accessed on 18 October 2011) http://scholar.harvard.edu/alesina/files/work_and_leisure_in_the_u.s._and_europe.pdf. Figure 1 shows a similar pattern of divergence in hours worked for employed people, though the hours worked per employed person has declined in all countries over this period.
Research by the Nobel Prize–winning economist Edward Prescott paints a similar picture. He reports that from 1993 to 1996, the hours worked per person in France were about 68 percent of the level in the United States. In addition, US output per person was much higher than in Europe. Prescott explains this difference based on the number of hours worked, not by differences in output per hour worked. In other words, the United States is richer, not because it is more productive but simply because people work more.
Where Do Differences in Hours Worked Come From?
The immediate question is, why do people work more in the United States? A natural place to look for explanations is the labor supply decisions of households. One possibility is simply that the tastes of US and European households are different. Perhaps Europeans prefer having fewer goods and more leisure. Although this is possible, economists prefer to start from the presumption that people have broadly similar tastes and look first to see if there are other plausible explanations.
The differences in hours worked are not explained by Europeans having poorer technology. Both the United States and European countries are highly developed, so technologies used in one country are used in the others as well. Supporting this is the fact that, as we already noted, productivity does not appear to be lower in Europe.
Another candidate explanation is that there are differences in the tax system. Figure 23.4.3 "Labor Supply" shows an individual labor supply curve—in either Europe or the United States. Notice in Figure 23.4.3 "Labor Supply" the wage on the vertical axis is the real wage after taxes. This is defined as follows:
$real\ wage\ after\ taxes\ = real\ wage \times (1 − tax\ rate).$
In this equation, the tax rate is a marginal tax rate. This means that it is the tax paid on the extra amount you earn if you work a little bit more. Suppose the tax rate is 0.40 and your real wage per hour is $10. Then, if you work an extra hour, you pay$4 to the government, and you retain $6. Figure $3$: Labor Supply Toolkit: Section 31.3 "The Labor Market" If you want to see the underpinnings of the labor supply curve, you can look in the toolkit. Figure 23.4.3 "Labor Supply" shows that an increase in the after-tax real wage will cause an individual to supply more time to the market and thus consume less time as leisure. The increase in the wage creates an incentive for the individual to substitute away from leisure because it has become more costly. Suppose that we compare two identical individuals in Europe and the United States. If the marginal tax rate in Europe is higher than it is in the United States, then the after-tax wage in Europe will be smaller. Since labor supply is upward sloping, individuals in Europe will work less than individuals in the United States. For this to be a convincing explanation, two things must be true: 1. Marginal tax rates must be higher in Europe. 2. Labor supply must slope upward enough to match the differences in hours. Marginal tax rates are indeed lower in the United States than in Europe. Recent research finds that the marginal tax rate on labor income is about 34.5 percent in the United States compared to 57.7 percent in Europe (Germany, France, Italy, and the United Kingdom).Alberto F. Alesina, Edward L. Glaeser, and Bruce Sacerdote, “Work and Leisure in the U.S. and Europe: Why So Different?” (Harvard Institute for Economic Research, Working Paper #2068, April 2005), accessed June 30, 2011, www.colorado.edu/Economics/morey/4999Ethics/AlesinaGlaeserSacerdote2005.pdf. So, if you work an extra hour and earn a pretax wage of$10, then you would keep $6.55 in the United States and$4.23 in Europe.
The evidence is also consistent with the view that labor supply increases as the after-tax real wage increases. Figure 23.4.4 "Differences in Hours Supplied" shows the implication of this. On the vertical axis are two different levels of the after-tax real wage: a low one for Europe and a higher one for the United States. These differences in the after-tax real wage translate into differences in hours, using the labor supply curve of an individual. Thus, as in Figure 23.4.4 "Differences in Hours Supplied", individuals in the United States work more hours than in Europe. As this is true for everyone in the labor force, this argument immediately translates into a statement about hours worked for the aggregate economy.
Figure $4$: Differences in Hours Supplied
There are two real wages after taxes shown: one for Europe and one for the United States. These differences in real wages translate into differences in hours worked.
Can the difference in the after-tax real wage explain the observed difference in hours worked? This depends on how responsive labor supply is to changes in the real wage. Figure 23.4.5 "Responsive and Unresponsive Labor Supply" shows two labor supply curves. In one case (the solid curve), labor supply is very responsive to changes in the wage. Relatively small differences in taxes then have substantial effects on hours worked. In the other case (the dashed curve), labor supply is not very responsive to the wage. Differences in tax rates are then unlikely to be able to explain the differences in hours worked.
Figure $5$: Responsive and Unresponsive Labor Supply
For the solid labor supply curve, hours worked responds strongly to changes in the real wage after taxes, while for the dashed curve, the response is very weak.
Prescott argues that the difference in taxes between the United States and Europe is enough to account for the differences in hours worked. To make this argument, Prescott holds fixed the labor supply curve ( Figure 23.4.4 "Differences in Hours Supplied") across countries and asks how much of the observed difference in hours can be explained by tax policy. This is a movement along the labor supply curve because the vertical axis measures the after-tax real wage. To support this argument, however, Prescott assumes that labor supply is indeed quite responsive to changes in after-tax wages.
Key Takeaways
• The average hours worked varies over countries. In the United States, the average hours worked are greater than in Europe.
• One way to explain differences in hours worked is through the higher marginal labor income taxes paid in Europe.
Exercises
1. Draw a diagram of the labor market to show how taste differences might explain differences in hours worked across countries.
2. In Figure 23.4.4 "Differences in Hours Supplied", why is a tax policy change a movement along the labor supply curve and not a shift in the labor supply curve? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/23%3A_Jobs_in_the_Macroeconomy/23.04%3A_Hours_Worked.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What are common forms of government intervention in labor markets?
2. Why do governments intervene in labor markets?
The employment and unemployment experience of Europe is quite different from that of the United States. We have developed some frameworks that help us understand the sources of these differences. But we have not yet really addressed the question at the heart of this chapter: what is the impact of different labor market policies in the two places?
Government interventions in the labor market are commonplace in most European countries. In Europe, there are many examples of restrictions on hiring, firing, the closing of plants, and so forth. There are some restrictions of this kind in the United States as well but not to the extent that we observe in Europe. In part this is because public opinion in Europe is more supportive of such regulations, as compared to the United States. For example, in 2003, the French food producer Danone decided to close two unprofitable factories in France. This news, which would almost certainly have been unexceptionable in the United States, led to massive protests, boycotts, and condemnation by politicians.
Europe is not the only part of the world in which governments intervene directly in labor markets. Labor regulations have recently been under consideration in China as well.Joseph Kahn and David Barboza, “China Passes a Sweeping Labor Law,” New York Times, World Business, June 30, 2007, accessed June 30, 2011, http://www.nytimes.com/2007/06/30/business/worldbusiness/30chlabor.html.
The new labor contract law, enacted by the Standing Committee of the National People’s Congress, requires employers to provide written contracts to their workers, restricts the use of temporary laborers and makes it harder to lay off employees.
Because of China’s communist history, most workers are not represented by labor unions. It is the government that steps in to represent workers. The need to do so is enhanced by the increasing share of private rather than publically owned firms in China’s economy.
We finish this chapter by considering some of the policies that have been adopted by governments in an attempt to influence the functioning of labor markets. We are interested both in why policymakers think these policies are a good idea and in the effect of these policies on the economy.
Unemployment Insurance
In Figure 23.3.2 "Worker Flows in the United States", we described the flow of workers between situations of employment, unemployment, and out of the labor force. We also argued that having a flexible labor market in which people can change jobs easily may more than compensate for the fact that people may sometimes spend time in unemployment.
But this is abstract economist-speak. People who lose their jobs, even if only temporarily, see their livelihood vanish. The reallocations of jobs that are beneficial to the economy as a whole may be costly, even devastating, to the affected individuals. For this reason, most developed economies have some kind of unemployment insurance to protect their workers. Unemployment insurance means that, if you are unemployed, you will receive some income from the government. Exactly how long you receive this income for and exactly how much you get depends on where you live. Some countries have much more generous unemployment insurance than others. Even if you live in the United States, the amount of insurance varies from state to state.
When it comes to buying car insurance, home insurance, or life insurance, households typically decide for themselves how much insurance to purchase. It is not a decision made by the government. Unemployment insurance is different: it is provided by the government rather than by private companies. This insurance is funded by taxes levied on firms and workers together.
The reason unemployment insurance is provided by the government is because it might be difficult for private firms to provide this coverage. Private insurance companies rely on the fact that not everyone makes claims on insurance at the same time. For example, a provider of home insurance knows that 20 percent of the houses that they insure will not burn down in the same month. But in a recession, the high rate of unemployment means that a lot of people claim benefits at the same time. If private insurers were providing the benefits, insurance companies might go bankrupt, leaving workers without insurance. The government, by contrast, can use its ability to borrow, so it can finance unemployment insurance in one year from tax receipts it will receive in the future.
In the United States, the amount of insurance you receive typically depends on how much you have earned over the past year. A rule of thumb is that workers get about 25 percent of their wage income paid back through unemployment insurance. Benefits are available for only 26 weeks, although this is usually extended when the economy is in a recession. Other countries have much more generous programs.“The Ins and Outs of Long-Term Unemployment,” OECD Employment Outlook 2002, accessed June 30, 2011, http://www.oecd.org/dataoecd/36/48/17652683.pdf. Table 4.1 provides an extensive cross-country comparison. In Denmark, for example, unemployment benefits are about 90 percent of labor income and can last for up to 4 years.
Unemployment insurance has two main effects. First, and most obviously, this insurance makes it easier for unemployed people to sustain their level of consumption until they regain employment. Thus this form of insurance helps support consumption smoothing. Second, unemployment insurance affects the incentives of the unemployed. If individuals know they will receive some income even when they are unemployed, they are more likely to be willing to search extensively for good jobs. Instead of feeling the need to take the first job that comes along, people can wait longer and search longer for a job that is a really good match.
Unemployment insurance therefore contributes to labor market flexibility. It is, however, tricky to decide just how much unemployment insurance should be provided. After all, if unemployment insurance is too generous, then unemployed workers will be tempted to defer getting a new job for a long time—perhaps indefinitely. For this reason, governments usually restrict the period of time for which a worker can collect insurance to provide an incentive for them to search for a job.
Firing Costs
Imagine that you are the human resources (HR) manager of a firm in the United States. Suppose that the demand for your firm’s product has declined, so you need to lay off some workers. You will be obliged to provide two weeks’ notice to them. In many cases, that will be the end of your firm’s obligations, although workers may sometimes be entitled to additional severance payments as part of their employment contracts. In the United States, employment contracts are largely a private matter between a firm and its workers. A firm cannot fire a worker for a discriminatory reason, but otherwise the government stays out of the contractual agreements among workers and firms. According to the Department of Labor, “In general, if the reason for termination is not because of discrimination on these bases, or because of the employee’s protected status as a whistleblower, or because they were involved in a complaint filed under one of the laws enforced by the Department of Labor (see Whistleblower and Non-Retaliation Protections), then the termination is subject only to any private contract between the employer and employee or a labor contract between the employer and those covered by the labor contract.”“Termination,” US Department of Labor, accessed June 30, 2011, www.dol.gov/dol/topic/termination/index.htm.
In other countries, matters are not so simple. Imagine now that you are the HR manager of a firm in Portugal. Your product demand has fallen off, and you want to reduce output. In contrast to the United States, you may not be able to simply lay off workers. In Portugal, and in many other countries, there are numerous laws that make it costly to dismiss workers.
If you want to design a public policy to reduce the unemployment rate, it is tempting to make it harder to fire workers. If it is difficult to fire people, then fewer individuals will move from employment into unemployment. As we discussed earlier, though, spells of unemployment are sometimes necessary if workers are to move from less productive jobs to more productive ones. An increase in firing costs makes the labor market less flexible, so the economy will adjust less effectively to changes in workers’ productivities.
There is also a more subtle unintended consequence of firing costs. If it is harder to fire workers, then firms become more reluctant to hire workers. Neither firms nor workers know the true value of a match in advance. When you take a part-time job, your productivity at that job and job satisfaction cannot be known ahead of time. Suppose there was a law that stated that once you accept a job you must stay with that employer for five years. You would certainly become very careful about deciding to accept a job offer. Exactly the same applies to firms. If the cost of laying off a worker is very high, then the firm will simply not hire the worker. A policy designed to promote employment can actively discourage it.
The French government, as we saw at the beginning of the chapter, made an attempt to introduce labor market reforms based on exactly this reasoning and tried to make the argument that we have just outlined to the protesters in the streets. If there were more flexibility in the firm’s employment decision, they argued, firms would become more willing to hire young workers. This would help to reduce youth unemployment. The following New York Times article tells what happened next.Elaine Sciolino, “Chirac Will Rescind Labor Law That Caused Wide French Riots,” New York Times, April 11, 2006, accessed June 30, 2011, http://www.nytimes.com/2006/04/11/world/europe/11france.html?_r=1.
President Jacques Chirac crumbled under pressure from students, unions, business executives and even some of his own party leaders on Monday, announcing that he would rescind a disputed youth labor law intended to make hiring more flexible. The retreat was a humiliating political defeat for both Mr. Chirac and his political protégé, Prime Minister Dominique de Villepin […]
It also laid bare the deep popular resistance to liberalizing France’s rigid labor market, and makes any new economic reform politically impossible before a new government is in place, and perhaps not even then.
“Dead and buried,” is how Jean-Claude Mailly, leader of the leftist union Force Ouvrière, described the fate of the labor law. “The goal has been achieved.”
[…]
The new law was intended to give employers a simpler way of hiring workers under 26 on a trial basis without immediately exposing companies to the cumbersome and costly benefits that make hiring and firing such a daunting enterprise. Opposition to the law reflects the deep-rooted fear among the French of losing their labor and social protection in a globalized world.
[…]
In its initial form, the law allowed employers to fire new employees within two years without cause. In the face of mounting pressure, Mr. Chirac watered it down so that employers could subject new employees to only a yearlong trial period, and then would have to offer a reason for any dismissal.
Students and unions, bolstered by support from the opposition Socialists and even some business leaders, had vowed to continue their street protests until the law was rescinded.
The Socialists were quick to proclaim victory on Monday. “This is an unquestionable retreat,” Francois Hollande, the leader of the Socialist Party, told reporters. “It is a grand success for the young and an impressive victory for the unity of the unions.”
[…]
Restrictions on Hours
Another tempting policy to increase employment is to limit the number of hours an employee can work. Suppose that a firm needs 1,200 hours of labor time a week. If a typical worker works 40 hours per week, then the firm will need to hire 30 workers. But if the government were to legislate a 30-hour workweek, then the firm would need to hire 40 workers instead.
This idea of “spreading work” through restrictions on hours was part of the response in the United States to the Great Depression. During the early 1930s, the US government instituted such restrictions under the heading of the “National Economic Recovery Act.” The idea persists to the present day. In France, the government passed a law limiting hours worked to 35 hours per week (for workers at large firms) starting in the year 2000. In Germany, the government operates a policy called Kurzarbeit, whereby it subsidizes firms who retain workers for shorter hours in times of recession.
One problem with such policies is that restrictions on hours reduce the value of a match between a worker and a firm. Consequently, fewer matches will be formed, and more workers will be unemployed. Another problem is that it reduces flexibility in the labor market, which leads to less efficient functioning of the economy.
As a concrete example, consider auto manufacturers in the years following the Great Depression in the United States. This industry had substantial variations in hours worked over the model year. During times of high demand for cars (the spring), factories and their workers were working overtime to meet the increased demand. Restrictions on hours meant that overtime working had to be replaced by increased hiring. Firms that wanted to produce more output had to hire and train new workers. This was costly, so firms sometimes found it was better simply to accept that they would not meet the high demand.
In the case of France’s 35-hour workweek, matters were a bit more complicated. The mandated short workweek imposed some rigidity on firms. However, during the negotiations for this change in the laws, French labor unions agreed to some other changes that improved the flexibility of the labor market. France later moved away from the 35-hour workweek by permitting firms and workers to agree to longer work hours if they wish.
Key Takeaways
• Most governments provide workers with unemployment insurance. In many countries, governments also impose costs on firms that fire workers and also restrict hours worked.
• One rationale for intervention by governments is to provide insurance to workers that is not available in private markets. Governments also take action in an attempt to increase employment rates.
Exercises
1. Can a firm in the United States fire a worker without permission of the government?
2. What was one of the arguments in France for restricting the hours worked per week? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/23%3A_Jobs_in_the_Macroeconomy/23.05%3A_The_Government_and_the_Labor_Market.txt |
In Conclusion
Europe and the United States differ in many ways. From the perspective of macroeconomists, some of the most striking differences are in the laws governing labor markets.
In the United States, labor markets are relatively flexible. It is relatively easy for firms to hire and fire workers, and it is relatively easy for workers to move between jobs. This brings many benefits to the economy as a whole, the most important being that it helps ensure good and productive matches between workers and firms. It also has some less attractive implications, particularly for workers. Job security is very limited, and workers might find themselves out of a job with very little warning.
In Europe, labor markets tend to be more rigid. We have explored some of the ways in which this is true. Minimum wages are often higher, unemployment insurance is more generous, and the costs of hiring and firing workers are greater. As a consequence, European countries are typically characterized by higher unemployment than the United States. In addition, unemployment duration tends to be longer: workers who become unemployed tend to take longer to find a new job. This makes the labor market a more difficult place for workers who do not have jobs but a better place for those who do have jobs because they typically enjoy higher salaries and greater security.
We have analyzed the differences between these two parts of the world, but we have not explained why these different economies have settled on such different configurations of labor laws. The explanation is not simple and goes well beyond economics into questions of history, politics, and sociology. Still, there is probably some truth in the simplest explanation: voters have different preferences about how their working lives should look. Perhaps voters in Europe prefer a world of greater job security for the employed, even if it comes at the cost of unemployment problems and a less-efficient economy. Perhaps voters in the United States prefer a dynamic economy, even if it comes at the cost of more uncertainty for working people.
Key Links
exercises
1. A Washington Post article quoted the following opinion from a French student.Molly Moore, “French Students Hit Streets to Protest New Labor Law,” Washington Post, World News, March 17, 2006, accessed July 7, 2011, www.washingtonpost.com/wp-dyn/content/article/2006/03/16/AR2006031601908.html. Do you agree or disagree with these views? Do you think of the labor market experience in your country differently?
“They’re offering us nothing but slavery,” said Maud Pottier, 17, a student at Jules Verne High School in Sartrouville, north of Paris, who was wrapped in layers of scarves as protection against the chilly, gray day. “You’ll get a job knowing that you’ve got to do every single thing they ask you to do because otherwise you may get sacked. I’d rather spend more time looking for a job and get a real one.”
2. (Advanced) What effect does unemployment insurance have on the savings behavior of employed households? Think about the life-cycle model, discussed in Chapter 28 "Social Security" (and in the toolkit). How would you add the prospect of unemployment to the household’s life-cycle decisions on consumption and saving?
3. Explain how each of the following factors might affect the duration of unemployment for a single unemployed worker: (a) rate of unemployment in the economy, (b) age of the worker, (c) skills of the worker, (d) country of the worker, (e) generosity of unemployment insurance, (f) wealth of the worker, and (g) employment status of the worker’s spouse. What other factors can you contribute to this list?
4. The following table contains information about worker output in two jobs. Explain why worker B has an absolute advantage in both jobs. What is the most efficient assignment? Which worker has a comparative advantage in job 1? Calculate the opportunity cost of assigning the workers to job 2. Which worker has a lower opportunity cost of taking job 2?
5. Consider the following job assignment problem based on the table titled “Output Level per Hour from Assigning Jobs”. Here there are three workers, three jobs, and the prospect of not working. In the table, the value of output produced not working can be interpreted as the value of either leisure time or the output produced at home (say, in the garden). Find the optimal assignment of workers to jobs. Should anyone be unemployed? If not, how would you change the table so that someone was not working?
6. Explain why making it easier to fire people might reduce the unemployment rate.
7. Suppose that there is a legal minimum wage, set in nominal terms. Draw a diagram to show how this can lead to unemployment. Now suppose that there is inflation. What happens to the employment rate? What happens to the unemployment rate?
Worker Job 1 Job 2
A 1 9
B 2 12
TABLE \(1\): OUTPUT LEVEL PER DAY IN DIFFERENT JOBS
1. Worker Job 1 Job 2 Job 3 Not Working
A 10 12 6 0
B 8 1 1 2
C 6 3 5 3
TABLE \(2\): OUTPUT LEVEL PER HOUR FROM ASSIGNING JOBS
Economics Detective
1. Go to the website for the Organisation for Economic Co-operation and Development ( http://www.oecd.org/home/0,2987,en_2649_201185_1_1_1_1_1,00.html). Find the latest table reporting unemployment rates in Europe. How is unemployment defined in this table?
2. Find a recent discussion of employment protection laws across countries. In which countries are jobs most regulated? Has this changed much over time? Can you find any evidence relating the measure of employment protection laws with the unemployment experience of the individual countries?
3. Go to the website for the Current Population Survey ( http://www.bls.gov/cps). Develop a figure similar to Figure 23.3.2 "Worker Flows in the United States" for the current month. Why do the numbers differ from those reported in Figure 23.3.2 "Worker Flows in the United States"? Find a year when the United States was in a recession. What were the rates of job flows like during the recession?
4. Find a discussion of the unemployment insurance that would apply to you if you lost a job where you currently live. Does it matter in your state/country why you are not currently employed? In your state/country, do you have to continue to look for a job to receive unemployment insurance? If so, what do you have to do?
5. In Europe, is the amount of unemployment insurance determined by individual countries or by the European Union?
6. Go to the website for the Bureau of Labor Statistics ( http://www.bls.gov) and find out what ages are classified as working age in the United States. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/23%3A_Jobs_in_the_Macroeconomy/23.06%3A_End-of-Chapter_Material.txt |
You wake up one morning, drag yourself out of bed, and, bleary-eyed, throw on some clothes. You stumble out of your apartment and across the road to your neighborhood coffee shop. “Coffee, please,” you say to the barista, those being the only two words that you are capable of getting out of your system before you get some caffeine into it. She pours a cup of the coffee of the day and places it on the counter in front of you. Just smelling the coffee makes you feel a little bit better already.
“That’ll be a dollar.” You reach into your pocket, pull out a crumpled twenty, hand it to her, and reach for the cup. “I’m sorry,” she says, pulling the cup away from you, “I can’t accept that.” “Why on earth not?” you ask, bemused. “It’s the wrong color,” she says. “You could have used that yesterday, but—look—this is what bills look like now.” And she reaches into her register and shows you a bright purple \$20 bill, like the one in the following figure .
Figure \(1\): The New \$20 Bill
Imagine if you woke up one morning and found that all money was now this color.
In this story, normal green dollar bills were accepted as money yesterday, while purple dollar bills were worthless colored pieces of paper. But today, purple dollar bills are accepted as money, and green dollar bills are just worthless pieces of paper. This sounds absurd. Yet it is not so far from what happened in a dozen different countries on January 1, 2002. If you had awakened in Italy on that day and gone down the street to a neighborhood café, you would have noticed that the simple act of buying coffee had changed from the day before. Your local café still looked as it did on December 31, 2001. But where you had previously paid with notes and coins called Italian lira, you would now pay with a completely new currency called the euro.
The same was true in France, Finland, Germany, Greece, and seven other European countries. On that day, 12 countries all officially gave up their own currencies and instead adopted a common currency—the euro. Admittedly, the transition was not quite as stark as in our story: there was a period of about 2 months in which euros and the old local currencies both circulated. But the essence is the same. At one time, euro notes were just colored pieces of paper that shopkeepers would not accept for transactions. Then, not that long afterward, those colored pieces of paper became valuable, while the old currencies turned into worthless pieces of paper.
This was an amazing event for the international economy. Familiar currencies like the French franc, the German deutschmark, the Greek drachma, and the Spanish peseta simply disappeared. The following figure shows some of these vanished currencies. Some of the world’s largest economies changed their currency. In Chapter 30 "The Global Financial Crisis", we take up another aspect of this event: what it means for a country to disband its central bank and delegate monetary policy to a centralized entity. To make sense of this event, we need to answer a disarmingly simple-looking question, which is the theme of this chapter:
Why do people want to hold apparently worthless pieces of paper?
Here are some of the banknotes that disappeared from circulation in Europe upon the advent of the euro.
Road Map
Understanding what happened in Europe requires us to answer two more basic questions:
What is money? and Why is it valuable?
We begin this chapter by looking at what makes something a money. Surprisingly, this is not straightforward: we will see that money has several attributes, and many different things can act as money. Then we look at what we can do with money. We use money to buy goods and services, we use money to buy other kinds of money, and we use money to buy money in the future.
Before exploring the world of money, we need to make one clarification. In everyday language, if you bought a camera for \$200 and sold it for \$300, we would say that you made money from the deal. Economists, however, use the term money more precisely, in ways that we make clear in this chapter. An economist would say that your resale of the camera earned you income, and you received that income in the form of money. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/24%3A_Money-_A_Users_Guide/24.01%3A_The_Color_of_Money.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What gives money value?
2. What are the functions of money?
Take a look at some currency—a dollar bill, for example. It is nothing more than a piece of paper with writing on it. A very pretty piece of paper, perhaps, with fancy writing and some pictures, but it is still just a piece of paper. Yet people voluntarily give up valuable goods or services in exchange for pieces of paper. This is the mystery of money.
The question motivating this chapter—why do people want money?—is a deep one. That may seem a surprising claim because obviously we all like having money. But questions that seem trivial sometimes provide insights into how the world works. If we can understand why people want these intrinsically worthless pieces of paper, then we can understand why money is valuable. And to understand why people want these pieces of paper, we need to know what people want to do with their money.
The Characteristics of Money
A striking feature of modern developed economies is that people are typically specialists in production and generalists in consumption. By this we mean that most of us work at one or at most two jobs, producing (or, more often, helping to produce) a very small number of things—for example, a cattle farmer produces beef, a software designer produces computer code, and a nurse produces health services. However, we all purchase hundreds of goods and services.
There is no law that says that we have to buy goods and services using money. An alternative is to trade goods or services directly for one another. This is called barter. We do see some barter in the world. A restaurant may allow its employees free meals at the end of the night, which means that some of the employees’ wages effectively takes the form of food. If a car mechanic and a caterer live next door to each other, they may have an informal arrangement whereby the mechanic repairs the caterer’s truck in exchange for food for a birthday party.
Sometimes we know exactly where to buy the goods and services that we want. At other times, we go looking—perhaps walking or driving from store to store, perhaps searching using a phone book or the Internet. We do this because we don’t know which store has the goods we want in stock; in addition, we might not know the prices that different stores are charging, and we want to hunt around for the best deal.
To understand the role that money plays in an economy, begin by imagining a world where we must search for the goods and services that we want to buy and there is no money, so all trades take place through barter. Imagine, for example, that you are a web designer, and you want to buy a used car. You must look around for someone who has a car for sale. This search takes time: it has an opportunity cost in that you would prefer to spend that time working or enjoying leisure. Eventually, you find someone who has a car that you are interested in buying. But your problems are not over. He has a car for sale, but what can you give him in exchange? You have to hope that he is interested in obtaining some web design services in exchange for the car. Successful barter requires a coincidence of wants: you must have what the other person wants, and they must have what you want.
A world of nothing but barter is hard to imagine. Each time you wanted to buy something from a seller in a store, you would have to exchange some good or service for that good. If you went to a café, you might have to wash the dishes in return for a coffee. Professors of economics wanting a meal would have to go from restaurant to restaurant trying to find a chef who wanted to hear an economics lecture. They would probably go hungry. It is easy to see why all societies find some way of making these transactions easier.
If you can carry some kind of money around with you to make purchases like these, life is much easier. You still have to hunt for the goods and services that you want, but you don’t have to worry about whether the other party in the transaction wants the product that you sell. Money, therefore, plays a key role in ensuring that trades occur. Trades, in turn, create value in our economy. People are not forced to buy or sell things; they do so only if the trade leaves them better off than they were prior to trading. Money therefore plays a critical role in value creation.
The reason that we rarely see exchange without money is that it is so inefficient. Without money, a coincidence of wants is unlikely, so desirable trades do not occur, and value is not created. With money, transactions are much easier. If you want a meal in a restaurant, the owner will always serve it to you if you have money. Likewise, you obtain money by working at your job. You don’t care what good or service your employer produces; as long as your employer pays you in money, you are happy to supply your labor time to them.
Let us think for a moment about what characteristics this money needs to have:
• Money must be portable. If you are going to walk around searching for goods and services, you want to be able to carry money with you. Sacks of coal would not make a very good money.
• Money must be divisible. Different goods have different prices, and the money we use must accommodate that. Watches would not make a very good money.
• Money must be durable. Daffodils would not make a very good money.
It is easy to list many things that are reasonably portable, divisible, and durable: chocolate chip cookies, cigarettes, and printer paper are just a few examples. These are not typically used as money, although they could be. If you went into a fast-food restaurant, asked for a burger, and then offered to pay using chocolate chip cookies, you can be confident that you would not get the food that you want. That is because there is a fourth characteristic of money that is rather different from the other three.
• Money must be acceptable.
Something can function as money only if people are willing to accept it as money. It is not impossible to imagine a world where chocolate chip cookies function as money. If everyone else is willing to accept cookies in payment for goods and services, then you will be willing to do so as well. But if other people accept only printed pieces of paper as money, then you would be foolish to accept chocolate chip cookies for the product that you sell.
Fiat Money
We know of no country, of course, that actually uses chocolate chip cookies for money. In most countries, money takes a particular form called fiat money. Fiat money is money that is not backed by any physical commodity, such as gold. Instead, the currency is intrinsically useless pieces of paper that attain value in exchange.
Fiat is a Latin word that means “let it be.” Fiat money is money just because the government says so. In a fiat money system, the government does not promise to exchange goods for money. In addition, money is not generally something that we can directly consume: most people would not enjoy eating a dollar bill. So if it doesn’t taste good and the government doesn’t promise to give you something in exchange for it, what gives fiat money value? Why are we all willing to work hard to get pieces of these—intrinsically worthless—pieces of paper?
The answer is because these pieces of paper are acceptable as money. Other people will accept them, so you and I will as well. To put it another way, fiat money has value because everyone believes it has value. Think back to the story with which we opened the chapter. The US economy uses green and white pieces of paper as money. US residents are willing to give up valuable goods and services in exchange for these green and white pieces of paper because they believe that others, in turn, will accept them. Such an arrangement sounds fragile, and it is. If everyone stopped believing that fiat money had value, this would be a self-fulfilling prophecy. Something very much like this happens in the circumstances of very high inflation rates, as explained in Chapter 26 "Inflations Big and Small".
Suppose the money in an economy changed overnight from green pieces of paper to purple pieces of paper, as we fancifully suggested at the beginning of this chapter. Everyone now works for and accepts the new purple currency. You are forced to follow. It would be foolish for you to work and accept green paper because no one would give you goods or services in exchange. Instead, you demand to be paid in purple paper because that is what you now need to buy goods and services.
Of course, we do not often observe these switches across colors of paper within an economy. People get used to one type of currency, and it is difficult to change everyone’s behavior at once. Still, Europe did, in effect, switch from green pieces of paper to purple pieces of paper. Sure enough, no one in Europe these days is willing to accept French francs, Portuguese escudos, or Finnish marks. These are the old pieces of paper. Now people will accept only the new pieces of paper.
That conversion was not truly instantaneous. Prior to the changeover to the euro, there was a switch to a dual unit of account: French bank statements in 2001 gave balances in both French francs and euros, for example. Even now, years after the changeover, bills in Europe often still appear in both the old local currency and euros. It was also possible to use the euro as a store of value before the changeover because banks started establishing accounts in euros.
Even though fiat money issued by the government is, in the end, just pieces of colored paper, it typically does have one particular property that stems from the power of the state. The US government states that it will accept dollars in settlement of government debts—most importantly, tax bills. The government also states that dollars can be used in settlement of private debts. Dollars are legal tender.There is a subtle question here about whether this aspect of money means that even intrinsically worthless currency must always have some value. If people owe debts to the government that are specified in money terms, then they will be willing to pay something for legal tender currency.
The Functions of Money
Thus far, we have thought about money in terms of its characteristics. We can also think about what makes a good or bad money in terms of the functions that it serves.
Medium of Exchange
If you walk into an electronics store and see a camera with a price tag of \$500, the store is making an offer to you and other customers: if you hand over ten \$50 bills, you can have the camera in exchange. Money serves as a medium of exchange.
There are other ways to purchase a camera rather than cash. You could write a check, for example, or use a debit card (a card that immediately deducts the \$500 from your bank account and pays it into the store’s account). The fact that there are different ways of paying for something is a clue that there is, in fact, no single thing that we can call money. Money is anything that does what money does.
Interestingly, one common form of purchase does not involve money at all. If you use a credit card to buy a camera, you do not pay at all at the time of purchase, so no money—by any definition—changes hands. In this case, you receive the camera in exchange for a promise to pay for the camera later. It is only when that promise to pay is fulfilled that you hand over the money for the purchase.
Store of Value
Any medium of exchange must also serve as a store of value. This just means that money should keep its value between the time that you receive it (in exchange for goods that you sell or work that you do) and you spend it again.
If an object lost all or most of its value over a short period, then it would not be acceptable in exchange. So something that serves as money must be a store of value. Imagine for a moment an economy in which ice played the role of money. Except on the coldest days, the ice you receive on payday would not last long enough for you to buy anything with it. It would be a terrible store of value and, as a result, would not do a good job of facilitating exchange.
Paper money and coins are not like ice. They are durable and do not dissolve with use. Because of this, you can be confident that the dollar you have in your pocket today will still be a dollar you can spend tomorrow. The fact that people are willing to hold money for long periods of time is indicative of the role of money as a store of value. If money were not a store of value, then all people would want to get rid of cash as soon as they received it. To mix our metaphors: if money were ice, it would become a hot potato.
Being a store of value is more than just a physical property of money. Currency in your pocket can remain there for a long periods of time before disintegrating. So, in a physical sense, that currency retains its worth. But, if prices are increasing, then in terms of what the currency can buy, the money in your pocket is not retaining its value. In times of inflation, money functions less well as a store of value.
Unit of Account
Almost universally, prices are quoted in terms of some currency, such as pesos, dollars, or euros. Goods and services sold in the United States have prices in terms of US dollars. The dollar serves as a unit of account. But when the very same goods and services are sold in Europe, they are priced in a different unit of account: euros. This role of money is so familiar as to be mundane, yet our economy simply could not function without a commonly accepted monetary measuring stick. It would be like building a house without an accepted measure of length or running an airline without an accepted measure of time.
The unit that people use to keep account of their monetary transactions varies from country to country. In Mexico, prices are quoted in pesos, in India prices are quoted in rupees, and so on. In most countries, the medium of exchange and the unit of account are the same thing, but this need not be true.
Because the US dollar is known throughout the world, it is often used as a unit of account in unexpected places. Prices of commodities in international transactions may be quoted in terms of the dollar even when the transaction does not directly involve the United States. Luxury hotels in China and elsewhere sometimes quote prices in US dollars even to guests who are not coming from the United States. In Chapter 18 "The State of the Economy", we discuss both nominal and real gross domestic product (real GDP). Nominal GDP is the value of all the goods and services produced in an economy, measured in terms of money. Money is used as a unit of account to allow us to add together different goods and services. Even the concept of real GDP uses money as a unit of account: the difference is that we use money prices from a base year to value output rather than current money prices. As another example, after the changeover to the euro, that currency became the medium of exchange and the “official” unit of account. But many people—at least in terms of their own thinking and mental accounting—continued to use the old currencies. In everyday conversation, people continued to talk in terms of the old currencies for months or even years after the change.On a bike trip in the summer of 2002, one of the authors had lunch in a French country restaurant. Though it was many months after the change to the euro, the menu was still in French francs. An elderly lady running the restaurant painstakingly produced a bill in euros: for each entry (in French francs), she multiplied by the exchange rate (euros to francs) and then added the amounts together. Even today, some bills and bank statements in Europe continue to quote the old currency along with the euro.
Meanwhile, merchants in countries who have not adopted the euro may still quote prices in that currency. In Hungary, the local currency is called the forint. Figure 24.2.1 "The Euro as a Unit of Account" shows a sign at a restaurant in Budapest, Hungary, advertising goods in both currencies: goulash soup, for example, is sold for 1,090 forint or 4.40 euro. If, as may well be the case, the restaurant is also willing to accept euros in payment, then the euro is also acting as a medium of exchange alongside the forint.
Figure \(1\): The Euro as a Unit of Account
A sign at a restaurant in Hungary quotes prices in euros and the local currency (forint).
Source: Image taken by the authors
Key Takeaways
• Fiat money has value because everyone believes it has value.
• The three functions of money are medium of exchange, store of value, and unit of account.
Exercises
1. In what sense are you a specialist in production and a generalist in consumption?
2. Why is money less effective as a store of value when inflation is high?
3. In times of inflation, money is also less effective as a unit of account. Why? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/24%3A_Money-_A_Users_Guide/24.02%3A_What_Is_Money%3F.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is arbitrage?
2. What is the law of one price?
Having defined money through its characteristics and functions, we now turn to the uses of money. By looking at what we can do with money, we can understand how intrinsically worthless pieces of paper acquire their value.
Let us imagine, then, that you are lucky enough to find a \$100 bill on the sidewalk. You have no way of returning it to its rightful owner. What might you do with this money? The first and most obvious answer is that you can use it to buy something you want: you can take the \$100 and purchase some goods and services.
The Value of Money
The observation that we use money to buy things tells us more about the value of money. Economists often make a distinction between real and nominal values; this distinction can be applied to money as well. First, what is the nominal value of money? This is almost a trick question: we are asking, “How many dollars is a dollar bill worth?” The answer, which does not require a doctorate in economics, is that a dollar bill is worth \$1.
Nominal variables—those measured in dollars or other currencies—can be converted into real variables—that is, those measured in units of real gross domestic product (real GDP). To convert a nominal variable to a real variable, we simply divide by the price level. For example, if your nominal wage is \$20 per hour and the price level is \$10 (meaning that a typical unit of real GDP costs this amount), then your real wage is 2 units of real GDP.
Toolkit: Section 31.8 "Correcting for Inflation"
If you want to review the process of correcting for inflation, you will find more details in the toolkit.
Exactly the same principle can be applied to money itself. The real value of a dollar is obtained by dividing one by the price level. Thus
Think of an economy in which real GDP is measured in pizzas and suppose the price level—the price of a pizza—is \$10. Then the value of a dollar bill is 1/10 of a pizza.
Although \$1 is always worth \$1, you are not guaranteed that the dollar bill in your pocket will buy the same amount of goods and services from one day to the next. If your local café increases the price of a cookie from \$1.00 to \$1.25, then your \$1 will no longer buy you a cookie; its value, measured in cookies, has declined. If the price level increases, then the real value of money decreases. For notes and coins to be a good store of value, it must be the case that prices are not increasing too quickly. We discuss this problem in more detail in Chapter 26 "Inflations Big and Small".
Using Money to Make Money: Arbitrage
An old joke has it that the secret to getting rich is very simple: buy at a low price and sell at a high price. So another use of your \$100 would be to buy goods not to consume but to resell—a process known as arbitrage.
Suppose you discovered that a particular model of digital camera could be bought much more cheaply in Minneapolis, Minnesota, than in Flagstaff, Arizona. Then you could purchase a large number of cameras in Minneapolis, load them into a suitcase, fly to Flagstaff, and sell them for a profit. If the gap in price were large enough to compensate for your time and travel costs, then this would be a money machine. By buying cameras at a low price and selling them at a high price, you could make as much profit as you wished.
This situation would not persist. You, and other entrepreneurs as well, would start to bid up the price of cameras in Minneapolis. Meanwhile, the increased supply of cameras in Flagstaff would cause prices there to decrease. Before too long, your money machine would have dried up: the gap between the Flagstaff price and the Minneapolis price would no longer justify the effort.
Arbitrage ensures that the prices of individual goods do not vary too much across different regions of the United States. Taken to its extreme, it would imply that the price level would be the same throughout the country. Economists call this idea the law of one price. The law of one price says that different prices for the same good or service cannot persist because arbitrage eliminates such differences. Arbitrageurs would buy the good at the low price and sell it at the high price. Demand would increase in the market where the price was low, causing that price to increase. Supply would increase in the market where the price was high, causing that price to decrease. This process would continue until the prices were equalized across the two markets.
There are, of course, differences in the prices of individual goods and services in different states and different cities. These differences are primarily due to the fact that some items cannot be arbitraged. If cameras are cheaper in Minneapolis than in Flagstaff, then they can be bought and sold as we described. But if apartments in Flagstaff are cheaper than in Minneapolis, it isn’t possible to ship them across the country. Likewise services typically cannot be arbitraged. Thus we do not expect the law of one price to be literally true for every good and service. Nevertheless, the law of one price does lead us to expect that the overall price level will not differ too much in different parts of the country.
It can be difficult to apply the law of one price in practice because we have to be careful about what we mean by the “same” product. An apparently identical shirt at two different retailers might not qualify as the same—perhaps one retailer allows goods to be returned, while the other does not allow returns. Identical goods are not the same if they are in different places: a Toyota on a dealership lot in Kentucky is not the same as the identical model car on a lot in Pretoria, South Africa, and so on. In such situations, the law of one price tells us that we should not expect prices of goods to be “too different,” depending on the costs of transportation and the other costs of arbitrage.
We said earlier that money makes an economy more efficient because it makes transactions easier. Money makes arbitrage easier as well. Arbitrage would be a less certain way of making money in an economy with barter. First, the lack of a clear unit of account would make arbitrage opportunities less transparent. Second, the lack of a reliable medium of exchange would make arbitrage risky: the person in Flagstaff who wants to buy a digital camera from you might not have anything you want, so you might end up giving up something you own and not getting something you want in return.
Key Takeaways
• Arbitrage is the process of making a profit by buying goods at a low price and selling them at a higher price.
• When arbitrage is possible, we expect the same good to sell at the same price. There are no arbitrage profits to be made when the law of one price holds.
Exercises
1. All else being the same, if the price level increases, what happens to the real value of money?
2. Explain why the law of one price is less likely to hold for a service than for a good. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/24%3A_Money-_A_Users_Guide/24.03%3A_Using_Money_to_Buy_Goods_and_Services.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is the difference between the nominal exchange rate and the real exchange rate?
2. How is the law of one price related to the nominal exchange rate?
As we all know, there are multiple currencies in the world. These are most often associated with a single country: the yen in Japan, the yuan in China, the peso in Mexico, and so on. Sometimes many countries will use the same money, with the leading example being the use of the euro by the member countries of the European Union ( http://ec.europa.eu/economy_finance/euro/index_en.htm). Sometimes multiple currencies are in use in a single place: when you land at a major European airport, such as Frankfurt, Germany, or Amsterdam, the Netherlands, you will see that you can buy a cup of coffee at the airport using many different currencies. Likewise, the US dollar is freely accepted in some countries in addition to the local currency, British pounds formerly were freely accepted in Ireland, and so on.
If you happened to find your $100 right before going on a trip to another country, you might decide to use it to buy the money of that country. For example, if you were about to take a trip to Canada, you could take the bill into a bank or a foreign exchange merchant and exchange it for Canadian dollars. If you want to buy goods and services in Canada, you need Canadian dollars because they are the medium of exchange in that country. When you make such an exchange, you buy the local currency using your home currency. If you travel from the United States to Europe, you buy euros using dollars. The price you pay is the dollar price of the euro: the amount in dollars you must pay to obtain 1 euro. This is completely analogous to using a dollar to buy a bottle of soda, when you pay the dollar price of soda. In practice, it is often unnecessary to carry out a physical exchange of notes and coins. In most countries, you can go to an automated teller machine (ATM) and withdraw local currency directly. Your bank deducts the equivalent sum in your home currency from your bank account. You are still carrying out an exchange, of course, but it is hidden from view, and you will see it only when you look at your next statement. The same is true if you make a purchase using a credit card. Just as a US resident traveling to Europe wishes to buy euros with dollars, a visitor to the United States from, say, Holland will need to buy dollars with euros. The price she pays is the euro price of the dollar: the number of euros needed to obtain$1. The price of one currency in terms of another is called an exchange rate.
Toolkit: Section 31.20 "Foreign Exchange Market"
If you want to review the definition of an exchange rate, you will find more details in the toolkit.
If we think of two currencies—euros and dollars, for example—then there are two exchange rates to keep in mind: the price of euros in dollars and the price of dollars in euros. (You might suspect, correctly, that these two prices are linked; we return to this shortly.) In a world of 3 currencies, each has a price in terms of the other two currencies, so there are 6 (= 3 × 2) different prices. And in a world of 100 currencies, then for each one, there are 99 prices for the other currencies. So there are 100 × 99 = 9,900 prices to quote! A Zambian traveling to Armenia wants to know about the kwacha price of drams, a Malaysian traveling to Oman is interested in the ringgit price of rials, and so on.
Foreign Exchange Markets
Imagine a series of three visitors traveling from the United States to Europe. First, we have someone arriving on vacation. Chances are that she will want to exchange dollars for euros to have money to spend on hotels, meals, and so on. She also buys souvenirs in Europe—goods that she imports back to the United States. Our second visitor spends a lot of time in Europe for work purposes. He might open a bank account in, say, Germany. If he wanted, he could use this bank account to keep some of his wealth in Europe. He would buy euros with his dollars, deposit these euros in the bank to earn interest, and then—at some point in the future—he would take his money out of the bank in Germany and exchange the euros for dollars. (Later, we will consider how you can decide if this is a good investment strategy. For now, our point is that this type of financial investment is another source of demand for euros.) Our third visitor to Europe is a professional wine buyer who wants to purchase wine to sell in a US restaurant. She travels to the wine-growing regions of Europe (France, Spain, Italy, Germany, Portugal, etc.) and must exchange dollars for euros to pay for her purchases.
Our three visitors represent a microcosm of the transactions that take place in the foreign exchange market every day. Households and firms buy euros to pay for their imports of goods and services (souvenirs, wine, etc.). Many different goods and services are produced in Europe and sold in the United States. Some are imported by retailers, others by specialist import-export firms, and still others by individuals, but in all cases there is an associated purchase of euros using dollars.
The demand for euros also arises from financial investment by households, firms, and financial institutions. For example, a wealthy private investor in the United States may purchase stock issued by a company in Europe. To buy that stock, the US investor sells dollars and buys euros. In practice, such transactions are typically carried out by financial institutions that undertake trades on behalf of households and firms.
Most exchanges of dollars for euros do not actually entail someone traveling to Europe. Think about the foreign currency needs of a large multinational firm that produces goods and services in Europe but sells its output in the United States. The company naturally needs euros to pay workers and suppliers in Europe. Since it sells goods and thus earns revenues in dollars, the company must convert from dollars to euros very frequently. But you will not see the company’s chief financial officer in an airport line to exchange money. Instead, such currency operations are conducted through financial institutions, such as commercial banks.
Because of all these transactions, there are very active and sophisticated markets in which currencies are traded. We can represent these markets using the familiar supply-and-demand framework. Figure 24.4.1 "The Market for Euros" shows a picture of the market where euros are bought and sold. Buyers from the United States buy euros with dollars, and European traders sell euros in exchange for dollars.Of course, it is not literally the case that everyone who is buying is from the United States and that everyone selling is from Europe. If you have dollars, you can buy euros; if you have euros, you can sell them for dollars. But it is simpler to explain if we think of Europeans selling euros and Americans buying them. The supply and demand curves refer to the object being traded—euros. Thus the quantity of euros is shown on the horizontal axis. The price on the vertical axis is in dollars.
This market is just like any other you encounter. The demand curve is downward sloping: as the price of euros increases, the quantity of euros demanded decreases. This is the law of demand at work. As the price of euros increases, people in the United States will find that goods and services produced in Europe are more expensive. For example, suppose that 1 euro costs $1, and a Mercedes automobile costs EUR 50,000.There is an established set of three-letter symbols for all the currencies in the world. Euros are denoted by EUR, US dollars are denoted by USD, Australian dollars are denoted by AUD, and so forth. In this book we use the familiar$ symbol for US dollars and the three-letter symbols otherwise. A list of the currency codes can be found at http://www.xe.com/iso4217.php. Then its cost in dollars is $50,000. Now imagine that euros become more expensive, so that EUR 1 now costs$2. You now need $100,000 to buy the same Mercedes in Europe. So an increase in the price of euros means that Americans choose to buy fewer goods and services produced in Europe. Exactly the same logic tells us that an increase in the price of the euro makes European assets look less attractive to investors. A German government bond, a piece of real estate in Slovenia, or a share in a Portuguese firm might look like good buys when the euro costs$1 yet seem like a bad idea if each euro costs $2. The supply curve also has a familiar upward slope. As the price of euros increases, more people in Europe sell their euros in exchange for dollars. They do so because with the higher dollar price of euros, they can obtain more dollars for every euro they sell. This means that they can buy more US goods and services or dollar-denominated financial assets. This diagram shows the foreign exchange market in which euros are bought and sold. As the price of euros (in dollars) increases, more euros are supplied to the market, but fewer euros are demanded. The price where supply equals demand is the equilibrium exchange rate. (The market also shows us the equilibrium number of euros traded, but here we are more interested in the price of the euro.) Toolkit: Section 31.9 "Supply and Demand" The foreign exchange market is an example of a market that we can analyze using the tool of supply and demand. You can review the supply-and-demand framework and the meaning of equilibrium in the toolkit. Arbitrage with Two Currencies So far, we have talked about buying foreign currencies to purchase either assets or goods and services. Another reason to buy foreign currencies is in the hope that you could make money by trading them. Let us think about how you might try to make money in the foreign exchange market. You might start with some dollars and exchange them for euros. Then you could take those euros and exchange them for dollars again. Is it possible that, by doing this, you could end up with more money than you started with? Could you buy euros cheaply and then sell them at a high price, thus making a profit? Begin by supposing that dollars and euros are only two currencies in the world, and there are only two economies: the United States and Europe (a shorthand for “those European countries that use the euro”). Imagine that there are two separate markets: in the euro market, the price of 1 euro is$2; in the dollar market, the price of one dollar is EUR 1. With these two prices, there is money to be made by buying and selling currencies. Start with 1 euro. Sell that euro in the market for euros and obtain $2. Use those dollars to buy euros in the market for euros and obtain 2 euros. Now we are talking business: you started with 1 euro, made some trades, and ended up with 2 euros. There is, of course, a catch. The prices that we just suggested would not be consistent with equilibrium in the foreign exchange markets. As we have just seen, there is a simple recipe for making unlimited profit at these prices, not only for you but also for everyone else in the market. What would happen? Everyone would try to capitalize on the same opportunity that you saw. Those with euros would want either to sell them in the euro market—because euros are valuable—or to use them to buy dollars in the dollar market—because dollars are cheap. Those with dollars, however, would not want to buy expensive euros in the euro market, and they would not want to sell them in the dollar market. Hence, in the euro market, the supply of euros would shift rightward, and the demand for euros would shift leftward. The forces of supply and demand would make the dollar price of euros decrease. In the dollar market, the supply of dollars would shift leftward, and the demand for dollars would shift rightward, causing the euro price of dollars to increase. The mechanism we just described is arbitrage at work again. The arbitrage possibility between the dollar market for euros and the euro market for dollars disappears when the following equation is satisfied: $price\ of\ euro\ in\ dollars \times price\ in\ dollar\ in\ euros\ = 1.$ When this condition holds, there is no way to buy and sell currencies in the different markets and make a profit. As an example, suppose that EUR 1 costs$2 and $1 costs EUR 0.5. These prices satisfy the equation because $2 \times 0.5 = 1$. Imagine you start with$1. If you use it in the dollar market for euros to buy euros, then you will have EUR 0.50. If you then use these in the euro market for dollars to buy dollars, you will get $2 for each euro you supply to the market. Since you have half of a euro, you will end up with$1, which is what you started with. There is no arbitrage opportunity.
By now you have probably realized that there is a close connection between the market for euros and the market for dollars (where dollars are bought and sold using euros). Whenever someone buys euros, they are selling dollars, and whenever someone sells euros, they are buying dollars. In our two-country, two-currency world, the market for euros and the market for dollars are exactly the same market, just looked at from two different angles.
Here we show the market where euros are bought and sold with dollars (a) and the market where dollars are bought and sold with euros (b). Because of arbitrage, these are just two different ways of looking at the same market.
We illustrate this in Figure 24.4.2 "The Market for Euros and the Market for Dollars". In part (a) of Figure 24.4.2 "The Market for Euros and the Market for Dollars", we show the market where euros are bought and sold, and in part (b) of Figure 24.4.2 "The Market for Euros and the Market for Dollars" the market where dollars are bought and sold. The supply curve for dollars is just the demand curve for euros, and the demand curve for dollars is the same as the supply curve for euros. For example, suppose 1 euro costs $2. From part (a), we see that, at this price, people would supply EUR 3,200. In other words, there are individuals who are willing to exchange EUR 3,200 for$6,400. If we think about this from the perspective of the market for dollars, these people would demand $6,400 in the market when$1 costs EUR 0.50—and, indeed, we see that this is a point on the demand curve in part (b). The market is in equilibrium when EUR 1.00 costs $1.25, or equivalently when$1 costs EUR 0.80. At this exchange rate, holders of dollars are willing to give up $2,500, and holders of euros are willing to give up EUR 2,000. Arbitrage with Many Currencies We live in a world with many different currencies, not just two. Figure 24.4.3 "Exchange Rates" shows some exchange rates from http://www.oanda.com, a site that provides current and historical data on exchange rates and that is also an online market where you can trade currencies. So, on March 11, 2007, just after midnight, the price of a euro in dollars was 1.3115. At the same time, the price of a dollar in British pounds was 0.5176. Figure $3$: Exchange Rates These tables come from http://www.oanda.com. The table on the left shows exchange rates among four currencies and the table on the right shows the rates at which you can actually conduct trades at this site. If you look at the table on the left side of Figure 24.4.3 "Exchange Rates", you see that it provides both the dollar price of the euro and the euro price of the dollar (and similarly for the other currency pairs). Tables such as this one have already built in the arbitrage condition, so you cannot keep buying and selling the same currency in exchange for dollars and make money. When there are multiple currencies, we can imagine more complicated trading strategies. As an example, consider the following string of transactions. 1. Take a dollar and use it to buy euros. 2. Take the euros and buy Japanese yen. 3. Take the yen and buy dollars. If you end up with more than$1, then there are profits to be made buying and selling currencies in the manner outlined here. Can you make a profit this way? The answer, once again, is no. If you could, then the markets for foreign currency would not be in equilibrium: everyone would buy euros with dollars, sell them for yen, and then sell the yen for dollars. Once again, exchange rates would rapidly adjust to remove the arbitrage opportunity.
To verify this, let us go through this series of transactions using Figure 24.4.3 "Exchange Rates". One dollar will buy you EUR 0.7625. Now take these and use them to buy yen. You will get $0.7625 \times 155.1910 = JPY 118.3331.$ Now, use these yen to buy dollars, and you will get $118.3331 \times 0.00845 = 0.9999.$ You start with $1; you end with$1 (give or take a rounding error).
These calculations assume that there are no costs to trading foreign currencies. In practice, there are costs involved in these exchanges. A traveler arriving at an airport in need of local currency does not see rates posted as in the left-hand table in Figure 24.4.3 "Exchange Rates". Instead, they see something that looks like the right-hand table, where rates are posted in two columns: bid (buying) and offer (selling). The bid is a statement of how much the currency seller is willing to pay in local currency for the listed currency. The offer column is the price in local currency at which the seller is willing to sell to you. Naturally, the offer price is bigger than the bid: the seller buys currencies at a low price and sells them at a high price. The difference between the bid and offer prices is called the spread. The existence of the spread means that if you try to buy and sell currencies with the dealer, you will actually lose money. At the same time, the spread creates a profit margin for the dealer and thus pays for the service that the dealer provides.
Arbitrage with Goods and Currencies
We have talked about arbitrage with goods and arbitrage with foreign currencies. We can also put the two together to study the prices of goods that are traded across international borders. Arbitrage of goods from one country to another is a bit more complicated because it involves buying and selling currencies as well as goods. To see how this works, imagine you are going on a trip to Europe. You are allowed two suitcases filled with belongings free of charge on the airplane. What about filling a suitcase full of new blue jeans, transporting them to Europe, and then selling them there? Could you make money that way?
Suppose that the dollar price of 1 euro is $1.50. Further, suppose that the price of a pair of blue jeans is$70.00 in the United States and EUR 50.00 in Paris. Consider the following sequence of actions.
1. Take $70 out of your pocket and buy a pair of blue jeans. 2. Travel with these blue jeans to Paris. 3. Sell the jeans for euros. 4. Buy dollars with your euros. The question is whether you can make money in this way. The answer is given by how many dollars you will have in your pocket at the end of these steps. When you sell the jeans in Paris, you will have EUR 50.00. If the dollar price of euros is$1.50, then by selling the jeans in Paris you will get 50 × $1.50 =$75. This is a profit of $5 for each pair of jeans—you are in business. Once again, the opportunity for arbitrage suggests that this situation is unlikely to persist. Entrepreneurs will buy jeans in the United States, take them to Paris, and sell them there. Market forces in three different markets will work to eliminate the profit. First, the activity of arbitrageurs will increase the demand for jeans in the United States, causing the US price of jeans to increase. Second, the increased supply of jeans in Paris will cause the price there to decrease. And third, there will be an increased supply of euros in the foreign exchange market, which will cause the euro to depreciate. This is shown in Figure 24.7 "International Arbitrage Restores the Law of One Price". When blue jeans cost$70 in the United States and EUR 50 in France, and the exchange rate is $1.50 per euro, arbitrageurs can make a profit by importing blue jeans to Europe from the United States. These price changes continue until there are no profits to be made by arbitrage. Exactly how much of the adjustment will take place in each market depends on the slopes of the supply and demand curves. In Figure 24.4.4 "International Arbitrage Restores the Law of One Price", we have drawn the new equilibrium as follows: blue jeans cost EUR 49 in Europe and$71.05 in the United States; and the exchange rate is $1.45 per euro. At these prices, $price\ of\ blue\ jeans\ in\ dollars\ =\ price\ of\ blue\ jeans\ in\ euros \times price\ of\ euro\ in\ dollars,$ and there is no longer any possibility of arbitrage. This is another illustration of the law of one price. If we were literally talking just about arbitrage in blue jeans, most of the adjustment would take place in the markets for blue jeans in the United States and Europe, and there would be a negligible effect on the exchange rate. But if the same kinds of arbitrage opportunities exist for lots of goods, then there will be an impact on the exchange rate as well. For tradable goods, the law of one price says that the $dollar\ price\ of\ good\ =\ euro\ price\ of\ good \times dollar\ price\ of\ euro.$ When this condition holds, there are no arbitrage profits to be gained by purchasing the good with dollars, selling it for euros, and then buying dollars with euros. Likewise, if this condition holds, there are also no arbitrage profits from purchasing the good with euros, selling it for dollars, and then buying euros with dollars. In general, we expect that such arbitrage will occur very quickly. There are no profits to be made from arbitrage when the law of one price holds. The Economist has kept track of the price of a McDonald’s Big Mac in a number of countries for many years, creating something they call the “the Big Mac index.” Table 24.4.1 "The Economist’s Big Mac Index, July 2011" contains some of their data. The last column of Table 24.4.1 "The Economist’s Big Mac Index, July 2011" gives the price of a Big Mac in each selected country in July 2011, converted to US dollars at the current exchange rate. That is, the last column is calculated by dividing the local currency price (the second column) by the exchange rate (the third column). A Big Mac costs$4.07 in the United States but more than twice as much in Norway. China is a real deal at only $1.89. Country Local Currency Price of Big Mac Local Currency Price of a Dollar Price in US Dollars United States USD 4.07 1 4.07 Norway NOK 45 5.41 8.31 Euro Area EUR 3.44 0.70 4.93 Czech Republic CZK 69.3 17.0 4.07 China CNY 14.7 6.45 1.89 Table $1$: The Economist’s Big Mac Index, July 2011 Source: “The Big Mac Index: Currency Comparisons, to Go,” Economist online, July 28, 2011, accessed August 2, 2011, http://www.economist.com/blogs/dailychart/2011/07/big-mac-index. The price differentials in this table violate the law of one price: there is (apparently) profit to be made by buying Big Macs at a low price and selling them at a high price. Applying the principle of arbitrage, we should all be flying to China, buying Big Macs, traveling to Norway, and selling them on the streets of Oslo. Of course, there are a few small problems with this scheme, such as the following: • It is expensive to fly back and forth between China and Norway. • There is a limited capacity for transporting Big Macs on the airplane. • The quality of the Big Mac might deteriorate while it is being transported. • You might not be permitted to import meat products from China into Norway. • You might have to pay taxes when you bring Big Macs into Norway. • It might be tough to open a McDonald’s in Oslo. This long list easily explains the deviations from the law of one price for Big Macs. Similar considerations explain why the law of one price might not hold for other goods. The law also does not apply to services, such as tattoos, since these cannot be imported and exported. The law of one price is most applicable to goods that are homogeneous and easily traded at low cost. Economists use the law of one price as a guide but certainly do not expect it to hold for all products in all places. Using the Law of One Price to Understand the Exchange Rate There is another way to interpret the finding that Big Macs do not cost the same in each country. The Economist uses this information to draw conclusions about the values of different currencies and how these values are likely to change over time. From this perspective, the Big Mac is more expensive in Europe than in the United States because dollars are cheap in Europe. Put differently, we say that the dollar is undervalued relative to the euro. If the price of a dollar in euros were 0.85 instead of 0.70, then a Big Mac would cost the same in the United States and Europe. Completely equivalently, we can say that that the euro is overvalued relative to the dollar. With this in mind, we might expect the undervalued dollar to increase in value relative to the euro. That is, we would expect the price of a dollar in euros to increase. Similarly, we would conclude that the Norwegian kroner is overvalued relative to the dollar, the Chinese yuan is undervalued, and the Czech Koruna is neither overvalued nor undervalued. To see how this works more generally, look back at our arbitrage condition for blue jeans. If we divide both sides by the price of blue jeans in euros, we get This equation says that, according to the law of one price, the dollar price of the euro should equal the dollar price of blue jeans divided by the price of blue jeans in euros. This is exactly the kind of calculation that underlies the Big Mac index, only with blue jeans instead of Big Macs. Equivalently, the law of one price says that the Suppose we think about this equation applying (approximately) to all goods and services. We can then get a better prediction of the exchange rate by looking at a general price index in each country: Because of all the reasons why the law of one price does not literally hold, economists certainly do not expect this equation to give an exact prediction of the exchange rate. Nevertheless, it can provide a useful indication of whether a currency is undervalued or overvalued. A currency is undervalued if, following this equation, its price is too low compared to the ratio of price levels in the two countries. A currency is overvalued if, following this equation, its price is too high compared to the ratio of price levels in the two countries. As in our discussion of the euro, if a currency is overvalued, then we would expect its value to decrease over time. This is called a depreciation of the currency. Likewise, we would expect the price of an undervalued currency to increase over time. This is called an appreciation of the currency. The market forces behind these currency movements come from the buying and selling of currencies for trading purposes. If the Chinese yuan is undervalued, goods produced in China will be relatively cheap in US dollars. The demand for Chinese exports will be high, and this will lead to a large demand for the yuan. Eventually the dollar price of the yuan will increase—that is, the yuan will appreciate, and the dollar will depreciate. Changes in the Exchange Rate Even though the law of one price does not literally hold for all goods and services, it reminds us that the value of$1 in the United States is linked to its value in the rest of the world. As a result, we expect that price level changes are likely to lead to changes in the exchange rate. We see this more clearly if we write our previous equation in terms of growth rates. Using the formula for growth rates, we find the following:
$growth\ rate\ of\ price\ of\ dollar\ in\ euros\ =\ growth\ rate\ of\ price\ of\ European\ bundle\ of\ goods\ − growth\ rate\ of\ price\ of\ US\ bundle\ of\ goods.$
Toolkit: Section 31.21 "Growth Rates"
The formulas for using growth rates can be found in the toolkit.
If the bundle of goods in each country corresponds roughly to the goods in the Consumer Price Index (CPI), then the growth rate of these prices corresponds to the inflation rate. The growth rate of the exchange rate is just another term for the percentage appreciation of the currency. Thus we get the following:
$percentage\ appreciation\ of\ the\ dollar ≈ European\ inflation\ rate − US\ inflation\ rate.$
So, if the inflation rate in the United States is higher than it is in Europe, we expect the euro price of the dollar to decrease. We expect depreciation of the dollar if US inflation exceeds European inflation. Inflation reduces the real value of money domestically; it will also tend to reduce the value of money in terms of what it can purchase in the rest of the world. This makes sense. If our currency is becoming less valuable at home, then we should also expect it to become less valuable in the rest of the world.
The Real Exchange Rate
The law of one price is connected to another measure of the exchange rate—the real exchange rate. This exchange rate is a measure of the price of goods and services in one country relative to another when prices are expressed in a common currency. It is about exchanging goods, rather than money, across countries.
The real exchange rate between the United States and Europe is given as follows:
You can think of the real exchange rate as the number of units of European gross domestic product (GDP) you can get for one unit of US GDP.Let us check the units of the real exchange rate. The US price level over the European price level is in dollars/euros: it is the price of a unit of US real GDP divided by the price of a unit of European real GDP. The nominal exchange rate is measured in euros per dollar. Thus the units are as follows:The dollars and the euros cancel out in this expression, so the real exchange rate is just a number. For example, if the price level in the United States is $1,600, the price level in Europe is EUR 400, and the price of dollars in euros is EUR 0.5, then the real exchange rate is as follows: One unit of US GDP will get you two units of European GDP. The real exchange rate is intimately linked to the law of one price. The easiest way to see this is to suppose that we measure US real GDP and European GDP in the same units: that is, suppose we use the same bundle of goods in each case. We know that the law of one price should hold for tradable goods—that is, goods for which arbitrage is possible and practical. If every good that went into GDP were tradable, then the law of one price would hold for every good, and the real exchange rate would equal 1. If the real exchange rate was not 1, you could make arbitrage profits by buying and selling “units of GDP.” As before, suppose the US price level is$1,600, the European price level is EUR 400, and the nominal exchange rate (dollars per euro) is 0.5. Imagine that US GDP and European GDP measure the same bundle of (tradable) goods. Then you could take $800 and buy EUR 400. With these euros, you could buy a basket of goods in Europe. You could sell this basket in the United States for$1,600. The law of one price is violated. We would expect the following:
• Prices in the United States would increase.
• Prices in Europe would decrease.
• The nominal exchange rate would depreciate (the dollar would become less valuable).
Because arbitrage is not possible for all goods and services, we do not expect—nor do we observe—the real exchange rate to be exactly one. But this benchmark is still useful in understanding movements in the real exchange rate.
The Real Exchange Rate in Action
The real exchange rate matters because it is the price that is relevant for import and export decisions. Suppose you are trying to decide between buying a mobile phone manufactured in the United States and one manufactured in Finland. If the dollar appreciates against the euro, then the US phone retailer needs fewer dollars to purchase euros, so Finnish phones will be cheaper in US stores. If prices decrease in Finland, the imported phone again becomes relatively cheaper. If prices increase in the United States, the US phone will be more expensive. In other words, increasing prices in the United States, decreasing prices in Finland, and appreciation of the dollar all make you more likely to buy the imported phone rather than the domestically produced phone.
More generally, anything that causes the real exchange rate to increase will make imports look more attractive compared to goods produced in the domestic economy. Examined from the point of view of Europe, the same increase in the real exchange rate makes US goods look more expensive relative to goods produced in Europe, so Europeans will be likely to import fewer goods from the United States. An increase in the real exchange rate therefore leads to an increase in US imports and a decrease in US exports—that is, it leads to a decrease in net exports.
The real exchange rate can and does vary substantially over time. Argentina in the 1990s provides a nice illustration of real exchange rates in action. We discuss this in more detail in Chapter 26 "Inflations Big and Small". Argentina had a currency board during this period. Under a currency board, a country maintains a fixed exchange rate by backing its currency completely with another currency. Although Argentina did have its own currency (the Argentine peso), each peso in circulation was backed by a US dollar held by the Argentine central bank. You could at any time exchange pesos for dollars at a nominal exchange rate of 1.
Figure 24.4.5 "The Real Exchange Rate in Argentina" shows what happened to prices in Argentina and the United States over this period. Look at 1992–95. Both countries had some inflation. But prices were increasing faster in Argentina than in the United States. The real exchange rate (Argentina–United States) is given by
because the price of the peso in dollars was 1. Therefore the real exchange rate appreciated as Argentine inflation outpaced US inflation.
The appreciation of the real exchange rate meant that Argentine goods became more expensive in other countries, so Argentine exports became less competitive. (The problem was compounded by the fact that the US dollar [and hence the peso] also appreciated against the currencies of neighboring countries such as Brazil.) Without the currency board, it would have been possible for the nominal exchange rate (price of the peso in dollars) to decline, offsetting the effects of the inflation rate. Instead, this appreciation of the real exchange rate ended up causing substantial economic problems in Argentina in the 1990s. In the second half of the decade, the real exchange rate began to depreciate because the inflation rate in Argentina was lower than in the United States. The appreciation at the start of the decade had been so large, however, that the real exchange rate in 1999 was still higher than it had been in 1992.
Figure $5$: The Real Exchange Rate in Argentina
Argentina’s real exchange rate appreciated between 1992 and 1995 because the nominal (US dollar–Argentine peso) exchange rate was constant and equal to one, and the price level increased more rapidly in Argentina than in the United States.
Source: CPI inflation figures from International Monetary Fund World Economic Outlook database ( www.imf.org/external/pubs/ft/weo/2006/01/data/dbcselm.cfm?G=205) and Bureau of Labor Statistics ( www.bls.gov).
If countries want to have a permanently fixed exchange rate, there is an option that is more radical than a currency board. Countries can decide to adopt a common currency, like the European countries that adopted the euro. There are several reasons why countries might decide to take such a course of action. The first advantage of a common currency is that it enhances the role of money as a medium of exchange. There is no longer a need to exchange one currency for another, making it easier to trade goods and services across countries. People do not have to deal with the inconveniences of exchanging currencies: individuals do not have to exchange cash at airports, and firms do not need to manage multiple currencies to conduct international business. In the jargon of economics, a single currency removes transaction costs. These costs might be individually small, but they can add up when you consider just how many times households and firms needed to switch from one of the euro area currencies to another.According to studies supporting a common currency, these gains from reduced transactions costs were substantial. One of the key analyses was the Delors report. A summary of that report is available at “Phase 3: the Delors Report,” European Commission, October 30, 2010, accessed August 22, 2011, http://ec.europa.eu/economy_finance/euro/emu/road/delors_report_en.htm. A complete report on the history of the euro is available at “One Currency for One Europe: The Road to the Euro,” European Commission, 2007, accessed August 22, 2011, http://ec.europa.eu/economy_finance/publications/publication6730_en.pdf.
One way to picture this advantage is to imagine the reverse. Suppose, for example, that each state in the United States decided to adopt its own currency. Trade across state lines would become more complicated and more costly. Even more starkly, imagine that your hometown had its own currency, so you had to exchange money whenever you traveled anywhere else.
A second advantage of a single currency is that it makes business planning easier. A firm in Belgium can write a contract with another firm in Spain without having to worry about the implications of currency appreciation or depreciation. Thus an argument for the move to a single currency was that such a change was likely to encourage trade among countries of the European Union. Again, imagine how much more complicated business would be in the United States if each state had its own freely floating currency.
Finally, a common currency enhances capital flows. Just as it is easier for businesses to trade goods and services, it is also easier for investors to shift funds from country to country. With a common currency, investors do not have to pay the transactions costs of converting currencies, and they no longer face the uncertainty of exchange rate changes. When capital flows more easily across borders, investment activity is more productive, enhancing the growth of the countries involved.
Key Takeaways
• The nominal exchange rate is the price of one currency in terms of another. The real exchange rate compares the price of goods and services in one country to the cost of these goods and services in another country when all prices are in a common currency.
• From the law of one price, a tradable good in one country should have the same price as that same good in another country when the goods are priced in the same currency. This means that the exchange rate is equal to the ratio of the prices expressed in the two different currencies. Put differently, by the law of one price, the real exchange rate between tradable goods should be 1.
Exercises
1. If the price of a euro was \$2 and the price of a dollar was 1 EUR, how would you make a profit?
2. If goulash sells for either 1,090 forint or 4.40 euro, what is the price of the forint in terms of the euro? Do the two prices of cabbage quoted in Figure 24.2.1 "The Euro as a Unit of Account" yield a different euro price for the forint? Is there an arbitrage possibility here (or elsewhere on the menu)? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/24%3A_Money-_A_Users_Guide/24.04%3A_Using_Money_to_Buy_Other_Monies-_Exchange_Rates.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is the difference between nominal interest rates and real interest rates?
2. What is the yield curve?
3. What is the Fisher equation?
We have now discussed how you could use your $100 to buy goods and services or the money of another country. You can also use your money to buy money in the future. When we say this, we are simply describing a familiar transaction in an unfamiliar way: we are talking about saving. If you put money in a bank, then you are buying money in the future with money you give up today. When you save in this way, you become a participant in the credit markets (or loan markets). Toolkit: Section 31.24 "The Credit (Loan) Market (Macro)" A credit market (or loan market) brings together suppliers of credit, such as households who are saving, and demanders of credit, such as businesses and households who need to borrow. You can review the credit market in the toolkit. Arbitrage with Credit and Assets Suppose you do not want to spend your$100 until next year. You could just put the money under your mattress, but a better option is to find some way of getting more than $100 next year. One way to do this is to lend your money to someone else. For you, this might simply mean taking it to your bank and putting it in your savings account. When you do that, you are making a loan to the bank. Of course, the bank probably will not leave the money in its vault; it will lend that money to someone else. Banks and other financial institutions act as intermediaries between those who want to save and those who want to borrow. Figure $1$: The Credit Market and the Asset Market Credit markets and asset markets are two ways of looking at the same market: the market for$100 loans (a) with an equilibrium interest rate of 5 percent is the same as the market for an asset that promises to pay $105 in a year’s time (b). The credit market brings together the suppliers and demanders of credit, and the nominal interest rate is the price that brings demand and supply into balance. The supply of credit increases as the interest rate increases: as the return on saving increases, households will generally save more and thus supply more funds to the credit market. The demand for credit decreases as the interest rate increases: when it is expensive to borrow, households and firms will borrow less. At the equilibrium interest rate, the quantity of credit supplied and the quantity of credit demanded are equal. This is shown in part (a) of Figure 24.5.1 "The Credit Market and the Asset Market". There is another way to look at credit markets. Borrowers get money today in exchange for a promise to pay money later. Lenders purchase those promises by giving up money today. Instead of asking how much the interest rate is for a given$100 loan, we could ask what people would be willing to pay today for the right to receive $105 in a year’s time. The market for the promise to pay$105 in a year is illustrated in part (b) of Figure 24.5.1 "The Credit Market and the Asset Market". The units on the horizontal axis are $105 payments. These are assets: buyers are purchasing a piece of paper that is a promise to deliver$105 in a year’s time. The price on the vertical axis is the current price of that asset.
The nominal rate of return on an asset is the amount that you obtain, in percentage terms, from holding the asset for a year. In the case of the simple one-year asset we are considering, the return is given as follows:
We can also rearrange this to give us the price of the asset:
Notice what happens when we look at the market in this way. Buyers have become sellers, and sellers have become buyers. Borrowers are sellers: they sell the promise to pay. Lenders are buyers: they purchase the promise to pay. If we are looking at the same group of buyers and sellers as before, then the current equilibrium price of this asset would be $100. The nominal interest rate and the nominal rate of return defined through these two markets must be the same. If not, there would be an arbitrage possibility. Imagine, for example, that the interest rate is 5 percent but the price of the asset is$90. In this case, the rate of the return on asset is which is 22.2 percent. So you could make a lot of money by borrowing at a 5 percent interest rate and then purchasing the promises to pay $110 at price of$90.
If you could do this, so also could many major financial institutions—except that they would operate on a much larger scale, perhaps buying millions worth of assets and borrowing a lot in credit markets. So the demand for credit would shift outward, as would the demand for assets. This would cause the interest rate to increase and the asset price to increase, so the rate of return on the asset decreases. This would continue until the arbitrage opportunity disappeared.
In summary, we would say there is no arbitrage opportunity when the
$nominal\ rate\ of\ return\ on\ asset = nominal\ interest\ rate.$
The rate of return on the asset, in other words, is equivalent to the interest rate on the asset. Equivalently this means that
In the second line we replaced $(1 + nominal\ interest\ rate)$ with the nominal interest factor. The two are equivalent, but sometimes we find it more convenient to work with interest factors rather than interest rates.
The argument that we have just made should seem familiar. It is analogous to the argument for why there cannot be distinct dollar-euro and euro-dollar markets; they are just ways of looking at the same asset. Likewise, we can think of the sale of any asset as equivalent to borrowing, while for any example of credit we can also think of there being an underlying asset.
Different Assets
Very often economists and others talk about “the” interest rate, as if there were just a single asset in the economy. In fact, there are many different assets that you could buy with your $100, each with an associated interest rate. The following are various assets that you might purchase: • Currency and coin. To begin with, your$100 is itself an asset. If you put the money under a mattress and retrieve it after a year, it is very easy to calculate the nominal interest rate on $100. If you give up$100 today, you will get exactly $100 back next year. The nominal interest rate is zero. • Bank deposits. Bank deposits are also an asset. If you put your money in the bank, you are extending credit to the bank. Depending on the type of bank account, you may or may not earn interest on your deposits. • Foreign exchange. The money of other countries is likewise an asset. You can take dollars today and use them to purchase, say, euros or Japanese yen (JPY). Even in this case, there is a rate of return. For example, suppose that today you can buy JPY 100 with$1. Suppose also that in a year’s time, there are JPY 90 to the dollar. Then with your JPY 100, you can buy $1.11 (100/90 = 1.11). You obtained a nominal rate of return of 11 percent. • Gold and other precious metals. You could take your$100 and use it to buy gold. Unless you are a dentist or a jeweler, you will not have any direct use for the gold; you simply keep it and resell it at some future date. The rate of return on gold is purely a matter of what happens to the price of gold. If the price of gold (in dollars) increases by 10 percent, then you get a 10 percent rate of return.
• Government bonds. A government bond is also a loan contract; if you buy a government bond, you are extending credit to the government. The bond is a promise to pay a certain amount at some future date. Because the loan will be paid off a number of years in the future, it is slightly more complicated to calculate the interest rate.
• Shares. Another example of an asset is a share in a company, such as Dell Inc. If you purchase a Dell share, you have bought the right to a share in Dell’s profits. In this case, you expect not only one payment at a specified future date but also a sequence of payments whenever Dell pays out dividends. Notice that there is also a lot of uncertainty here: you do not know, when you purchase the share, how big these payments will be. The implied interest rate is therefore uncertain as well.
• Real estate. If you purchase a house, you own yet another kind of asset. The value of a house comes from the fact that people can live in it. If you rent your house out, then it gives you a flow of income, much like a share in a company. If you live in your house, then you consume that flow of services, but we still think of the house as an asset because at any time you can sell your house and transfer that flow of services to someone else.
We could list many more assets, but you should be getting the general idea. Most of these assets are more complicated than the simple one-year credit contract with which we began. For one thing, they often involve a whole stream of repayments at different dates, rather than just one repayment. For another, the amounts of these payments may be uncertain.
In 24.2 Section "What Is Money?", we pointed to the different characteristics and functions of money. For most of us, the word money conjures up images of currency and coins. But some of the other assets that we listed also can perform more or less well as money. For example, bank deposits in a checking account or with a linked debit card are portable, durable, divisible, and widely acceptable and serve as a medium of exchange. In general, any asset that performs the functions of money is money. Gold can be used as a store of value and perhaps also as a unit of account, but it is not often used as a medium of exchange. There are many different assets in the world, and they vary in the extent to which they perform these different functions and thus how good they are as money.
Arbitrage with Different Assets: The Term Structure of Interest Rates
We just observed that there are many different assets and thus many interest rates in the economy. But these interest rates are all linked to each other because the same people (particularly banks and other financial institutions) trade in many different markets.
One way in which assets differ is in terms of their maturity. To see how the returns on assets of different maturity are linked, consider two government bonds of different maturities: one-year bonds and two-year bonds. Here are two different ways you could save for two years.
1. Buy a one-year government bond. Collect the payment at the end of the year and then reinvest that money in another one-year bond.
2. Buy a two-year government bond.
There are three interest rates relevant to your choice. The first one is the current interest rate on a one-year bond. The second is the interest rate on a one-year bond next year. The third interest rate is the annualized nominal interest rate on a two-year government bond. An annualized interest rate is the interest rate earned each year on a loan that lasts many years, and the annualized interest factor is (1 + the annualized interest rate). For example, suppose that the annualized rate on a two-year loan is 6 percent. Then you would earn 6 percent per year for two years, and
$repayment\ after\ two\ years = 100 \times 1.06 \times 1.06 = 112.36.$
As you might expect, these three interest rates are connected, and we can understand how by again thinking about arbitrage. If you purchase the two-year government bond return, you get
$100 \times (annualized\ nominal\ interest\ factor\ on\ two-year\ bond)^{2}$
Conversely, if you purchase the two one-year bonds, you get
$100 \times (nominal\ interest\ factor\ this\ year) \times (expected\ nominal\ interest\ factor\ next\ year).$
Notice that we have referred to next year’s interest factor as “expected.” This is because when you make your decision, you do not know what the interest rate will be.
When
$(annualized\ nominal\ interest\ factor\ on\ two-year\ bond)^{2} = nominal\ interest\ factor\ this\ year \times expected\ nominal\ interest\ factor\ next\ year,$
the two transactions have the same return. Once again, we can appeal to an arbitrage argument to say that we expect this equation to hold. There is one twist, however. When you make this decision, you do not know for sure what the interest rate will be on one-year bonds next year. You have to make a guess. Thus this arbitrage involves some risk.
This relationship is an example of the term structure of interest rates, which describes the relationship between the actual and expected returns on assets that are identical except for their maturities. A version of the relationship applies to not only assets of one-year and two-year maturity but also assets of all maturities.
From the term structure of interest rates, we learn something very significant: if the annual one-year interest rate is below the annual rate on a two-year loan, then interest rates are expected to increase in the future. For example, if the annual one-year interest rate is 5 percent and the annual rate on two-year loans is 6 percent, this means both borrowers and lenders expect one-year interest rates to be higher than 6 percent next year. (If desired, you can calculate exactly what the expected rate is by using the previous equation.)
We can see the connection between assets of different maturities by looking at the yield curve.For more details and additional graphs, see J. Huston McCulloch, “The US Real Term Structure of Interest Rates: With Implicit Inflation Premium,” updated October 30, 2009, accessed August 22, 2011, http://www.econ.ohio-state.edu/jhm/ts/ts.html. The yield curve shows the current annual return for assets of different maturities. Figure 24.5.2 "The Yield Curve" shows the yield curve for US Treasury securities in 2011.This is an average of rates in 2011 for US Treasury securities of different maturities from http://www.econstats.com/r/rusa_ew6.htm. On the horizontal axis of the yield curve is the number of years to maturity of the asset. On the vertical axis is the current annual yield on the asset. Notice that the yield curve is upward sloping: the longer the maturity, the higher the annual interest rate. This is generally what we observe, although sometimes the yield curve is inverted, meaning that higher maturity debt has a lower interest rate.
Figure $2$: The Yield Curve
All assets are linked, not just government bonds of different maturities. Suppose that the interest rate on one-year government bonds increases. To buy these bonds, financial institutions will start selling other assets—not only bonds at other maturities but also stocks, holdings of foreign currencies, and so on. As they sell those other assets, their prices will decrease, and their rate of return will increase. An increase in the interest rate on one-year treasuries therefore increases interest rates on other assets. Thus different interest rates typically move together, and it is usually not too misleading, at least for the purposes of macroeconomics, to think about there being a single interest rate in an economy.
Arbitrage with Assets and Goods: The Real Interest Rate
The exchanges we have described so far have all been in terms of dollars. The interest rates paid on such exchanges are nominal interest rates. In a world where prices are increasing, however, the nominal interest rate does not represent the true cost of borrowing and lending.
To see why, begin by recalling that the inflation rate is defined as the percentage change in the price level. This means that the price level next year is equal to the price this year multiplied by $(1 + inflation\ rate)$.If this is not clear to you, write out the inflation rate as follows: Then add one to both sides and multiply by the price level this year. Now imagine that two individuals, Bert and Ernie, want to write a credit contract. Bert wants to borrow some money to buy a pizza. The price of a pizza this year is $10, so Ernie lends Bert$10, and they agree on a nominal interest rate for this credit arrangement. This means that next year he will repay $10 \times (1 + nominal\ interest \rate).$
We could also imagine that Bert and Ernie decide to write a different kind of contract to guarantee a return in terms of pizzas. Because this rate of return is specified in terms of goods rather than money, it is a real interest rate. Ernie agrees to give Bert (enough dollars to buy) 1 pizza this year in return for being repaid (enough dollars to buy) $(1 + real\ interest\ rate)$ pizzas next year. Ernie lends Bert $10 as before (the equivalent of 1 pizza). To repay this loan next year, Bert must give Ernie enough money to buy (1 + real interest rate) pizzas. The price of a pizza has increased to $10 \times (1 + inflation\ rate)$, so Bert must give Ernie $10 \times (1 + real\ interest\ rate) \times (1 + inflation\ rate)$. If you have worked through this chapter carefully, you probably know what is coming next. Because of arbitrage, we know that these two contracts must be equivalent: $1 + nominal\ interest\ rate = (1 + real\ interest\ rate) \times (1 + inflation\ rate).$ As an approximation, this equation implies that theTo see this, multiply out the right-hand side and subtract$1 from each side to obtain nominal interest rate = real interest rate + inflation rate + real interest rate × inflation rate. Now, if the real interest rate and the inflation rate are small numbers, then when we multiply them together, we get a very small number that can be safely ignored. For example, if the real interest rate is 0.02 and the inflation rate is 0.03, then their product is 0.0006, and our approximation is about 99 percent accurate.
$nominal\ interest\ rate ≈ real\ interest\ rate + inflation\ rate.$
This relationship is called the Fisher equation.
Toolkit: Section 31.8 "Correcting for Inflation"
Nominal interest rates and real interest rates are related by the Fisher equation. To convert from nominal interest rates to real interest rates, we use the following formula:
$real\ interest\ rate ≈ nominal\ interest\ rate − inflation\ rate.$
If you want to know more about the Fisher equation, you can look in the toolkit.
For example, if a loan has a 12 percent interest rate and the inflation rate is 8 percent, then the real return on that loan is 4 percent. Since the nominal interest rate and the inflation rate are easily observed by most of us, we can use the Fisher equation to calculate the real rate of interest. We use the Fisher equation whenever we see a nominal interest rate and wish to convert it to a real interest rate. Just as it is the real exchange rate that matters for people trading goods and assets between countries, so it is the real interest rate that ultimately matters to borrowers and lenders in the economy.
In macroeconomics, we often look at the credit market for the entire economy, where savings and investment are matched in the economy as a whole. The price in this market is the real interest rate. The response of savings and investment to the real interest rate is shown in Figure 24.5.3 "The Credit Market". Once we know the equilibrium real interest rate, we calculate the implied nominal interest rate using the Fisher equation.
Figure $3$: The Credit Market
Adjustment of the real interest rate ensures that the flows in and out of the financial sector balance.
The (net) supply of loans in the domestic credit market comes from three different sources:
1. The private savings of households and firms
2. The savings or borrowing of governments
3. The savings or borrowing of foreigners
Households will generally respond to an increase in the real interest rate by reducing current consumption relative to future consumption. Households that are saving will save more; households that are borrowing will borrow less. Higher interest rates also encourage foreigners to send funds to the domestic economy. Government saving or borrowing is little affected by interest rates.
National savings are defined as private savings plus government savings (or, equivalently, private saving minus the government deficit). The total supply of savings is therefore equal to national savings plus the savings of foreigners (that is, borrowing from other countries). The matching of savings and investment in the aggregate economy is described as follows:
$investment = national\ savings + borrowing\ from\ other\ countries$
or
$investment = national\ savings − lending\ to\ other\ countries.$
This is the same thing as saying that the flows in and out of the financial sector in the circular flow must balance.
The demand for loans comes from firms who borrow to finance investment. As the real interest rate increases, investment spending decreases. For firms, a high interest rate represents a high cost of funding investment expenditures. This is evident if the firm borrows to purchase capital. It is also true if the firm uses internal funds (retained earnings) to finance investment since the firm could always put those funds in an interest-bearing asset instead.
Toolkit: Section 31.27 "The Circular Flow of Income"
The toolkit provides more detail on the flows in and out of the financial sector.
Arbitrage with Assets and Currencies: Uncovered Interest Parity
If you are like most people, you do not own assets in another country. You may own multiple assets—a savings account that pays you some interest every month, perhaps a certificate of deposit, or shares of some company—but the chances are that all your financial assets are denominated in a single currency. In fact, there is no reason why you should not own assets denominated in other currencies, such as euros, or pesos, or British pounds. You might consider opening a bank account in another country. Or you might even consider other financial investments in another country, such as purchasing a share in an international mutual fund, buying shares of a foreign company, or buying the debt of a foreign government.
Most of us do not know exactly how to go about making such investments. In fact, they are easy to carry out if you make use of the services of professional financial advisers. In any case, we are not really interested in the mechanics of foreign investment here. We want to answer a more fundamental question: how do you know if buying foreign assets would be a good idea? Consider the choice between two investment strategies.
1. Investing in the United States
• Deposit $100 in a US bank. • Wait for a year. 2. Investing in Europe • Take$100 and use it to buy euros.
• Deposit the euros in a European bank.
• Wait for a year.
• Withdraw the deposit and interest and use it to buy dollars.
To decide which is the better strategy, you need to determine how much you will earn in each case.
It is straightforward to determine how much you will get with the first option: you will get your $100 plus the interest payments. For example, if the interest rate at the US bank is 10 percent, then after a year you will earn$10 interest for a total of $110. What about the second strategy? How many dollars will you have if you deposit money in the European bank? This is a bit more complicated. First, you buy euros with your$100. Second, you deposit these euros in a European bank and earn interest. Third, at the end of the year, you withdraw your euros from the bank and sell them for dollars. For example, suppose that the current dollar price of euros is $1.25 and the interest rate paid on deposits in Europe is 5 percent. Suppose you also expect that the price of a dollar in euros will be EUR 0.70 in a year’s time. With the second investment strategy, • You take your$100 and buy EUR 80.
• You put these EUR 80 in the European bank for a year, giving you EUR 84 at the end of the year.
• You take these EUR 84 and use them to purchase $120. The second strategy therefore earns you more than the first strategy. It would be better to invest in Europe compared to the United States. Moreover, a slight variation on this strategy seems like it is a money machine. Consider the following. • Borrow$100 from a US bank for one year.
• Take the $100 and use it to buy euros. • Deposit the euros in a European bank. • Wait for a year. • Withdraw the deposit and interest and use it to buy dollars. • Repay the dollar loan plus interest. Using the same interest rates and exchange rates as previously, this transaction works as follows: you borrow$100, obtain $120 at the end of the year, pay back$110 to the bank, and end up with \$10 profit.
To evaluate this arbitrage possibility, you need to know (1) the current dollar price of euros, (2) the annual return on deposits in Europe, and (3) the price of a dollar in euros a year from now. Look carefully at the language we used. You need to know “the euro price of dollars a year from now.” But when we went through the example, we said “you expect that the price of dollar in euros will be EUR 0.70 in a year’s time.” As with the term structure of interest rates, there is some risk involved here. You cannot know the future exchange rate with certainty. This strategy entails a gamble about the future exchange rate. Still, if everyone has the same guess about the future exchange rate as you do, then such a situation could not last. Everyone would pursue the same strategy: borrow in the United States, buy euros, invest in Europe, and convert back in a year’s time. What would happen?
• The demand for credit would increase interest rates in the United States.
• The demand for euros would increase the dollar price of euros.
• The extra supply of savings in Europe would drive down the interest rate in Europe.
• Investors might anticipate the extra demand for dollars in a year’s time and expect the euro price of dollars to increase.
These forces would all tend to eliminate the profit opportunity.
So when do we expect this arbitrage opportunity to disappear? It disappears when investors expect to make the same profit whether they invest in Europe or the United States. The condition for this is as follows:
The left side is the return on investing in the United States. The terms on the right give the return on investing in Europe. When this condition holds, the returns on deposits in US and European banks are the same. This condition is called uncovered interest parity.
Because we do not know the price of euros next year for sure, this equation does not hold exactly when we look at actual data from the past. That is, the actual exchange rates combined with the actual returns on deposits do not quite satisfy this equation. This does not contradict the theory. Hindsight is perfect. The important point is that if people hold similar beliefs, then uncovered interest parity will hold ahead of time.
Using Uncovered Interest Parity to Understand the Exchange Rate
We can rearrange the uncovered interest parity condition as follows:
Written this way, the equation tells us that beliefs matter. Suppose everyone in the market believes that the dollar will depreciate relative to the euro in the future: that is, everyone expects a decrease in the euro price of the dollar. This makes investment in euro-denominated assets a better deal since we will get a lot of dollars per euro in the future. Investors will respond by selling dollars now to buy euros. This increase in the supply of dollars will cause the current euro price of dollars to decrease.
Thus we see that if everyone expects the euro price of dollars to decrease in the future, then the euro price of dollars will decrease today. When we talk about the market for currencies, demand and supply today depend on what households and firms think about the future exchange rate.
We can also rearrange the equation to see what it tells us about exchange rate beliefs:
If the interest rate in Europe is greater than the interest rate in the United States, then the condition tells us that investors must be expecting the dollar to appreciate.
Key Takeaways
• The nominal interest rate is the return on an asset in terms of money. The real interest rate is the return on an asset measured in terms of goods.
• The yield curve describes the relationship between the (annual) return on an asset and its maturity. Normally, the yield curve is upward sloping: assets with a longer maturity have a higher annual return.
• The Fisher equation links the real interest rate to the nominal interest rate. The real interest rate is approximately equal to the difference between the nominal interest rate and the inflation rate.
Exercises
1. If the nominal interest rate is 5 percent and the inflation rate is 3 percent, what is the real interest rate?
2. Can the real interest rate ever be negative?
3. What are the risks involved in investing in a foreign bank? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/24%3A_Money-_A_Users_Guide/24.05%3A_Using_Money_to_Buy_Assets-_Interest_Rates.txt |
In Conclusion
We began this chapter with a deceptively simple question about money: why do people want it? To answer that question, we first looked at what money is. We discovered that money is an asset that has certain defining characteristics, such as portability, divisibility, and durability. Most importantly of all, though, we said that money must have acceptability. What turns an asset into a money, ultimately, is the simple fact that enough people are willing to treat it as such.
If we look through history, we find that many different things have served as money in different places and at different times. As well as the familiar notes and coins, these include seashells, stones, cigarettes, cans of food, gold, and silver. These could successfully function as money because they were acceptable as money in their particular context.
We then imagined that you were lucky enough to find a $100 bill on the sidewalk and explored the various things that you could do with this money, including buying goods and services, buying other currencies, and buying assets. As we did so, we explored a number of different arguments, all based on arbitrage, that help us to understand the relationships between interest rates, exchange rates, asset prices, and inflation rates. We argued that arbitrageurs will step in when there are easy profit opportunities. Arbitrage does not say that riskless profit opportunities cannot exist. It says that they will not persist. If a riskless profit opportunity were to exist, then people would very quickly take advantage of it and, by so doing, eliminate it. Expressed more metaphorically, economists often say that there are no$100 bills lying on the ground waiting to be picked up. It is not that it is impossible for someone to drop a $100 bill, but if one person has dropped a large bill, someone else will almost certainly pick it up very quickly. There is an immediate and powerful lesson of arbitrage, one that you should bear in mind throughout life. If someone tells you of a surefire way to make easy money, beware! Key Links exercises 1. Suppose you go to a local café to order a drink. Instead of paying with the currency used in your home country, imagine you try to pay with the currency of another country. What do you think the response would be at the café? Why? What could you do to convince them to accept foreign currency at a local café? Imagine that you are at the border of two countries, say in a café near the US border with Canada. Do you think you could use Canadian currency in a US café near the border? 2. When you are traveling in a foreign country and want to use your debit card, what type of fees do you pay to withdraw money in foreign currency? Usually fees take two forms: a fixed fee, say$5, for any size transaction or a fee that is proportional to the amount you withdraw. If you want to make a large withdrawal, which type of fee do you prefer? If the fee is fixed, will this create an incentive to make more or fewer withdrawals? What does the fixed fee do to the size of the withdrawal you make?
3. Suppose the dollar price of euros is $10 and the euro price of dollars is EUR 1. Explain how you could make a profit in this market. What would you buy and what would you sell? Can this be an equilibrium in the foreign exchange market? Show that there are no arbitrage profits if the dollar price of the euro is$1.25 and the euro price of the dollar is EUR 0.80.
4. (Advanced) Using the relationship $price\ of\ euro\ in\ dollars \times price\ of\ dollar\ in\ euros = 1,$
how would you draw the supply and demand curves and depict equilibrium in the market for dollars and the market for euros?
5. Look at the left-hand table in Figure 24.4.3 "Exchange Rates". How are the numbers on the bottom left connected to the numbers on the top right? The diagonal has been left blank. What number could go on the diagonal?
6. Look at the left-hand table in Figure 24.4.3 "Exchange Rates". Suppose you start with GBP 100. Convert those pounds into euros and then convert the euros into dollars. How many dollars would you get? How many pounds do you get if you then convert your dollars into pounds?
7. Perform the same exercise as in Question 6 but use the table on the right-hand side of Figure 24.4.3 "Exchange Rates". How many pounds do you end up with?
8. If the nominal interest rate is 5 percent in France and 3 percent in Europe, according to uncovered interest parity, what do investors think is going to happen to the euro-dollar exchange rate?
9. If the real interest rate is 2 percent in China and 6 percent in India, and investors are not expecting any change in the rupee-yuan exchange rate, then what can you conclude about inflation rates in China and India?
10. Explain how inflation reduces the real value of a currency both domestically and in other countries.
Economics Detective
1. Think of a “basket of goods” you buy often. It should include at least four items (for example, an espresso, a CD, a hamburger, and a copy of Newsweek). E-mail a friend in another country to find the prices for that same basket of goods. Check the exchange rate between your country’s currency and that in your friend’s country. Contrasting the prices in the two countries, look for violations of the law of one price. Is there some way you could make some profit?
2. Check rental car rates across two countries. (This is easy to do online at large car rental companies.) Make sure you choose the same car and insurance options. How might you explain the differences in these rates? Are there arbitrage profits for you to make?
3. Find an issue of the Economist from the period in the 1990s when Argentina was pegging the peso to the US dollar through a currency board, and look up the Big Mac index. What was the exchange rate then? What was the price of a Big Mac in Argentina during that period? Compare the peso prices of Big Macs and dollars between the two time periods.
4. Which countries use the kwacha, the dram, the ringgit, the leke, the baht, and the rial?
5. Suppose you want to convert some US dollars to euros, deposit them in a bank in Italy for one year, and then convert your euros to dollars. Search the Internet to determine how you could arrange now to buy dollars with euros in one year’s time. What price would you have to pay for dollars?
6. Go to www.oanda.com and look at the latest exchange rate data. Find two currencies that have recently appreciated relative to the dollar and two currencies that have recently depreciated relative to the dollar.
7. Find a currency that has appreciated relative to the dollar since March 2007. Can you discover any explanations about why there was this change in the exchange rate?
8. Find data on the dollar price of the euro starting from the inception of the euro. Find periods when the dollar was appreciating relative to the euro. Find periods when the dollar was depreciating relative to the euro.
9. Who holds US government debt? What type of foreign exchange supported this?
10. Use www.minneapolisfed.org/community%5Feducation/teacher/calc to calculate the value of a dollar at different points in time. What would a dollar in 1955 buy today?
11. When you deposit money in the United States, you receive deposit insurance. If you deposit money in a bank in Italy or Japan or Mexico, will you receive deposit insurance? How does the existence of this insurance influence your decision about making deposits in foreign banks?
12. Call your bank to ask a hypothetical question: What will you have to do to deposit a large euro check in your dollar account? What will the bank charge you for this transaction? Are these costs proportional to the size of the euro check or is the cost a fixed number?
Spreadsheet Exercises
1. Suppose there are three currencies: dollars, pesos, and yuan. Write a spreadsheet program to find the dollar price of yuan given the dollar price of a peso and the peso price of the yuan such that there are no arbitrage profits to be made.
2. Suppose there are two countries: the United States and Mexico. Write a spreadsheet program to determine the interest rate on deposits in Mexico given the interest rate on deposits in the United States, the current exchange rate, and the expected future exchange rate so that there are no arbitrage profits to be made. All else being the same, how does a change in the US deposit rate affect the current exchange rate? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/24%3A_Money-_A_Users_Guide/24.06%3A_End-of-Chapter_Material.txt |
In August 2011, these 10 individuals were among the most powerful people in the world.
• Ben S. Bernanke
• William Dudley
• Elizabeth Duke
• Charles Evans
• Richard Fisher
• Narayana Kocherlakota
• Charles Plosser
• Sarah Raskin
• Daniel Tarullo
• Janet L. Yellen
You may not have heard any of these names before. It is certainly unlikely that you have heard of more than one or two of these individuals. Yet they decide how easy or difficult it will be for you to get a job when you graduate. They decide how expensive it is for you to buy a car. They decide how many pesos you get for a dollar if you travel from the United States to Mexico. They decide if the Dow Jones Industrial Average is going to increase or decrease. They decide whether the stock markets in Tokyo, London, Hong Kong, and Frankfurt are going to increase or decrease. They decide the cost of your vacation abroad and the cost of the clothes that you buy at home.
So who are they?
They are the members of a group called the Federal Open Market Committee (FOMC). They are responsible for setting monetary policy in the United States. Of course, they do not literally decide all the things we just mentioned, but their decisions do have a major influence on everything we listed. This chapter is about what these people do and why their choices matter so much for our day-to-day life. We begin with an example of this group at work.
FOMC Policy Announcement: February 2, 2005
For immediate release
The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 2-1/2 percent.
The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Output appears to be growing at a moderate pace despite the rise in energy prices, and labor market conditions continue to improve gradually. Inflation and longer-term inflation expectations remain well contained.
The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal. With underlying inflation expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.
Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Ben S. Bernanke; Susan S. Bies; Roger W. Ferguson, Jr.; Edward M. Gramlich; Jack Guynn; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.
In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 3-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.Federal Open Market Committee, “Press Release,” Federal Reserve, February 2, 2005, accessed July 20, 2011, http://www.federalreserve.gov/boarddocs/press/monetary/2005/20050202/default.htm.
This FOMC statement is from February 2005. We have deliberately chosen a statement from a few years ago because we want to begin with monetary policy prior to the economic crisis that began in 2008. This policy statement contains all the essential elements of monetary policy in normal times.
The 12 people listed in the second-to-last paragraph of this announcement were the FOMC members in February 2005. (These names are different from those we named at the start of the chapter because the composition of the FOMC changes over time.) The president of the United States was not one of them. And none of them are members of Congress. You did not vote for any of them. None of the three main branches of the US government (executive, legislative, or judicial) is involved in the setting of US monetary policy. The FOMC is part of a government body called the US Federal Reserve Bank, commonly known as the Fed. The Fed is independent: decisions made by the Fed do not have to be approved by other branches of the government.
In this statement we find the following phrases:
• “The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 2-1/2 percent.”
• “The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal.”
• “In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 3-1/2 percent.”
The first phrase indicates an action undertaken by the Fed: it changed its “target” for something called the “federal funds rate.” This is a particular interest rate related to the rate banks pay each other for loans. Although you will never borrow to buy a car or a house at this rate, the interest rates you confront are heavily influenced by the federal funds rate. For example, over the past few years, the federal funds rate has decreased from 5.25 percent in 2006 to a value of 0.25 percent at the time of writing (mid-2011). Over this same period of time, rates on other types of loans, including mortgages and car loans, decreased as well. For example, typical car loan rates were about 7–8 percent in 2006 and about 3–4 percent in mid-2011. In this way, the actions of the Fed affect all of us.
The second phrase contains the FOMC’s assessment of the state of the economy, expressed in terms of two goals: economic growth and the stability of prices. The Fed is charged with the joint responsibility of stabilizing prices and ensuring the full employment of economic resources. The final statement details another action with respect to a different interest rate, called the discount rate.
The FOMC issues statements such as this on a regular basis. Our goal in this chapter is to equip you with the knowledge to understand these statements, which will in turn help you make sense of the discussions of the Fed’s actions on television or in the newspapers. We want to answer the following questions:
What does the Federal Reserve do? And why are its actions so important?
Road Map
The FOMC statement reveals that, to understand the Fed, we need to know both the goals and the tools of the Fed. From the statement, we learn that the goals of the Fed are sustainable growth and stable prices. The Fed cannot do much to affect the long-run growth rate of the economy, but it can and does try to keep the economy close to potential output. At the same time, it tries to ensure that the overall price level does not change very much—in other words, it tries to keep inflation low. The Fed pursues these goals by means of several tools that it has at its disposal. The FOMC statement informs us that these tools include two different interest rates.
We begin with a little bit of background information. We briefly explain what the Federal Reserve does, and we note that other monetary authorities are similar, although not identical, in terms of goals and behavior. Because we have seen that the Fed’s actions frequently revolve around interest rates, we make sure that we know exactly what an interest rate is.
We then get to the meat of the chapter, which discusses the workings of monetary policy. We explain how the Fed uses its tools to affect the things it ultimately cares about. Broadly speaking, we can summarize the cyclic behavior of the Fed as follows:
• The Fed observes current economic conditions.
• The Fed decides on policy actions.
• These policy actions affect real GDP (gross domestic product) and inflation.
• The Fed observes the new economic conditions.
There is a long chain of connections between the Fed’s tools and the ultimate state of the economy. To make sense of what the Fed does, we follow these connections, step by step. As we do so, we create a framework for understanding the effects of monetary policy, called the monetary transmission mechanism. We must also look at the connection in the other direction: how does the state of the economy influence the Fed’s decisions? Figure 25.1.1 "The Links between Monetary Policy and the State of the Economy", which we use as a template for the chapter, summarizes the interaction between the monetary transmission mechanism and the behavior of the Fed. We conclude the chapter by looking at the tools of the Fed in more detail and by discussing some historical episodes through the lens of monetary policy.
The Federal Reserve looks at current economic conditions and decides on a policy response. This policy affects the state of the economy. The Fed then observes the new economic conditions and decides on a new policy response, and so forth. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/25%3A_Understanding_the_Fed/25.01%3A_Money_and_Power.txt |
learning ojbectives
After you have read this section, you should be able to answer the following questions:
1. When and why was the Federal Reserve System created in the United States?
2. What are the connections between the Federal Reserve System and the executive and legislative branches of the US government?
3. How does our study of monetary policy apply to other central banks around the world?
We start our discussion with institutions.
The Federal Reserve
The Federal Reserve System was formally established in an act of Congress on December 23, 1913, called the Federal Reserve Act ( http://www.federalreserve.gov/aboutthefed/fract.htm). The stated purpose of the act was as follows: “To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”The Federal Reserve Act is found at “Federal Reserve Act,” Board of Governors of the Federal Reserve System, accessed September 20, 2011, http://www.federalreserve.gov/aboutthefed/fract.htm, and the structure of the Federal Reserve System is presented at “The Structure of the Federal Reserve System,” The Federal Reserve Board, accessed September 20, 2011, http://www.federalreserve.gov/pubs/frseries/frseri.htm. The Federal Reserve System is built around a 7-member Board of Governors together with 12 regional banks. The members of the board are appointed by the president and approved by Congress to serve for 14 years. The FOMC, which is instrumental in the conduct of monetary policy, has 12 members.
Although the president and Congress play a role in the appointment of members of the Fed, their direct control stops there. The Fed is an independent body. The executive and congressional branches of the government have no formal input into the determination of monetary policy. Congressional control is limited to the fact that the chair of the Fed is required to report to Congress periodically and to Congress eventually having the power to change the laws governing the Fed’s conduct.
The goals of the Fed are specified in the section of the Federal Reserve Act titled “Monetary Policy Objectives”: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”“Federal Reserve Act: Monetary Policy Objectives,” Federal Reserve, December 27, 2000, accessed August 6, 2011, http://www.federalreserve.gov/aboutthefed/section2a.htm. These objectives provide guidance to the Fed: it is required to pay attention to the level of economic activity (“maximum employment”) and to the level of inflation (“stable prices”). Exactly how the Fed promotes these goals—and chooses among them if necessary—is not specified. In some cases, the different aims of the Fed may conflict. For example, promoting employment may not be consistent with low inflation. The February 2, 2005, statement explicitly notes the balance between these goals.
The Fed has three main ways of affecting what goes on in the economy. The first was alluded to, although not mentioned by name, in the February 2, 2005, policy announcement. It is called open-market operations and represents the main way that the Fed influences interest rates. A second tool—the discount rate—was mentioned explicitly in the policy announcement. The third tool—reserve requirements—was not mentioned on February 2, 2005, but is nonetheless an important weapon in the Fed’s arsenal. Later on in this chapter, we examine the tools of the Fed in detail. For the moment, it is enough to know that the Fed affects the economy through changes in interest rates.
Central Banks in Other Countries
Our discussion in this chapter applies to not only the United States but also other countries. Wherever there is a currency, there is a monetary authority—a central bank—charged with the control of that currency. For example, in Europe, the European Central Bank (ECB; http://www.ecb.int/home/html/index.en.html) dictates monetary policy for all those countries that use the euro. In Australia, the Reserve Bank of Australia (RBA; http://www.rba.gov.au) manages monetary policy.
Different central banks do not all function in exactly the same way. To illustrate, here are policy announcements from the Bank of England (BOE; www.bankofengland.co.uk/publications/news/2006/078.htm), the Central Bank of Egypt (CBE; www.cbe.org.eg/public/PRESS_Release_For_Monetary_Policy/2011/MPC_PressRelease_09_06_2011_E.pdf), and the RBA ( http://www.rba.gov.au/media-releases/2011/mr-11-09.html). The details of the announcements are not critical. However, all have a “Monetary Policy Committee” rather than an FOMC. The different banks target slightly different interest rates: the BOE targets the “Bank rate paid on commercial bank reserves”; the CBE refers to overnight deposit and lending rates, the “7-day repo,” and the discount rate; and the RBA refers to the “cash rate.” You do not need to worry about exactly what these different rates are. All three banks are looking at the overall state of the economy, in terms of both output and inflation, and are setting interest rates to pursue broadly similar goals.
News Release: Bank of England Raises Bank Rate by 0.25 Percentage Points to 4.75 Percent, 3 August 2006 “News Release,” Bank of England, August 3, 2006, accessed July 20, 2011, www.bankofengland.co.uk/publications/news/2006/078.htm.
The Bank of England’s Monetary Policy Committee today voted to raise the official Bank rate paid on commercial bank reserves by 0.25 percentage points to 4.75 percent.
The pace of economic activity has quickened in the past few months…As a result, over the past few quarters GDP [gross domestic product] growth has been at, or a little above, its long-run average and business surveys point to continued firm growth.…
CPI [Consumer Price Index] inflation picked up to 2.5 percent in June, and is expected to remain above the 2.0 percent target for some while. Higher energy prices have led to greater inflationary pressures, notwithstanding muted earnings growth and a squeeze on profit margins.…
Against the background of firm growth, limited spare capacity, rapid growth of broad money and credit, and with inflation likely to remain above the target for some while, the Committee judged that an increase of 0.25 percentage points in the official Bank rate to 4.75 percent was necessary to bring CPI inflation back to the target in the medium term.
Press Release, June 9, 2011: The Central Bank of Egypt Decided Not to Raise Its Policy Rates “Press Release,” Central Bank of Egypt, June 9, 2011, accessed July 20, 2011, www.cbe.org.eg/public/PRESS_Release_For_Monetary_Policy/2011/MPC_PressRelease_09_06_2011_E.pdf.
In its meeting held on June 9, 2011, the Monetary Policy Committee (MPC) decided to keep the overnight deposit and lending rate unchanged at 8.25 and 9.75 percent, respectively, and the 7-day repo at 9.25 percent. The discount rate was also kept unchanged at 8.5 percent.
Headline CPI increased by 0.20 percent in May [month to month] following the 1.21 percent in April, bringing the annual rate down to 11.79 percent from 12.07 percent registered in April. …
Meanwhile, real GDP contracted by 4.2 percent in 2010/2011 Q3 which marks the first negative year-on-year growth since the release of quarterly data in 2001/2002. …
Against the above background, the slowdown in economic growth should limit upside risks to the inflation outlook. Given the balance of risks on the inflation and GDP outlooks and the increased uncertainty at this juncture, the MPC judges that the current key CBE [Central Bank of Egypt] rates are appropriate.
Media Release Number 2011-09: Statement by Glenn Stevens, Governor: Monetary Policy Decision Glenn Stevens, “Media Release,” Reserve Bank of Australia, June 7, 2011, accessed July 20, 2011, http://www.rba.gov.au/media-releases/2011/mr-11-09.html.
At its meeting today, the Board decided to leave the cash rate unchanged at 4.75 per cent.
The global economy is continuing its expansion, led by very strong growth in the Asian region, though the recent disaster in Japan is having a major impact on Japanese production, and significant effects on production of some manufactured products further afield. Commodity prices have generally softened a little of late, but they remain at very high levels, which is weighing on income and demand in major countries and also pushing up measures of consumer price inflation. …
Growth in employment has moderated over recent months and the unemployment rate has been little changed, near 5 per cent. Most leading indicators suggest that this slower pace of employment growth is likely to continue in the near term…
CPI inflation has risen over the past year, reflecting the effects of extreme weather and rises in utilities prices, with lower prices for traded goods providing some offset. The weather-affected prices should fall back later in the year, though substantial rises in utilities prices are still occurring. The Bank expects that, as the temporary price shocks dissipate over the coming quarters, CPI inflation will be close to target over the next 12 months.
At today’s meeting, the Board judged that the current mildly restrictive stance of monetary policy remained appropriate. In future meetings, the Board will continue to assess carefully the evolving outlook for growth and inflation.
In this chapter, we talk, for the most part, about the Federal Reserve. We focus on the United States principally because we do not want to get too bogged down in learning the different languages used by different central banks. From looking at the statements of the Fed, the BOE, the CBE, and the RBA, we see that the terminology of monetary policy varies greatly from country to country, the names of the key interest rates differ, and so forth. The underlying principles of monetary policy are largely the same in all countries, however.
Key Takeaways
1. The Federal Reserve System of the United States was created in 1913. A key motivation for the creation of a central bank was to manage the stock of currency and thus influence the state of the aggregate economy, particularly output and prices.
2. In the United States, the central bank is independent. Decisions about monetary policy are made within the Federal Reserve System. Members of the Board of Governors of the Federal Reserve System are nominated by the president and approved by the Senate.
3. There are central banks around the world, conducting monetary policy with similar tools and with the same basic model of the aggregate economy in mind.
Exercises
1. What is the input of the US president in determining monetary policy?
2. By learning about how the Federal Reserve System in the United States conducts monetary policy, what can we learn about other countries? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/25%3A_Understanding_the_Fed/25.02%3A_Central_Banks.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is the link between the actions of the Fed and the state of the economy?
2. What interest rate does the Fed target?
3. What components of aggregate spending depend on the interest rate?
The actions of monetary authorities, such as the Fed and other central banks around the world, influence interest rates and thus the levels of employment, output, and prices. The links between a central bank’s actions and overall economic performance are far from straightforward, however. The process is summarized by the monetary transmission mechanism (shown in Figure 25.3.1 "The Monetary Transmission Mechanism"), which is the heart of this chapter. The monetary transmission mechanism is more than just some theory that economists have devised to try to make sense of monetary policy. It summarizes how the Fed thinks about its own actions.
The Fed targets a short-term nominal interest rate. Changes in this rate lead to changes in long-term real interest rates, which affect spending on investment and durable goods, ultimately leading to a change in real GDP.
The monetary transmission mechanism explains how the actions of the Federal Reserve Bank affect aggregate economic variables, and in particular real gross domestic product (real GDP). More specifically, it shows how changes in the Federal Reserve’s target interest rate affect different interest rates in the economy and thus influence spending in the economy. Through open-market operations, the Fed targets a short-term nominal interest rate. Changes in that interest rate in turn affect long-term nominal interest rates. Changes in long-term nominal rates lead to changes in long-term real interest rates. Changes in long-term real interest rates affect investment and durable goods spending. Finally, changes in spending affect real GDP. We will examine every step of this process.
This chapter focuses on the effects of Fed actions, but essentially the same analysis applies to the study of monetary policy in other countries. The channels of influence are to a large degree independent of which country we study, although the magnitudes of the policy effects might differ across countries. Monetary policy differs across countries more through the targets set by different central banks than through the transmission mechanism.
How Well Can the Fed Meet Its Target?
On February 2, 2005, the Federal Open Market Committee (FOMC) decided to increase the target federal funds rate to 2.5 percent. The word target is critical here. If you listen to television news, you might get the impression that the Fed sets interest rates. It does not. It influences them, with greater or lesser success at different times.
Figure 25.3.2 "Target and Actual Federal Funds Rate, 1971–2005" shows the monthly target and actual federal funds rate between 1971 and 2008. From this picture, it is evident that the target and actual federal funds rates move together. We can conclude that the first stage of the monetary transmission mechanism is reliable. The Fed can influence the federal funds rate. So far so good—at least for this period of time. As we shall see later, when we consider more recent events, the Fed was much less successful in targeting the federal funds rate during the periods of financial distress in 2007 and 2008.
The target and actual federal funds rates move closely together.
From Short-Term Interest Rates to Long-Term Interest Rates
The next question is, do movements in the federal funds rate lead to corresponding movements in long-term interest rates? By “long-term,” we mean the rates on assets that have a maturity of at least 1 year and, in particular, assets that have a maturity of 5 years, 10 years, or even longer. Arbitrage among different assets means that annual interest rates on assets with different maturities are linked. As a result, the actions of the Fed to influence short-term rates also affect long-term rates.
Figure 25.3.3 "Short-Term and Long-Term Interest Rates" shows the relationship between the federal funds rate and longer-term interest rates. Broadly speaking, these long rates move with the federal funds rate. But it is also clear that the longer the horizon on the debt, the less responsive is the interest rate to movements in the federal funds rate.
This is one of the difficulties faced by the Fed: it can target short-term rates very accurately, but its influence on long-term rates is much less precise. Since—as we shall see—many economic decisions depend on long-term rates, the Fed’s ability to influence the economy is imperfect. Some writers have suggested that the Fed is an all-powerful organization that can move the economy around on a whim. There is no doubt that the Fed wields a great deal of power over the economy. Nevertheless, the Fed’s influence is substantially limited by the fact that it cannot control long-term interest rates with anything like the same precision that it brings to bear on the federal funds rate.
Figure \(3\): Short-Term and Long-Term Interest Rates
The Fed’s ability to influence long interest rates is much more limited than its ability to affect short rates.
From Nominal Interest Rates to Real Interest Rates
So far in this section, we have been considering nominal interest rates, but we know that the decisions of firms and households are based on real interest rates. The link between nominal and real interest rates is given by the Fisher equation:
\[real\ interest\ rate ≈ nominal\ interest\ rate − inflation\ rate.\]
To use this relationship, we simply subtract the inflation rate from the nominal interest rate. So if the nominal interest rate were 15 percent, as it was in the early 1980s, and the inflation rate were 12 percent, then the real interest rate would be 3 percent. But if the inflation rate were higher—say, 18 percent—then the real interest rate would be minus 3 percent.
Toolkit: Section 31.25 "The Fisher Equation: Nominal and Real Interest Rates"
The toolkit reviews the derivation of the Fisher equation.
Figure 25.3.4 "Real and Nominal Interest Rates" shows the nominal and real rates of return for a one-year Treasury bond. Because inflation is positive, the nominal interest rate exceeds the real rate. The figure shows that the nominal and real rates typically move closely together. In the early 1980s, for example, the real interest rate was negative. Presumably when households lent money in the early 1980s, they did not expect a negative return on their saving but instead expected that the nominal interest rate would exceed the inflation rate. From that perspective, the negative real interest rate is a consequence of higher than anticipated inflation.
The Fed’s ability to influence longer-term nominal rates through its influence on the federal funds rate apparently extends to the real interest rate as well. The connection is not perfect, however. On some occasions, movements in nominal rates are decoupled from movements in real rates.
Changes in nominal interest rates generally lead to changes in real interest rates, but the link between the two is imperfect.
From Real Interest Rates to Spending on Durable Goods
Real rates of interest influence spending by both households and firms. The main categories of purchases that are affected by interest rates are as follows:
• Investment spending by firms
• Housing purchases by households
• Durable goods purchases by households
What do these have in common? In each case, the purchase yields a flow of benefits that extends over some significant period of time. If a firm builds a new factory or purchases a new piece of machinery, it typically expects to be able to use that plant and equipment for years or decades. When a household buys a new home, it expects either to live there for a long time or else to sell it to someone else who can live there. If you buy a durable good such as a new car or a refrigerator, you expect to obtain the benefits of that purchase for several years.
Figure 25.3.5 "Real Interest Rates and Spending on Durable Goods" shows the relationship between the real interest rate and spending on durable goods. The higher the real interest rate is, the lower is the amount of spending on durable goods. Of course, the relationship need not be a straight line; we have just drawn it this way for simplicity. As you might imagine, monetary policymakers are very interested in the exact form of this relationship. They want to know exactly how big a change in durable goods spending is likely to follow from a given change in interest rates.
Figure \(5\): Real Interest Rates and Spending on Durable Goods
At higher interest rates, firms are less likely to borrow for investment projects, and households are less likely to borrow to purchase housing and durable goods such as new cars. Thus spending on durable goods is lower at higher interest rates and vice versa.
Discounted Present Value and Spending on Durable Goods
To understand in more detail why interest rates affect spending on durable goods, consider the purchase of a machine by a firm. Firms carry out such investment spending because they expect the machine to yield a flow of profits not only in the present but also for several years into the future. A machine is a capital good; it is used in the production of other goods and is not used up during the production process. The fact that the returns from the machine accrue over several years is what we mean by the term durable.
It is not correct to simply add profit flows in different years because a dollar today is usually worth more than a dollar next year. Why? If you take a dollar today and put it in a savings account at the bank, you will get your dollar plus interest back next year. If the interest rate is 10 percent, then \$1 this year is worth \$1.10 next year. Turning it around, \$1 next year is worth only about 91 cents this year (because 1/1.1 = 0.91).
The technique for adding together flows of resources in different periods is called discounted present value. To work out whether a given investment is profitable, a firm must calculate the value, in today’s terms, of the flows of profits that it expects to receive. It then compares this to the cost of the investment. If the discounted present value of the profits exceeds the cost, the firm will undertake the investment.
Toolkit: Section 31.5 "Discounted Present Value"
You can review discounted present value in the toolkit.
Table 25.3.1 "Return on Investment" illustrates a simple investment decision. In year 1, you pay for a machine, and it yields some profit in that year. The next year, the machine yields further profit. Suppose you, as a manager of a firm, must decide whether or not to buy this machine. How do you make this decision? In the first year, you pay \$970 for the machine and earn only \$500 back, so you are down \$470. In the second year, you will earn an additional \$500—but you have to wait a year to get this money. Think of the profits in year 2 as being in real terms—that is, already corrected for inflation.
Year Payment for Machine Real Profit from Machine
1 970 500
2 0 500
Table \(1\): Return on Investment
To decide about the purchase of the machine, you need to know the interest rate. If the interest rate were zero, the calculation would be easy. You could just add together the profit flows in the 2 years, observe that \$1,000 is more than the \$970 that you have to pay for the machine, and conclude that the purchase is a good idea. Now suppose the real interest rate is 5 percent, which means that the real interest factor is 1.05. Then the discounted present value of the profit flows from the machine is given by the following equation:
In this case, the purchase is still a good idea. You will earn \$976 in present value terms, exceeding the \$970 that you have to pay, so you still come out ahead.
But what if that the real interest rate is 10 percent? In this case,
This is less than the amount that you had to pay for the machine. The investment no longer looks like a good idea. The higher the interest rate, the more we must discount future earnings, so the less likely it is that a current investment will be profitable.
In most real-life cases, the flow of profits extends for several years, so the discounted present value calculation is somewhat harder. (Still, even harder calculations can be done easily with a calculator or a spreadsheet.) Our example may be simple, but it illustrates our key point. As the real interest rate decreases, the discounted present value of profits from a machine increases. In the economy, there are at any given time many possible investment opportunities. Some have higher profit flows than others. At lower interest rates, more machines will be profitable to purchase: investment increases as the real interest rate decreases.
Households purchase homes and durable consumption goods, such as cars and household appliances. If the household borrows to make such purchases (through mortgages, car loans, or other personal loans), then exactly the same logic applies. Higher interest rates will tend to deter the household from these purchases, whereas lower interest rates will encourage purchases.Even if the household uses its own accumulated saving to buy the durable good, there is an opportunity cost of using these funds: it could have put the money in the bank instead. The higher the real interest rate, the better it looks to put money in the bank. Households usually have some choice about when exactly to purchase such goods. If interest rates are high this year, it probably makes sense to put off that purchase of a new washing machine until next year, when rates might be lower.
The effect of an increase in the real interest rate on spending on durable goods is captured in Figure 25.3.6 "The Relationship between the Real Interest Rate and Spending on Durable Goods".
When the real interest rate increases, spending on durable goods decreases.
From Spending on Durable Goods to Real GDP
Look again at Figure 25.3.1 "The Monetary Transmission Mechanism". We have so far explored the links from the Fed’s decision on a target to spending on durable goods and net exports. Now we examine how changes in spending affect total output in the economy.
The aggregate expenditure model allows us to see how changes in aggregate spending translate into changes in GDP, at a given price level. The idea underlying the aggregate expenditure model is that, by the rules of national income accounting, real GDP must equal both production and spending. If spending increases, then it must be the case that production increases as well. The key diagram of the aggregate expenditure model is shown in Figure 25.3.7 "Aggregate Spending Depends Positively on Income".
Variations in the real interest rate influence the level of aggregate spending through the level of autonomous spending (the intercept term). To see why, recall that total spending is the sum of consumption, investment, government purchases, and net exports. The intercept term of the expenditure relationship includes all the influences on spending other than output. Thus any changes in consumption, investment, or net exports that are not induced by changes in output show up as changes in the intercept term. In particular, if an increase in interest rates causes firms to cut back on their investment spending, then the planned spending line shifts downward.
The economy is in equilibrium when spending equals real GDP.
We saw in Figure 25.3.6 "The Relationship between the Real Interest Rate and Spending on Durable Goods" that, as the real interest rate increases, the level of spending on durables decreases. This leads to a decrease in spending, given the level of income, and thus a decrease in the intercept of the spending line, as shown in Figure 25.3.8 "Increases in Real Interest Rates Reduce Real GDP". The magnitude of the reduction in spending—that is, the shift downward in the spending line—will depend on the sensitivity of durable spending to real interest rates. The more sensitive durable spending is to changes in the real interest rate, the larger the shift in the spending line will be when the real interest rate changes.
Figure \(8\): Increases in Real Interest Rates Reduce Real GDP
As a consequence of increases in real interest rates, aggregate spending decreases.
The initial reduction in spending induced by the increased real interest rate is then magnified by the multiplier process. The reduction in durable spending leads to a contraction in output. The resulting decrease in income leads households to spend less, leading to further contractions in output and income. In the end, the overall reduction in output exceeds the initial reduction in spending. This is visible in Figure 25.3.8 "Increases in Real Interest Rates Reduce Real GDP" from the fact that the horizontal difference between the old and new equilibrium points is larger than the vertical shift in the spending line.
Toolkit: Section 31.30 "The Aggregate Expenditure Model"
You can review the aggregate expenditure model and the multiplier in the toolkit.
The Real Interest Rate–Real GDP Line
We can summarize much of the monetary transmission mechanism by means of a relationship between real interest rates and real GDP, as shown in Figure 25.3.9 "The Relationship between the Real Interest Rate and Real GDP". After we work through all the connections from real interest rates to the various components of spending and real GDP, we find that there is a level of real GDP associated with each real interest rate. The higher the interest rate, the lower is real GDP.
This picture summarizes several steps in the monetary transmission mechanism to show the relationship between real interest rates and real GDP.
As the monetary authority changes the real interest rate, the economy moves along this curve. So, for example, a reduction in the real interest rate leads to increased spending on durables, which, through the multiplier process, increases aggregate output. The shape of the curve tells us something about the Fed’s ability to influence the economy. Suppose that (1) durable spending is very sensitive to the real interest rate and (2) the multiplier is large; then imagine that the Fed cuts interest rates. Firms and households both respond to this change. Firms decide to carry out more investment: they buy new machinery, open new plants, and so forth. Households, attracted by the low interest rates, borrow to buy new cars and new homes. As a result, durable spending increases substantially. Furthermore, this increase in spending leads to higher income and thus to further increases in spending by households. The end result is a large increase in real GDP. In this case, the curve is flat.
When the curve is flat, the Fed is able to have a big influence on the economy. When the curve is steep, it is harder for the Fed to affect economic activity.
Figure 25.3.10 "The Fed’s Influence on the Economy Depends on the Real Interest Rate–Real GDP Relationship" shows both this case and the case where it is harder for the Fed to influence the economy. If spending on durable goods is not very responsive to changes in the real interest rate and the multiplier is small, then changes in interest rates end up having only a small effect on real GDP. In the diagram, this shows up as a steep curve. The Fed’s ability to use the monetary transmission mechanism to its advantage requires good knowledge of the shape of this relationship between interest rates and output.
Key Takeaways
1. The monetary transmission mechanism describes the links between the actions of the Fed and the state of the aggregate economy.
2. The Fed targets a short-term nominal interest rate called the federal funds rate. The Fed does not set this rate directly but rather uses its tools to influence this interest rate.
3. The main components of spending that depend on the real interest rate are spending by households on durable goods and investment. When these components of spending are sensitive to the interest rate, then the Fed can influence the economy through small variations in its target federal funds rate.
Exercises
1. Which interest rate determines investment spending—the real interest rate or the nominal interest rate?
2. Some newspapers state that the Fed sets the interest rate. Is that right? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/25%3A_Understanding_the_Fed/25.03%3A_The_Monetary_Transmission_Mechanism.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. How do prices adjust in the economy?
2. What are the effects of monetary policy on prices and inflation?
3. What is the Taylor rule?
We now understand the effect of an interest rate increase on output. According to the monetary transmission mechanism, we expect that this will result in lower spending and a lower real gross domestic product (GDP). Remember, though, that the Fed is also charged with worrying about prices and inflation. Look back at the Federal Open Market Committee (FOMC) announcement with which we opened the chapter. Much of that announcement concerns inflation, not output. It states that “inflation and longer-term inflation expectations remain well contained,” that “underlying inflation [is] expected to be relatively low,” and that “the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability. ”Federal Open Market Committee, “Press Release,” Federal Reserve, February 2, 2005, accessed July 20, 2011, http://www.federalreserve.gov/boarddocs/press/monetary/2005/20050202/default.htm.
The statements by the Bank of England, the Central Bank of Egypt, and the Reserve Bank of Australia likewise betray a strong concern with inflation. The policy of many central banks is directed toward the inflation rate. This policy, appropriately called inflation targeting, focuses the attention of the monetary authority squarely on forecasting inflation and then controlling inflation through its current policy choices.
Price Adjustment and Inflation
The inflation rate is defined as the growth rate of the overall price level. In turn, the price level in the economy is based on the prices of all the goods and services in an economy. From one month to the next, some prices increase, others decrease, and still others stay the same. The overall inflation rate depends on what is happening to prices on average. If most prices are increasing and few are decreasing, then we expect to see inflation.
A complete explanation of inflation requires an understanding of all the decisions made by managers throughout the economy as they decide whether to change the prices of the goods and services that they sell. Some managers might find themselves facing increasing costs and strong demand for their product, so they would choose to increase prices. Others might have decreasing costs and weak demand, so they would choose to decrease prices. The overall inflation rate depends on the aggregation of these decisions throughout the economy and is summarized in a price adjustment equation. The price adjustment equation is shown in Figure 25.4.1 "Price Adjustment".
Toolkit: Section 31.31 "Price Adjustment"
The net effect of all the price-setting decisions of firms yields a price adjustment equation, which is as follows:
$inflation\ rate = autonomous\ inflation − inflation\ sensitivity \times output\ gap.$
The price adjustment equation summarizes, at the level of the entire economy, all the decisions about prices that are made by managers throughout the economy. It tells us that there are two reasons for increasing prices. The first is that there may be underlying (autonomous) inflation in the economy, even when it is at potential output. This depends, among other things, on the inflation rate that firms anticipate. The second reason for increasing prices is if the output gap is negative. The output gap is the difference between potential output and actual output:
$output\ gap = potential\ real\ GDP − actual\ real\ GDP.$
A positive gap means that the economy is in recession—below potential output. If the economy is in a boom, then the output gap is negative.
Figure $1$: Price Adjustment
The price-adjustment equation tells us that when real GDP is below potential output, the output gap is positive, and the actual inflation rate is below its autonomous level. The opposite is true if real GDP is above potential output.
The output gap matters for inflation because as GDP increases relative to potential output, labor and other inputs become scarcer. Firms see increasing costs and increase their prices as a consequence. The second term of the price adjustment equation shows that when real GDP is above potential output (the output gap is negative), there is upward pressure on prices in the economy. The inflation rate exceeds autonomous inflation. By contrast, when real GDP is below potential output (the output gap is negative), there is downward pressure on prices. The inflation rate is below the autonomous inflation rate. The “inflation sensitivity” tells us how responsive the inflation rate is to the output gap.
If the output gap were the only factor affecting prices in the economy, then we would often expect to see deflation—decreasing prices. In particular, we would see deflation whenever the economy was in a recession. Although the United States and some other economies have occasionally experienced deflation, it is relatively rare. We can conclude that there must be factors other than the output gap that cause inflation to be positive.
Autonomous inflation is the inflation rate that prevails in the economy when the economy is at potential output (the output gap is zero). In the United States in recent decades, the inflation rate has been positive but low, meaning that prices have been increasing on average but at a relatively slow rate. Autonomous inflation is typically positive because most economies have some growth of the overall money supply in the long run. A positive output gap then translates not into deflation but simply into an inflation rate below the level of autonomous inflation. Thus in the FOMC statement with which we opened this chapter, the discussion is not about how contractionary policy will cause deflation; it is about how this policy will moderate the inflation rate. Positive autonomous inflation means that firms will typically anticipate that their suppliers or their competitors are likely to increase prices in the future. A natural response is to increase prices, so actual inflation is positive.
The Effect of an Increase in Interest Rates on Prices and Inflation
The monetary transmission mechanism teaches us that an increase in real interest rates reduces spending and hence leads to a reduction in real GDP. In the (very) short run, the reduction in spending translates directly into a decrease in real GDP because prices are fixed. The reduction in GDP increases the output gap in the economy. Our price adjustment equation tells us in turn that this will tend to reduce the inflation rate in the economy.
Some firms will then adjust prices very quickly to the changing economic conditions. We do not think that the price level in the economy is literally fixed—unable to move—for any significant period of time. That said, some firms are likely to keep their prices unchanged for several months, even in the face of changing economic conditions. Thus the adjustment of prices in the economy takes some time. It will be months, perhaps years, before all firms have adjusted their prices.
In summary, an increase in interest rates leads to a gradual reduction in the inflation rate in the economy. Contractionary monetary policy leads to a reduction in economic activity and, over time, lower inflation. US monetary policy in the early 1980s provides a good illustration. At the start of that decade, the inflation rate was over 10 percent. To reduce inflation, the Fed, under Chairman Paul Volcker, conducted a contractionary monetary policy that sharply increased real interest rates. The immediate result was a severe recession, and the eventual result was a reduction in inflation, just as the model suggests.
Closing the Circle: From Inflation to Interest Rates
We have now traced the effects of monetary policy from interest rates to spending to real GDP to inflation. The effects of monetary policy do not stop there. Instead, as inflation adjusts in response to monetary policy, there is a feedback to interest rates through monetary policy itself. This is shown in Figure 25.4.3 "Completing the Circle of Monetary Policy".
We close the monetary policy circle by observing that the Fed’s policies depend on the state of the economy.
Observers of the Fed’s behavior over the past 20 or so years have argued that the Fed generally follows a rule that makes its choice of a target interest rate somewhat predictable. The rule that summarizes the behavior of the Fed is sometimes called the Taylor rule; it is named after John Taylor, an economist who first characterized Fed behavior in this manner.Comments on John Taylor’s career and his contributions to monetary economics by Fed Chairman Ben Bernanke are available at “Opening remarks to the Conference on John Taylor’s Contributions to Monetary Theory and Policy, Federal Reserve Bank of Dallas, Dallas, Texas,” Federal Reserve, October 12, 2007, accessed September 20, 2011, http://www.federalreserve.gov/newsevents/speech/bernanke20071012a.htm. The Taylor rule stipulates a relationship between the target interest rate and the state of the economy, typically represented by both the inflation rate and some measure of economic activity (such as the gap between actual and potential GDP). Usually, we think that the monetary authority operates with a lag so that the interest rate the monetary authority sets at a point in time reflects the output gap and inflation from the recent past. According to the Taylor rule, the Fed will increase real interest rates when
• inflation is greater than the target inflation rate,
• output is above potential GDP (a negative output gap).
Conversely, the Fed will decrease real interest rates when
• inflation is less than the target inflation rate,
• output is below potential GDP (a positive output gap).
The Fed will want to increase interest rates and thus “put the brakes on the economy” when inflation is high and when they think that real GDP is above its long-run level (potential output). The Fed will want to decrease interest rates when inflation is relatively low and the economy is in a recession.
An example of a Taylor rule is shown in Figure 25.4.4 "The Taylor Rule". The vertical axis is the real interest rate target of the Fed, and the horizontal axis is the inflation rate. As the inflation rate increases, the Fed, according to this rule, then increases the interest rate.
Figure $4$: The Taylor Rule
The monetary policy rule shows how the Fed adjusts real interest rates in response to changes in inflation rates. As inflation increases, the monetary authority targets a higher real interest rate.
The different pieces of the Taylor rule can be in conflict. For example, the Fed may face a situation where inflation is relatively high, yet the economy is in recession. The precise specification of the rule then provides guidance as to how the Fed trades off its inflation and output goals. The rule is largely descriptive: it summarizes in a succinct manner the actions of the Fed. In doing so, it allows individuals to predict with some accuracy what actions the Fed is likely to take in the future.
The Taylor rule describes Fed policy in terms of the real interest rate. We know, however, that the Fed actually targets a nominal rate. This has a surprising implication when we examine how the Fed responds to inflation. Suppose the Fed is currently meeting its target inflation rate—say, 3 percent—and the federal funds rate is currently 5 percent. The real interest rate is therefore 2 percent (remember the Fisher equation). Now suppose the Fed sees that inflation has increased from 3 percent to 4 percent. The increase in the inflation rate has the effect of decreasing the real interest rate—again, this comes directly from the Fisher equation. The real interest rate is now only 1 percent. Yet the Taylor rule tells us that the Fed wants to increase the real interest rate. To do so, it must increase nominal interest rates by more than the increase in the inflation rate. In our example, the inflation rate increased by one percentage point, so the Fed will have to increase its target for the federal funds rate by more than one percentage point—perhaps to 6.5 percent.
The Taylor rule completes the circle of monetary policy. As indicated by Figure 25.4.3 "Completing the Circle of Monetary Policy", the monetary policy rule links the state of the economy, represented by the inflation rate and the output gap, to the interest rate. There is usually a lag in the response of the Fed to the state of the economy. So, for example, the decision made at the FOMC meeting in February 2005 reflected information on the state of the economy through the end of 2004, at best.
In Summary: The Three Key Pieces of the Monetary Transmission Mechanism
We now have the three pieces we need to understand the relationship between monetary policy, inflation, and real GDP:
1. The Taylor rule linking the real interest rate to the inflation rate ( Figure 25.4.4 "The Taylor Rule")
2. The inverse relationship between the real interest rate and real GDP ( Figure 25.3.9 "The Relationship between the Real Interest Rate and Real GDP")
3. The price adjustment process ( Figure 25.3.1 "Price Adjustment")
Together, these three pieces paint a complete picture of the monetary policy process. The top left panel in Figure 25.4.5 "The Adjustment of Inflation over Time" is taken from Figure 25.4.4 "The Taylor Rule" and shows a positive relationship between inflation and the real interest rate. The top right panel in Figure 25.4.5 "The Adjustment of Inflation over Time" is taken from Figure 25.3.9 "The Relationship between the Real Interest Rate and Real GDP" and shows the relationship between real GDP and the interest rate. As shown in the figure, the higher the real interest rate, the lower real GDP is. As a reminder, higher real interest rates lead to lower aggregate spending. Finally, from the price-setting equation, changes in real GDP lead to changes in the inflation rate. We showed this previously in Figure 25.4.1 "Price Adjustment", and it appears in the bottom right panel of Figure 25.4.5 "The Adjustment of Inflation over Time". If real GDP decreases, the output gap increases, and the inflation rate decreases.
We can use Figure 25.4.5 "The Adjustment of Inflation over Time" to summarize the conduct of monetary policy. In this diagram, we see the Taylor rule in action: the Fed sees high inflation and so increases the real interest rate.
• Start at the top right panel with “Last Period’s Interest Rate.” The panel shows us the level of real GDP that resulted from the interest rate choice. The bottom right panel then shows the inflation rate that came from the price adjustment equation. Point A therefore shows the state of the economy last period—that is, it shows last period’s inflation and last period’s real GDP. This is the information that the Fed uses when making its decision for this period.
• Given last period’s inflation rate, the top left panel shows us the value of the real interest rate that the Fed wants to choose this period. The Fed therefore sets a new target for the federal funds rate. This increases real interest rates, both short term and long term, which in turn leads to a decrease in durable goods spending.
• From the top right panel we can see that the Fed has chosen a higher interest rate than last period, which means that there is a decrease in real GDP.
• Decreased real GDP causes the inflation rate to decrease, as we see in the bottom right panel.
• Coming up to its next meeting, the FOMC again looks at the current state of the economy (point B), and the process begins again.
We have simplified the discussion here in two ways. First, we neglected the fact that the output gap also enters into the Taylor rule. The basic idea remains the same in that more complicated case. Second, we did not discuss autonomous inflation. Autonomous inflation, remember, captures managers’ expectations of future inflation and future demand conditions. It, too, will tend to change over time. Theories of autonomous inflation are a subject for more advanced courses in macroeconomics.
Figure $5$: The Adjustment of Inflation over Time
Last period the economy was at point A, with high output and high inflation. Because inflation is too high, the Fed increases the real interest rate (top left). This reduces this period’s output (top right), which in turn leads to a reduction in the inflation rate (bottom right). The economy ends up at point B.
Key Takeaways
1. The price adjustment equation describes the dependence of price changes (inflation) on the output gap, given the autonomous inflation rate.
2. Given prices, monetary policy influences the output gap. Over time, prices adjust in response to the effects of monetary policy on the output gap.
3. The Taylor rule describes the dependence of the interest rate targeted by the Fed on the inflation rate and the output gap.
checking you understanding
1. Describe why a reduction in the target interest rate will ultimately lead to higher inflation.
2. If the economy is in a recession, what should happen to the target interest rate according to the Taylor rule? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/25%3A_Understanding_the_Fed/25.04%3A_Monetary_Policy%2C_Prices%2C_and_Inflation.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. How does monetary policy operate in an open economy?
2. How does monetary policy in other countries influence the US economy?
Monetary policy has international implications as well. Changes in interest rates lead to changes in supply and demand in the foreign exchange market. Chapter 24 "Money: A User’s Guide" explains this connection. In turn, changes in exchange rates affect exports and imports and influence the overall demand for goods and services. Among other things, this means that the monetary policy of other countries will have an effect on your own country. So if you live in Europe, you are not immune to Federal Open Market Committee (FOMC) actions. And if you live in the United States, you are not immune to the actions of the European Central Bank (ECB).
The Monetary Transmission Mechanism in the Open Economy
The key element in the monetary transmission mechanism is the ability of the central bank to influence the real interest rate. Changes in real interest rates lead to changes in spending on durable goods, which are a component of aggregate expenditures. But there is also another channel of influence. If the Fed cuts interest rates, for example, then the demand for dollars to invest in US asset markets will be reduced. This will reduce the foreign currency price of dollars. The weaker dollar means that goods produced in the United States are cheaper, so US exports will increase, and US imports will decrease. Thus changes in interest rates lead to changes in exchange rates, which in turn lead to changes in net exports. Net exports are also a component of aggregate expenditures. This is illustrated in Figure 25.5.1.
Figure \(1\)
There is an additional channel of the monetary transmission mechanism that operates through the exchange rate. Changes in interest rates lead to changes in exchange rates, which in turn lead to changes in net exports. This channel reinforces the effect operating through interest rates.
Even when we include this channel, it is just as easy to understand the monetary transmission mechanism as it was before. When interest rates are cut, there is an increase both in spending on durables and net exports. Both channels lead to higher aggregate spending and thus higher output.
Toolkit: Section 31.20 "Foreign Exchange Market"
You can review the workings of the foreign exchange market and the definition of the exchange rate in the toolkit.
Monetary Policy in the Rest of the World
The United States does not exist alone in the world economy. US financial markets are influenced by events in other countries, such as the actions of the ECB. Likewise, citizens in Europe are influenced by monetary policy in the United States.
Suppose the ECB cuts interest rates in Europe. As in the United States, the typical mechanism for this would be a purchase of debt issued by European governments. An increase in the price of this debt is equivalent to a decrease in interest rates. If nothing else happens, this decrease in European interest rates gives rise to an arbitrage opportunity. Investors want to move funds to the United States to take advantage of the higher interest rates. There is an increased demand for US assets and hence an increased demand for dollars. Interest rates in the United States decrease, which tends to increase durable goods spending and stimulate the US economy. Against that, the higher value of the dollar leads to fewer exports from the United States and more imports into the United States, so US net exports will decrease.
Completely analogously, monetary policy in the United States influences interest rates in other countries. If the Fed undertakes an open market sale of US government debt, for example, interest rates will increase in other countries as well as in the United States.
The US Federal Reserve and the ECB are big players in world financial markets. Their actions move world interest rates and world currency markets. There are other countries that are relatively small in the world economy. For example, suppose the Central Bank of Iceland increases interest rates in that country. The mechanisms that we have explained still apply: investors will find Icelandic assets more attractive, and there will be an increased demand for the Icelandic krona. However, the flows of capital into Iceland will be negligible in terms of the world economy. They will not have any noticeable effect on interest rates in Europe or the United States.
Key Takeaways
1. In an open economy, interest rate changes induced by monetary policy influence exchange rates and thus net exports.
2. Actions by monetary authorities in other countries influence the net exports of the United States through exchange rate changes and through the level of aggregate spending on the United States by households in other countries.
Exercises
1. If the Fed increases its target value for the federal funds rate, what happens to the value of the dollar?
2. If the ECB increases its target interest rate, what happens to US net exports? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/25%3A_Understanding_the_Fed/25.05%3A_Monetary_Policy_in_the_Open_Economy.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What do banks do?
2. What are the tools of the Fed?
We have not yet said very much about exactly how the Fed changes interest rates. The Fed has three major tools at its disposal: open-market operations, the reserve requirement, and the discount rate. We discuss these in turn. Monetary policy operates through the Fed’s interactions with the banking system, so we first must make sure we understand what banks do in the economy.If your find this material interesting, a course on Money and Banking will delve much further into the details of how banks operate and how they interact with the monetary authority. Throughout this discussion, we use the credit market to think about how the Fed operates.
Toolkit: Section 31.24 "The Credit (Loan) Market (Macro)"
You can review the workings of the credit market in the toolkit.
What Do Banks Do?
Financial markets (that is, banks and other financial institutions) provide the link between savings and investment in the economy. A bank is a profit-making entity that takes in deposits from households and firms and makes loans to firms, households, and the government.
Banks can be fragile institutions. The fragility of banks is discussed in more detail in Chapter 22 "The Great Depression". They must ensure that their depositors are not worried that the bank might go out of business, taking their money with it. Banks do many things to ensure that their customers have confidence in them. Perhaps the most important is that they keep a certain amount of their assets in a very liquid form, such as cash. This means that if a depositor comes in to withdraw his or her money, the bank will be able to meet that demand. These liquid deposits are called the reserves of the bank.
Most banks in the United States are members of the Federal Reserve System. This membership comes with a responsibility to hold some fraction of deposits on reserve. This is called a reserve requirement. Current reserve requirements are at “Reserve Requirements,” Federal Reserve, accessed September 20, 2011, http://www.federalreserve.gov/monetarypolicy/reservereq.htm#table1. Reserve requirements limit the amount of deposits that banks are able to loan out to firms and households. Suppose a bank has \$1,000 on deposit and the reserve requirement is 10 percent. Then the bank must hold at least \$100 on reserve and can loan out at most \$900. We say “at least \$100” since the bank is free to hold more than 10 percent on reserve. In uncertain times, when a bank is unsure how many depositors are likely to want to withdraw their money, the bank may choose to keep reserves above and beyond the level required by the Fed.
What does a bank do if it finds itself with insufficient reserves on a given day to meet its reserve requirements? The answer is that it borrows—either from other banks or from the Federal Reserve itself. Because the Federal Reserve can influence the interest rates at which banks borrow, it can influence the behavior of banks.
Open-Market Operations
In the memo with which we opened the chapter, the Federal Open Market Committee (FOMC) decided to increase the target federal funds rate to 2.5 percent. But what exactly does this mean, and how did the Fed accomplish it? The federal funds rate is the interest rate in a particular market—the market where banks make overnight loans to each other. Overnight loans, as the name suggests, are assets that have a very short time to maturity (one day). The interest rate on these loans is therefore one of the “shortest” interest rates in the economy, which is why it is targeted by the Fed. The interest rate is so named because the loans are made using the funds that banks have available in their accounts at the Federal Reserve.
The Federal Reserve does not participate directly in this market. It influences the federal funds rate by buying and selling in a different market—the market for short-term government debt. These purchases and sales are called open-market operations.Section 14 of the Federal Reserve Act describes open-market operations. Let us examine how this works. The effect of open-market operations can be seen in the market for government debt. Part (a) of Figure 25.6.1 "The Market for Government Bonds" shows the supply and demand of this asset. The horizontal axis shows the quantity of assets (think of this as the amount traded on a given day), and the vertical axis shows the price of those assets. The participants in this market are financial institutions and others who hold, or want to hold, bonds as part of their portfolio of assets. Current owners will be willing to sell bonds if their price is sufficiently high. Conversely, if the price of bonds decreases, more people will want to purchase them. The same institution could be either a supplier or a demander, depending on the price. It is perfectly possible that a financial institution would want to buy bonds if their price were low and sell them if their price were high.
(a) The price of bonds is determined by supply and demand. (b) These same transactions are represented in a credit market, which is another way of looking at exactly the same market.
Part (b) of Figure 25.6.1 "The Market for Government Bonds" shows the equivalent representation of this as a credit market. When the Fed buys bonds, it is making a loan. When the government or private investors sell bonds to the Fed, they are borrowing from the Fed. The crossing of the supply and demand curves tells us the equilibrium price of government bonds. It also tells us how many bonds changed hands that day, but our interest here is in what is happening to prices.
Now suppose the Federal Reserve steps into this market and buys some government bonds. This increases the demand for bonds, so the price of bonds will increase. This is shown in part (a) of Figure 25.6.2 "Intervention by the Federal Reserve". Part (b) of Figure 25.6.2 "Intervention by the Federal Reserve" shows the same action viewed through the lens of a credit market. Conversely, if the Fed decides to sell some of its stock of government bonds, the supply of bonds will shift out, and the price of bonds will decrease (see Figure 25.6.3 "Intervention by the Federal Reserve").
When the Federal Reserve conducts an expansionary open-market operation, it purchases bonds (a) or, equivalently, supplies more credit (b). The price of bonds increases, or, equivalently, the interest rate decreases.
When the Federal Reserve conducts a contractionary open-market operation, it sells bonds (a) or, equivalently, demands more credit (b). The price of bonds decreases, or, equivalently, the interest rate increases.
Thus the Federal Reserve, by buying or selling government bonds in this market, has the ability to influence the price of bonds. This means that it can affect the interest rate on those bonds.
From this relationship, we know the following:
• If the Fed buys bonds, then the price of bonds increases, and interest rates decrease.
• If the Fed sells bonds, then the price of bonds decreases, and interest rates increase.
The Fed’s actions in this market have an effect on interest rates in other markets, as banks and other financial institutions adjust their portfolios in response to the changing interest rate on government bonds. The Fed calibrates its buying and selling to try to achieve its target interest rate in the federal funds market.
The Discount Rate
The February 2005 announcement by the FOMC also included an increase in the discount rate. The discount rate is the interest rate from another market—in this case a market established by the Fed itself.
We have said that if a bank is short on reserves, it can borrow. One source of loans is the federal funds market. Another source of loans is the Fed itself. Member banks have the privilege of borrowing from the Fed, and the rate at which a bank can borrow is called the discount rate. The Fed directly controls this interest rate. The Federal Reserve’s policies on such loans are set out in “Regulation A” of the Fed’s Board of Governors: “A Federal Reserve Bank [that is, a Regional Fed] may extend primary credit on a very short-term basis, usually overnight, as a backup source of funding to a depository institution that is in generally sound financial condition in the judgment of the Reserve Bank. Such primary credit ordinarily is extended with minimal administrative burden on the borrower.” “Regulation A (12 C.F.R. 201 as amended effective December 9, 2009),” Federal Reserve, accessed July 20, 2011, http://www.frbdiscountwindow.org/regulationa.cfm?hdrID=14&dtlID=77. Once a bank has established the right to borrow at the Fed’s “discount window,” the execution of such a loan is straightforward. The bank simply makes a toll-free call and provides a few pieces of basic information.
To see how this tool works, suppose the discount rate were very high, much higher than the interest the bank can earn by making a loan. Then the bank would find it prohibitively expensive to borrow from the Fed. If the bank were unsure that it could meet the needs of depositors, it would respond by holding reserves in excess of the reserve requirement. That is, with a very high discount rate, the bank would lend out a smaller fraction of its deposits. By contrast, if the Fed were to set the discount rate very low, the bank would make more loans and hold fewer reserves, safe in the knowledge that it could always borrow from the Fed if necessary.
From this reasoning, we can see that as the discount rate is increased, banks hold more excess reserves and lend less. This shows up in Figure 25.6.4 "An Increase in the Discount Rate" as a shift inward in the supply of credit. Thus the Fed can increase interest rates by increasing the discount rate.
An increase in the discount rate reduces the supply of credit and therefore increases the real interest rate.
Reserve Requirements
Reserve requirements are outlined in Section 19 (A) of the Federal Reserve Act:
(A) Each depository institution shall maintain reserves against its transaction accounts as the Board may prescribe by regulation solely for the purpose of implementing monetary policy—
1. in the ratio of 3 per centum for that portion of its total transaction accounts of \$25,000,000 or less, subject to subparagraph (C); and
2. in the ratio of 12 per centum, or in such other ratio as the Board may prescribe not greater than 14 per centum and not less than 8 per centum, for that portion of its total transaction accounts in excess of \$25,000,000, subject to subparagraph (C) [which stipulate that the reserve requirements could be changed].
Suppose the Fed were to increase the reserve requirement from 10 percent to 20 percent. In the previous example, all else being the same, a bank with deposits of \$1,000 would be required to have at least \$200 on deposit, rather than the \$100 that was required originally. To fulfill this larger reserve requirement, the bank would be allowed to lend only \$800 at most. Banks therefore respond to an increase in the reserve requirement by holding a larger fraction of deposits on reserve and lending out a smaller fraction of their deposits. This reduces the supply of credit in the economy since a smaller fraction of saving is actually being lent.
As shown in Figure 25.6.5 "An Increase in Reserve Requirements", the supply of credit shifts inward, and the interest rate increases. This picture is exactly the same as Figure 25.6.4 "An Increase in the Discount Rate". When we think about the credit market, the increase in the discount rate and the increase in the reserve requirement have the same effect. Thus we learn that the Fed can increase interest rates by increasing the reserve requirement. Often, increases in the reserve requirement are coupled with other measures, such as open-market operations, to increase interest rates. A decrease in the reserve requirement works in a symmetric fashion, though in the opposite direction.
An increase in reserve requirements reduces the supply of credit and therefore increases the real interest rate.
Key Takeaways
1. Banks act as intermediaries, taking the deposits of households and making loans to firms and households who wish to borrow. Banks also borrow from other banks and from the Fed.
2. The main tools of the Fed are as follows: (a) open-market operations, (b) lending at the discount rate to member banks, and (c) setting the reserve requirements on member banks.
Exercises
1. Can a bank borrow from the Fed?
2. What are reserve requirements?
3. In an open market sale, does the money supply increase or decrease? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/25%3A_Understanding_the_Fed/25.06%3A_The_Tools_of_the_Fed.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What monetary policy did the Fed pursue during the Great Depression?
2. Why is stabilization of the economy through monetary policy so difficult?
We finish this chapter by going back to the actual actions of the Fed and focusing on two periods. First, we consider the Great Depression from a monetary perspective. Chapter 22 "The Great Depression" discusses that period in more detail and pays more attention to fiscal policy. Then we consider the period leading up to the February 2005 announcement.
The Great Depression Revisited
The Fed was in fact not very active during the Great Depression (some commentators might even say that this section should be titled “The Fed Inaction”). Yet monetary events were still critical.
A key short-term interest rate at that time was the so-called commercial paper rate. This rate decreased from about 6 percent in 1929 to a low of 0.8 percent by 1935. At first glance, therefore, it seems as if the monetary authority was implementing cuts in interest rates that could stimulate the economy. On closer examination, however, the picture is not so simple. During the Great Depression the inflation rate was negative—prices were decreasing on average. From the Fisher equation, a negative inflation rate means that the nominal interest rate understates the cost of borrowing. Decreasing prices mean that the nominal interest rate is smaller than the real interest rate. Even though nominal interest rates were decreasing in the early 1930s, the inflation rate was decreasing faster. As a result, the real interest rate increased. It became more expensive for households and firms to borrow, so spending decreased.
When prices decrease, the obligations of borrowers increase in real terms. People at the time did not typically anticipate these decreasing prices, so there was unanticipated deflation. Unanticipated deflation redistributes wealth from borrowers to lenders. Many firms, banks, and households were left with large (real) debts during the Great Depression. These led to bankruptcies and contributed to the contraction in economic activity.
Thus along with the high real interest rates came a series of bank failures. In addition, banks tended to hold more in excess reserves during this period, and thus loans, relative to deposits, decreased. These banking problems meant that the financial markets became less effective at connecting the savings of individual households with the investment plans of firms. It is perhaps not surprising that investment and spending on consumer durable goods decreased so much during the Great Depression.
In retrospect, the monetary authority could have been much more aggressive in dealing with the high real interest rates. They could have conducted open-market operations, buying bonds and decreasing interest rates. At the same time, this would have provided additional funds (sometimes called liquidity) to the banking system. Yet the Fed did not do so. Many observers now think that the severity of the Depression can be blamed in large part on these failures of the Fed. If so, this is good news, for it tells us that we are much more likely to be able to avert similar economic catastrophes in the future.
Monetary Policy from 1999 to 2005
Here is a brief summary of the target federal funds rate over the period from June 1999 to May 2005. Remember that these are nominal interest rates.
• Starting in June 1999, the target federal funds rate increased from 4.75 percent to 6.5 percent by January 2001.
• Starting in February 2001, the target federal funds rate decreased from 6.5 percent to a low of 1 percent by July 2004.
• In August 2004 the target federal funds rate was increased to 1.25 percent and was increased steadily to a level of 2.75 percent by May 2005.
We have already examined these targets, together with the actual federal funds rates, in Figure 25.3.3 "Target and Actual Federal Funds Rate, 1971–2005".
The time of tighter monetary policy, from June 1999 to January 2001, was a period of inflation concern. In the first part of 1999, the inflation rate averaged about 2 percent, and the unemployment rate was decreasing, reaching 4 percent in May 1999. Even though inflation was low, the Federal Open Market Committee (FOMC) statement from June 1999 called for an increase in the target federal funds rate, pointing to potential inflation as a rationale for increasing the target rate: “The Committee, nonetheless, recognizes that in the current dynamic environment it must be especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth.” Federal Open Market Committee, “Press Release,” Federal Reserve, June 30, 1999, accessed August 8, 2011, http://www.federalreserve.gov/boarddocs/press/general/1999/19990630/default.htm. The Fed’s tightening had the effect of reducing durable spending and thus bringing gross domestic product (GDP) down closer to potential output. As a consequence, there was less pressure on prices.
This policy continued through January 2001. By that point, the United States was very close to recession. (According to the National Bureau of Economic Research Business Cycle dating group, a recession began in March 2001.) From December 2000 to January 2001, the unemployment rate jumped from 3.7 percent to 4.7 percent. The Fed responded by allowing the federal funds rate to decrease steadily, starting in February 2001. This policy led to a federal funds rate of 1 percent by July 2003, a level that was maintained for a year. Historically, this was a very low rate. Over the year, inflation averaged about 2.3 percent, so the real federal funds rate was actually negative.
A turnaround in Fed policy occurred in August 2004. Inflation had started to increase somewhat in early 2004, and the unemployment rate had decreased to 5.3 percent in May 2004. So in August 2004, the Fed started a gradual increase of the target federal funds rate. Look back at Figure 25.3.3 "Short-Term and Long-Term Interest Rates". Recall that part of the monetary transmission mechanism is the link between the nominal federal funds rate, which is very short term, and much longer-term rates. Figure 25.3.3 "Short-Term and Long-Term Interest Rates" shows the federal funds rate along with the 1-year and 10-year Treasury bond yields. The loosening of monetary policy in February 2001 is evident from the decrease in the federal funds rate and the 1-year Treasury rate.
But the long-term Treasury rate seems not to follow the short-term rates that closely. In fact, it seems that the long-term rates started to decrease before the reductions in the federal funds rate began, and then the long-term rates did not decrease nearly as much over the February 2001–August 2004 period. After that time, although the federal funds rate was increased, the long-term rate did not respond much at all.
This reminds us of one the biggest challenges of monetary policy. Although the Fed is able to closely target the federal funds rate, it has much less ability to control longer-term rates. Someone making a loan for a long period of time will try to anticipate economic events over the course of the entire loan period. As a consequence, the loan rate may reflect anticipated events (such as the Fed’s loosening of monetary policy in February 2001) and may also not respond as much to rate changes that are seen as temporary.
Why Do Central Bankers Get Paid So Much?
We have made monetary policy look easy. The effects of the actions of the monetary authority are summarized by Figure 25.3.1 "The Monetary Transmission Mechanism". Given a choice of a target inflation rate and a target level of economic activity, the Fed (and other central banks) ought to know exactly what to do to reach these goals. So why are central bankers so vital to the functioning of the macroeconomy?
What Is the State of the Economy?
In 25.3.4 Section "Closing the Circle: From Inflation to Interest Rates", we described the Taylor rule as relating the target federal funds rate to the state of the economy, specifically the inflation rate and the output gap. As a matter of theory, this is straightforward to describe. The practice is rather harder.
First, it is a significant challenge simply to know the current state of the economy. In the United States, part of the preparation for FOMC meetings is an attempt to figure out the current output gap and other variables. The Board of Governors of the Federal Reserve has a large staff of professional economists, as do the various regional Federal Reserve banks. These economists spend much of their time helping the members of the FOMC understand the current state of the economy.
One particular problem is that the level of real GDP itself is calculated only on a quarterly basis. Potential GDP, meanwhile, is a theoretical construct that requires some guesses about “full employment.” It is not directly measured. So if the Fed learns that real GDP is growing rapidly, it has to judge whether this is because potential GDP is growing rapidly or because actual GDP is above potential.
Since the Fed does not meet to determine policy each day and the Fed’s policies themselves take time to work through the economy, it is not even enough to know the current state of the economy. The FOMC must also forecast the state of the economy for the near future. One talent of the previous Fed chairman, Alan Greenspan, was apparently his use of relatively unorthodox sources to get a sense of the state of the economy.
What Are the Effects of Monetary Policy?
Even if there were no uncertainty about the current state of the economy—that is, the inflation rate and the output gap—monetary policy is still difficult for other reasons. First, as we emphasized earlier, the Fed does not have direct control over the long-term real interest rates that matter for durable goods spending. The Fed can influence a short-term nominal rate, which in turn influences the long-term real rates. But the exact link from one interest rate to the other is not known by the Fed and may change over time. The Fed may fail to achieve the long-term rate that it is aiming for.
Second, the Fed does not have perfect knowledge of the monetary transmission mechanism. Consider again the links between real interest rates and output, as shown in Figure 25.3.9 "The Relationship between the Real Interest Rate and Real GDP". In reality, the Fed does not know exactly what the relationship between interest rates and output looks like. Reality looks more like Figure 25.7.1 "Controlling the Economy". In this picture the Fed is aiming for a high level of output. However, it misses its target real interest rate and actually ends up setting a higher real rate than it wanted. In addition, real GDP is more sensitive to interest rates than it thought, so the high rate leads to a big reduction in GDP. Thus because the Fed fails to achieve its target interest rate and also misjudges the monetary transmission mechanism, it ends up with much lower real GDP than it wanted.
Finally, the Fed has imperfect knowledge of the link between economy activity and price adjustment. Recall that the price setting equation stipulates that inflation depends on the output gap and something called autonomous inflation. As we have seen, this last term captures several factors, including the influence of expectations about the future on current price-setting behavior. This presents a double challenge to the Fed. First, to evaluate the effects of its policy on prices, the Fed needs to know the expectations that underlie autonomous inflation. Second, the Fed must recognize that its actions and statements influence these expectations. This is why the individuals involved in the making of monetary policy are so careful both about what they do and about what they say about what they do.
Figure $1$: Controlling the Economy
The Fed’s ability to control the economy depends on how knowledgeable it is about the state of the economy and on how accurately it can target interest rates.
What Should the Fed Do When Its Goals Are in Conflict?
We know that the goals of the Fed include price and output stability. Sometimes these goals conflict, and when they do, the task of central bankers becomes even more complicated.
The FOMC statement with which we opened this chapter stated that the “Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal.” But what if instead it had said the “Committee perceives the risks of low output growth and high inflation for the next few quarters to be roughly equal”? What would the appropriate monetary policy be in this case? Should the Fed use its power to stabilize prices or to promote economic activity?
The tension is evident from the Taylor rule. Here is an example: the target real interest rate increases when inflation is high and decreases when the output gap is high:
$real\ interest\ rate = −(1/2) \times (output\ gap) + (1/2) \times (inflation\ rate − 4\ percent).$
Remember that a positive output gap means that that the economy is in a recession: actual GDP is below potential. When the economy is in recession and inflation is not very high, the Taylor rule says that the Fed should reduce the real interest rate. And—from this same rule—the Fed should increase the real interest rate in the face of high inflation and a negative output gap. But what should the Fed do when inflation is high and there is a recession? High inflation argues for increasing real interest rates, but a positive output gap argues for a cut in rates.
The Fed—and, indeed, monetary authorities throughout the world—faced exactly this conflict in the mid-1970s when oil prices increased substantially as a result of actions by the Organization of Petroleum Exporting Countries. Researchers who have examined data over the past three decades have found that an increase in oil prices is typically met with an increase in the federal funds rate. The following discussion elaborates on the Fed’s response to oil price increases: Federal Reserve Bank of Cleveland, accessed July 20, 2011, www.clevelandfed.org/Research/inflation/Readingroom/Viewpoint/2005/oil-prices-economy04-05.cfm. A speech by then Fed Governor Ben Bernanke in 2004 provides more details: “Remarks by Governor Ben S. Bernanke at the Distinguished Lecture Series, Darton College, Albany, Georgia,” Federal Reserve, October 21, 2004, accessed July 20, 2011, http://www.federalreserve.gov/boardDocs/speeches/2004/20041021/default.htm. Thus, when faced with conflicting goals stemming from an oil price increase, the Fed seems to have put more weight on the goal of price stability.
When Things Go Badly Wrong
Everything that we have talked about in this section helps to explain why central bankers must be skilled and knowledgeable individuals with a good grasp of both economics and the workings of financial markets. Still, we have essentially been describing the job of a technocrat. Central bankers really earn their salaries in abnormal rather than normal times.
Starting in 2007 and stretching well into 2008, the United States and other countries began to experience financial crises that were similar in some ways to those experienced in the Great Depression. The financial crisis of 2008 is discussed in Chapter 19 "The Interconnected Economy" and Chapter 30 "The Global Financial Crisis". The crisis seemed to begin innocently enough, with a decrease in housing prices that left some people unable or unwilling to cover their mortgage payments. But because of the way financial markets work, it became very hard for lenders to work out which of their assets were “nonperforming”—that is, unlikely to be repaid. As a result, financial markets froze up.
Part of the Fed’s response was an aggressive use of the tools that we have described in this chapter. For example, the Fed reduced the federal funds rate down to 0.25 percent. At that point, the Fed had just about reached the limit of what was possible with monetary stimulus. The problem is that nominal interest rates cannot go below zero because cash has a nominal interest rate of zero. If you keep a dollar bill from this year to next year, it is worth \$1 next year. Therefore it would always be better just to keep cash rather than invest in an asset with a negative nominal return. The Fed had hit what is known as the zero lower bound.
Even though it was at the zero lower bound, the Fed still had other options. In normal circumstances, it operates in the economy by buying and selling short-term government debt, one of the many assets in the economy. But these were highly abnormal circumstances, and it is possible for the Fed to buy and sell other assets as well. This is what the Fed did. During the crisis, the Fed started purchasing many other assets, such as commercial paper. In other words, instead of just lending to banks, the Fed started lending directly to firms in the economy. Central banks in some other countries, such as the United Kingdom, pursued similar policies.Explaining what happened in 2008 involves understanding the actions of the Fed, but it requires many of our other tools as well. For that reason, we take up this crisis in more detail in Chapter 30 "The Global Financial Crisis".
Key Takeaways
1. Despite the large reduction in aggregate economy activity and deflation during the Great Depression, the Fed did not pursue a very aggressive policy. The effectiveness of the Fed was hampered by the unwillingness of households to deposit funds in banks and the unwillingness of banks to make loans.
2. The conduct of monetary policy is made difficult by uncertainty over the current state of the economy and the inexact nature of the effects of interest rates on real GDP and prices.
Exercises
1. In what ways was the Fed not very aggressive during the Great Depression?
2. How could the goals of the Fed be in conflict?
3. Does the Fed know the current state of the economy when it makes decisions? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/25%3A_Understanding_the_Fed/25.07%3A_The_Fed_in_Action.txt |
In Conclusion
A driving analogy is sometimes used to illustrate the problems of the Fed. In the best of all worlds, we would drive a car in perfect weather along straight, wide, dry roads. We would look out crystal clear windows with complete knowledge of exactly where we are on the road and what driving conditions are like up ahead. Then, with complete control over the car, we could adjust speed and direction to reach our destination.
This is not the right picture for monetary policy. Instead, the windshield is very dirty, obscuring current conditions and making predictions almost impossible. Although the driver is well trained, the connection between the tools of the car and its direction and speed is haphazard.
Suppose the driver sees a steep downhill in the distance that requires some slowing down. Putting on the brakes will eventually slow the car down, but the delay is hard to predict. Making matters worse, by the time the car slows, the road may be going uphill again.
More precisely, the first challenge for the Fed is determining the current state of the economy. The Fed must rely on economic data to determine the current state of the economy. This is not easy; data often arrive with lags and with measurement error. Furthermore, the data often provide conflicting signals about the current state of the economy.
The second challenge for the Fed is that the transmission mechanism is not cast in stone. Reducing real interest rates by, say, one percentage point does not create the same response in spending at all times. Instead, the links in the monetary transmission mechanism change over time and depend on numerous other variables in the economy. Understanding these links remains a key area of research in economics and is also a challenge for those responsible for the conduct of monetary policy.
Key Links
exercises
1. Have you ever noticed that banks are often housed in big imposing buildings? Why do you think this is the case?
2. Consider a Taylor rule given by $real\ interest\ rate = −(1/2) \times (output\ gap) + (1/2) \times (inflation\ rate − 4\ percent).$
1. Describe this rule in words. What is the target inflation rate in this rule?
2. If the inflation rate is 6 percent and the GDP gap is −2 percent, what should the real interest rate be? What nominal interest rate should the Fed set?
3. (Advanced) Draw a version of Figure 25.4.4 "The Taylor Rule" where you show how to relate the target interest rate to the output gap. Explain in words what it means to move along the curve. What shifts the curve you have drawn?
4. What would happen if the Fed set the discount rate below the rate of return on government bonds?
5. Do open-market operations have to be in the form of the Fed buying and selling government debt? Could an open-market operation occur with the Fed buying the stock of a company?
6. Explain why an increase in interest rates reduces the demand for durable goods.
7. Suppose the relationship between investment and interest rates is $investment = 100 − 4 \times real\ interest\ rate$ and suppose the multiplier is 2. If the interest rate decreases by one percentage point, what happens to real GDP (assuming no change in the price level)?
8. Give two reasons why it is difficult to conduct monetary policy.
9. Suppose the central bank in country A is more worried about inflation than the output gap, but the opposite is true in country B. What differences in the Taylor rule would you expect to see in the two countries? Must it be the case that country A has a lower target inflation rate than country B?
10. Explain why a positive output gap does not necessarily lead to decreasing prices.
Economics Detective
1. Find the most recent announcement of the Federal Open Market Committee (FOMC). How does it differ from the one from February 2, 2005? Who is currently on the FOMC?
2. Use the site http://www.hsh.com/calc-payment.html to calculate how your monthly payment would change as you vary the interest rate charged on a car loan for a \$30,000 car. This will give you a sense of how actions of the Fed would affect your monthly payments on a loan.
3. Find the names of five other central banks in the world economy. Find some information about their history (when were they established, for example), their design (are they independent?), and their operating procedures.
4. Find the web page for the Board of Governors of the Federal Reserve System and read about the tools of monetary policy. Based on your reading, (a) how often does the FOMC meet, and (b) how is its membership determined?
5. If you live in the United States, find the web page for the regional Fed closest to you. Try to find its most recent report on local economic conditions. Do you agree with this assessment of the local economy? What can you learn about the president of the regional Fed? What about the director of research, who is the staff member most likely to give advice to the president of the regional Fed about monetary policy?
6. Using your web research skills, find a discussion of Fed policy during times of high oil prices. How did the Fed resolve the tensions between increasing rates to combat inflation and decreasing rates to deal with unemployment? Try to find data on (real) oil prices and the federal funds rate. Did these two economic variables move together during periods of high oil prices?
7. In March 2008, the Fed opened the discount window to add liquidity into the financial system. Find the policy statements associated with this action and describe exactly what the Fed did.
8. Get data on the US economy to see how well the Taylor rule, $real\ interest\ rate = −(1/2) \times (output\ gap) + (1/2) \times (inflation\ rate − 4\ percent),$
fits the facts for the past five years.
9. Find an occasion when the Fed has changed reserve requirements. Did it also make other policy adjustments at the same time? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/25%3A_Understanding_the_Fed/25.08%3A_End-of-Chapter_Material.txt |
Through the years, people have been willing to wear some absurd slogans on their clothing. But surely one of the worst was the “WIN” button, introduced by United States President Gerald Ford in a speech on October 8, 1974. President Ford’s speech can be read and heard here: http://www.fordlibrarymuseum.gov/library/speeches/740121.asp. The button, shown in the following figure, was the symbol of a campaign against a perceived a social evil. And what was this great evil? It was inflation. “WIN” stood for “whip inflation now.” President Ford asked citizens to wear WIN buttons as a sign that they were enlisted in the battle against inflation.
Figure \(1\): Button: Whip Inflation Now
Wearing buttons might not have been the first bit of advice economists would have given to a leader interested in battling inflation. But this episode makes it evident that President Ford and his advisors viewed inflation as a major social problem. The president even invoked wartime imagery, concluding his speech by saying the following: President Ford’s speech can be read and heard here: http://www.fordlibrarymuseum.gov/library/speeches/740121.asp.
Only two of my predecessors have come in person to call upon Congress for a declaration of war, and I shall not do that. But I say to you with all sincerity that our inflation, our public enemy number one, will, unless whipped, destroy our country, our homes, our liberties, our property, and finally our national pride, as surely as any well-armed wartime enemy.
I concede there will be no sudden Pearl Harbor to shock us into unity and to sacrifice, but I think we have had enough early warnings. The time to intercept is right now. The time to intercept is almost gone.
My friends and former colleagues, will you enlist now? My friends and fellow Americans, will you enlist now? Together with discipline and determination, we will win.
When President Ford initiated this campaign, the US inflation rate was about 12 percent. In other words, a shirt that cost \$10.00 in 1973 cost about \$11.20 in 1974. This was the highest inflation rate that the United States had experienced since World War II. Inflation running at this rate is, at the very least, a significant inconvenience.
Still, compared to the experience of many countries, this level of inflation is negligible. Between World War I and World War II, Germany, Hungary, Austria, and Poland experienced massive rates of inflation. In one month in 1923, the annual inflation rate in Germany was 6,829 percent. This number is very difficult to fathom; it is astronomical compared to the inflation that President Ford was facing. At this rate of inflation, prices were doubling every three to four days.
Such rapid price increases forced people to change their behavior in extraordinary ways. The instant workers received their pay, they would rush out and spend it, for even a delay of a few hours could mean that your wages would buy fewer goods and services. Even ordering in a café became a game to beat inflation: “The price increases began to be dizzying. Menus in cafes could not be revised quickly enough. A student at Freiburg University ordered a cup of coffee at a cafe. The price on the menu was 5,000 Marks. He had two cups. When the bill came, it was for 14,000 Marks. ‘If you want to save money,” he was told, “and you want two cups of coffee, you should order them both at the same time.’” This comes from a PBS page with many excerpts about the German hyperinflation: “The German Hyperinflation, 1923,” Commanding Heights: The Battle for the World Economy, PBS, accessed September 20, 2011, http://www.pbs.org/wgbh/commandingheights/shared/minitext/ess_germanhyperinflation.html. And these are not just stories from long ago. In the past 25 years, there have been large inflations in Yugoslavia, Israel, Argentina, Brazil, Mexico, Ukraine, and Zimbabwe, for example.
What is the cause of inflation?
Road Map
In this chapter, we study the causes and consequences of inflation. Times of rapid inflation are especially helpful for understanding inflation in general. When inflation is the dominant feature of an economy, it is very easy to isolate the main forces at work. We will see, moreover, that the most interesting periods to study are the beginning and end of large inflations, for such times provide a particular insight into the connection between fiscal policy and monetary policy.
We first study the relationship between the inflation rate and changes in the amount of money circulating in an economy and explain that, in the long run, there is a close connection between the inflation rate and the growth rate of the money supply. We look at some data both for the United States and for other countries and examine some examples of hyperinflation. Then we explore the underlying cause of hyperinflations, which turn out to be connected to the tax and spending choices that governments make, and we conclude by discussing government policy to control inflation. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/26%3A_Inflations_Big_and_Small/26.01%3A_Rising_Prices.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions.
1. What is the quantity theory of money?
2. What is the classical dichotomy?
3. According to the quantity theory, what determines the inflation rate in the long run?
We begin by presenting a framework to highlight the link between money growth and inflation over long periods of time.The framework complements our discussion of inflation in the short run, contained in Chapter 25 "Understanding the Fed". The quantity theory of money is a relationship among money, output, and prices that is used to study inflation. It is based on an accounting identity that can be traced back to the circular flow of income. Among other things, the circular flow tells us that
$nominal\ spending = nominal\ gross\ domestic\ product\ (GDP).$
The “nominal spending” in this expression is carried out using money. While money consists of many different assets, you can—as a metaphor—think of money as consisting entirely of dollar bills. Nominal spending in the economy would then take the form of these dollar bills going from person to person. If there are not very many dollar bills relative to total nominal spending, then each bill must be involved in a large number of transactions.
The velocity of money is a measure of how rapidly (on average) these dollar bills change hands in the economy. It is calculated by dividing nominal spending by the money supply, which is the total stock of money in the economy:
If the velocity is high, then for each dollar, the economy produces a large amount of nominal GDP.
Using the fact that nominal GDP equals $real\ GDP \times the\ price\ level$, we see that
And if we multiply both sides of this equation by the money supply, we get the quantity equation, which is one of the most famous expressions in economics:
$money\ supply \times velocity\ of\ money = price\ level \times real\ GDP.$
Let us see how these equations work by looking at 2005. In that year, nominal GDP was about $13 trillion in the United States. The amount of money circulating in the economy was about$6.5 trillion. In Chapter 24 "Money: A User’s Guide", we discussed the fact that there is no simple single definition of money. This figure refers to a number called “M2,” which includes currency and also deposits in banks that are readily accessible for spending. If this money took the form of 6.5 trillion dollar bills changing hands for each transaction that we count in GDP, then, on average, each bill must have changed hands twice during the year $(13/6.5 = 2)$. So the velocity of money was 2 in 2005.
Toolkit: Section 31.27 "The Circular Flow of Income"
You can review the circular flow of income in the toolkit.
The Classical Dichotomy
So far, we have just written a definition. There are two steps that take us from this definition to a theory of inflation. First we use the quantity equation to give us a theory of the price level. Then we examine the growth rate of the price level, which is the inflation rate.
In macroeconomics we are always careful to distinguish between nominal and real variables:
• Nominal variables are defined and measured in terms of money. Examples include nominal GDP, the nominal wage, the dollar price of a carton of milk, the price level, and so forth. (Most nominal variables are measured in monetary units, but some are just numbers. For example, the nominal interest rate tells you how many dollars you will obtain next year for each dollar you invest in an asset this year. It is thus measured as “dollars per dollar,” so it is a number.)
• All variables not defined or measured in terms of money are real variables. They include all the variables that we divide by a price index in order to correct for the effects of inflation, such as real GDP, real consumption, the capital stock, the real wage, and so forth. For the sake of intuition, you can think of these variables as being measured in terms of units of (base year) GDP (so when we talk about real consumption, for example, you can think about the actual consumption of a bundle of goods and services by a household). Real variables also include the supply of labor (measured in hours) and many variables that have no specific units but are just numbers, such as the velocity of money or the capital-to-output ratio of an economy.
Prior to the Great Depression, the dominant view in economics was an economic theory called the classical dichotomy. Although this term sounds imposing, the idea is not. According to the classical dichotomy, real variables are determined independently of nominal variables. In other words, if you take the long list of variables used by macroeconomists and write them in two columns—real variables on the left and nominal variables on the right—then you can figure out all the real variables without needing to know any of the nominal variables.
Following the Great Depression, economists turned instead to the aggregate expenditure model to better understand the fluctuations of the aggregate economy. In that framework, the classical dichotomy does not hold. Economists still believe the classical dichotomy is important, but today economists think that the classical dichotomy only applies in the long run.
The classical dichotomy can be seen from the following thought experiment. Start with a situation in which the economy is in equilibrium, meaning that supply and demand are in balance in all the different markets in the economy. The classical dichotomy tells us that this equilibrium determines relative prices (the price of one good in terms of another), not absolute prices. We can understand this result by thinking about the markets for labor, goods, and credit.
Figure 26.2.1 "Labor Market Equilibrium" presents the labor market equilibrium. On the vertical axis is the real wage because households and firms make their labor supply and demand decisions based on real, not nominal, wages. Households want to know how much additional consumption they can get by working more, whereas firms want to know the cost of hiring more labor in terms of output. In both cases, it is the real wage that determines economic choices.
Figure $1$: Labor Market Equilibrium
Now think about the markets for goods and services. The demand for any good or service depends on the real income of households and the real price of the good or service. We can calculate real prices by correcting for inflation: that is, by dividing each nominal price by the aggregate price level. Household demand decisions depend on real variables, such as real income and relative prices.If you have studied the principles of microeconomics, remember that the budget constraint of a household depends on income divided by the price of one good and on the price of one good in terms of another. If there are multiple goods, the budget constraint can be determined by dividing income by the price level and by dividing all prices by the same price level. The same is true for the supply decisions of firms. We have already argued that labor demand depends on only the real wage. Hence the supply of output also depends on the real, not the nominal, wage. More generally, if the firm uses other inputs in the production process, what matters to the firm’s decision is the price of these inputs relative to the price of its output, or—more generally—relative to the overall price level.If you have studied the principles of microeconomics, the condition that price equals marginal cost is used to characterize the output decision of a firm. What matters then is the price of the input, relative to the price of output.
What about credit markets? The supply and demand for credit depends on the real interest rate. This means that those supplying credit think about the return they receive on making loans in real terms: although the loan may be stated in terms of money, the supply of credit actually depends on the real return. The same is true for borrowers: a loan contract may stipulate a nominal interest rate, but the real interest rate determines the cost of borrowing in terms of goods. The supply of and demand for credit is illustrated in Figure 26.2.2 "Credit Market Equilibrium".
The credit market equilibrium occurs at a quantity of credit extended (loans) and a real interest rate where the quantity supplied is equal to the quantity demanded.
Toolkit: Section 31.3 "The Labor Market", Section 31.24 "The Credit (Loan) Market (Macro)", and Section 31.8 "Correcting for Inflation"
You can review the labor market and the credit market, together with the underlying demand and supply curves, in the toolkit. You can also review how to correct for inflation.
The classical dichotomy has a key implication that we can study through a comparative statics exercise. Recall that in a comparative statics exercise we examine how the equilibrium prices and output change when something else, outside of the market, changes. Here we ask: what happens to real GDP and the long-run price level when the money supply changes? To find the answer, we begin with the quantity equation:
$money\ supply \times velocity\ of\ money = price\ level \times real\ GDP.$
Previously we discussed this equation as an identity—something that must be true by the definition of the variables. Now we turn it into a theory. To do so, we make the assumption that the velocity of money is fixed. This means that any increase in the money supply must increase the left-hand side of the quantity equation. When the left-hand side of the quantity equation increases, then, for any given level of output, the price level is higher (equivalently, for any given value of the price level, the level of real GDP is higher).
What then changes when we change the money supply: output, prices, or both? Based on the classical dichotomy, we know the answer. Real variables, such as real GDP and the velocity of money, stay constant. A change in a nominal variable—the money supply—leads to changes in other nominal variables, but real variables do not change. The fact that changes in the money supply have no long-run effect on real variables is called the long-run neutrality of money.
Toolkit: Section 31.16 "Comparative Statics"
You can find more details on how to conduct comparative static exercises in the toolkit.
We continue to assume that the velocity of money is a constant.In fact, the velocity of money might also grow over time as a result of developments in the financial sector. Saying that the velocity of money is constant is the same as saying that its growth rate is zero. Using this fact and rearranging the equation, we discover that the long-run inflation rate depends on the difference between how rapidly the money supply grows and how rapidly output grows:
$inflation\ rate = growth\ rate\ of\ money\ supply − growth\ rate\ of\ output.$
The long-run growth rate of output does not depend on the growth rate of the money supply or the inflation rate. We know this because long-run output growth depends on the accumulation of capital, labor, and technology. From our discussion of labor and credit markets, equilibrium in these markets is described by real variables. Equilibrium in the labor market depends on the real wage and not on any nominal variables. Likewise, equilibrium in the credit market tells us that the level of investment does not depend on nominal variables. Since the capital stock in any period is just the accumulation of past investment, we know that the stock of capital is also independent of nominal variables.
Therefore there is a direct link between the money supply growth rate and the inflation rate. The classical dichotomy teaches us that changes in the money supply do not affect the velocity of money or the level of output. It follows that any changes in the growth rate of the money supply will show up one-for-one as changes in the inflation rate. We say more about monetary policy later, but notice that there are immediate implications for the conduct of monetary policy:
• In a growing economy, there are more transactions taking place, so there is typically a need for more money to facilitate those transactions. Thus some growth of the money supply is probably desirable to match the increased income.
• If the monetary authorities want a stable price level—zero inflation—in the long run, then they should try to set the growth rate of the money supply equal to the (long-run) growth rate of output.
• If the monetary authorities want a low level of inflation in the long run, then they should aim to have the money supply grow just a little bit faster than the growth rate of output.
Keep in mind that this is just a theory. The quantity equation holds as an identity. But the assumption of constant velocity and the statement that long-run output growth is independent of money growth are assertions based on a body of theory. We now look at how well this theory fits the facts.
Key Takeaways
1. The quantity theory of money states that the supply of money times the velocity of money equals nominal GDP.
2. According to the classical dichotomy, real variables, such as real GDP, consumption, investment, the real wage, and the real interest rate, are determined independently of nominal variables, such as the money supply.
3. Using the quantity equation along with the classical dichotomy, in the long run the inflation rate equals the rate of money growth minus the growth rate of output.
Exercises
1. Is the real wage a nominal variable? What about the money supply?
2. If velocity of money decreases by 2 percent and the money supply does not grow, can you say what will happen to nominal GDP growth? Can you say what will happen to inflation? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/26%3A_Inflations_Big_and_Small/26.02%3A_The_Quantity_Theory_of_Money.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What does it mean to say that “inflation is always and everywhere a monetary phenomenon”?
2. What do we know about inflation and money growth in the United States?
3. What happened during past and recent hyperinflations?
According to the quantity equation, the inflation rate and the rate of money growth are closely linked. As the famous economist Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.”This quote comes from Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963). By this he meant that inflation could always ultimately be traced to “excessive” money growth. Keep in mind that we are talking about the long run here. Over shorter periods of time, changes in the money supply affect the level of real economic activity and have correspondingly less effect on the inflation rate.
Inflation and Money Growth in the United States
Figure 26.3.1 "Inflation and Money Growth in the Short Run" and Figure 26.3.2 "Inflation and Money Growth in the Long Run" show the relationship between inflation and money growth for the United States. For this discussion, money growth is measured as M1. The rate of money growth is on the horizontal axis, and the annual inflation rate is on the vertical axis.
The two figures differ in the time horizon used to compute the growth rates. In Figure 26.3.1 "Inflation and Money Growth in the Short Run", month-to-month changes in money and prices are used to calculate annual growth rates. If you listen to a radio report or read the newspaper about inflation, typically you will first be told about the monthly Consumer Price Index (CPI) and then be given an annual inflation rate. The annual growth rate is the amount by which the variable would increase if the monthly growth rate persisted for a year. The conversion is simply to take the monthly percentage change and convert it into an annual percentage change by multiplying by 12. So if the CPI increased from 112 to 118 over the past month, then the change for the month would be calculated as follows:
If prices increased at this rate each month at this same rate, then prices would increase by 12 × 5.36 percent = 64.32 percent over the year. The data for Figure 26.3.1 "Inflation and Money Growth in the Short Run" start in January 1959 and end in December 2010. So the first observation is the annual percentage change between January and February 1959.
Figure 26.3.2 "Inflation and Money Growth in the Long Run" examines annual growth rates based on observing the money supply and the price level at five-year intervals. The first observation is the annual growth rate for the period starting in January 1959 and ending in January 1964. The annual growth rates for a five-year period are computed for each month starting in January 1964. Here, instead of multiplying a monthly growth rate by 12 to get an annual rate, we divide a five-year rate by 5 to get an annual rate. The point of examining growth rates over longer periods of time goes back to the idea that we are investigating the relationship between prices and the money supply over long periods of time.
Comparing these two figures, you can see that the relationship between money growth and inflation is much tighter when we examine five-year periods, as in Figure 26.3.2 "Inflation and Money Growth in the Long Run", rather than the monthly changes in Figure 26.3.1 "Inflation and Money Growth in the Short Run". This is consistent with the view that the relationship between money growth and inflation is a long-term relationship, not a short-term relationship.
In the monthly data, the link between money growth and inflation is relatively weak. The correlation, a measure of how closely two variables move together, is only 0.20 in the monthly data. In contrast, for the annual growth rates computed by looking over a five-year period, the correlation is about 0.65, indicating that money growth and inflation move more closely together over longer periods of time.
Toolkit: Section 31.23 "Correlation and Causality"
You can review the meaning and measurement of correlation in the toolkit.
Money Growth and Inflation in Other Countries
In the United States, money growth and inflation rates are relatively moderate. Looking back at Figure 26.3.1 "Inflation and Money Growth in the Long Run", we see that the highest inflation rate in the past half-century was about 15 percent, in 1980. Some other countries have had a very different experience.
Figure 26.3.3 "Inflation and Money Growth in Different Countries" shows data on money growth and inflation from 110 countries.See George McCandless Jr. and Warren Weber, “Some Monetary Facts,” Federal Reserve Bank of Minneapolis Quarterly Review 19, no. 3 (Summer 1995): 2–11. The article provides a complete description of the data and the countries. On the vertical axis of the figure is the inflation rate, measured as the annual rate of change of the CPI. On the horizontal axis is the rate of growth of the money supply. So a point in the figure represents a single country and shows that country’s combination of inflation and money growth. The sample period used is 1960–1990, meaning that each point is an average over a three-decade period.
Figure \(3\): Inflation and Money Growth in Different Countries
Figure 26.3.3 "Inflation and Money Growth in Different Countries" clearly indicates that countries with high money growth are the countries that experience high inflation. If you were to draw a line through the points that came as close as possible to them, that line would have a positive slope. McCandless and Weber conclude as follows: “In the long run, there is a high (almost unity) correlation between the rate of growth of the money supply and the inflation rate. This holds across three definitions of money and across the full sample of countries and two subsamples.” George McCandless Jr. and Warren Weber, “Some Monetary Facts,” Federal Reserve Bank of Minneapolis Quarterly Review 19, no. 3 (Summer 1995): 2–11.
Big Inflations
Most of the countries in Figure 26.3.3 "Inflation and Money Growth in Different Countries" have inflation and money growth that are less than 20 percent. There are some outliers, however. For example, there is one country with inflation and money growth at 80 percent annually over the sample. This country is Argentina; we return to it later. There have been episodes in history where the rates of inflation were so large that they are difficult to comprehend.
Germany, 1922–24
Table 26.3.1 "Prices in Germany" contains data for Germany in the early 1920s.The data come from Thomas Sargent, “The Ends of Four Big Inflations,” in Inflation: Causes and Effects, ed. Robert Hall (Cambridge, MA: National Bureau of Economic Research, 1982). The data in this case show the levels of wholesale prices because reliable consumer price indices were not available. The second column is a measure of prices for each month, from January 1922 to June 1924. The third column computes the annual inflation rate by multiplying the monthly inflation rate by 12. The final column indicates the amount of time in days it would take for prices to double at the annual inflation rate indicated in the third column. (When the number in the last column is negative, it tells you how long it would take the price level to halve.)
Month and Year Price Level Annual Growth Rate (%) Doubling Time in Days
January 1922 3,670 60.3 419
February 1922 4,100 133.0 190
March 1922 5,430 337.1 75
April 1922 6,360 189.7 133
May 1922 6,460 18.7 1351
June 1922 7,030 101.5 249
July 1922 10,160 441.9 57
August 1922 19,200 763.7 33
September 1922 28,700 482.4 52
October 1922 56,600 814.9 31
November 1922 115,100 851.8 30
December 1922 147,480 297.5 85
January 1923 278,500 762.9 33
February 1923 588,500 897.8 28
March 1923 488,800 −222.7 −113.6
April 1923 521,200 77.0 328
May 1923 817,000 539.4 47
June 1923 1,938,500 1036.8 24
July 1923 7,478,700 1620.2 16
August 1923 94,404,100 3042.6 8
September 1923 2,394,889,300 3880.2 6
October 1923 709,480,000,000 6829.4 4
November 1923 72,570,000,000,000 5553.3 5
December 1923 126,160,000,000,000 663.6 38
January 1924 117,320,000,000,000 −87.2 −290
February 1924 116,170,000,000,000 −11.8 −2140
March 1924 120,670,000,000,000 45.6 555
April 1924 124,050,000,000,000 33.2 763
May 1924 122,460,000,000,000 −15.5 −1634
June 1924 115,900,000,000,000 −66.1 −383
Table \(1\): Prices in Germany
From the table, you can get a vivid sense of the pace of prices simply by counting the number of digits used to describe the price level. At the height of the inflation in October 1923, the annual inflation rate was over 6,800 percent. It is hard to make sense of a number like this, which is why we include the fourth column: at this inflation rate, prices double every 3 to 4 days. Rapid inflation of this kind is called hyperinflation.
Where does hyperinflation come from? The quantity theory tells us that the rapid price increases must be related to growth in the money supply, a reduction in output growth, or rapid growth in the velocity of money. Drawing on the quote from Milton Friedman, it is natural to first examine the growth rate of the money supply. Figure 26.3.4 "Money Growth and Inflation in Germany" shows the money growth and inflation rates for Germany during this period. The graph clearly shows that as prices were exploding in Germany, so too was the money supply. In 1922, prices increased 93 percent, and the money stock grew at 52 percent. In the following year, the average inflation rate was up to 433 percent, and the money supply grew at almost 300 percent.These are calculated as January to January growth rates.
In October 1923, when the inflation rate peaked at over 6,800 percent, the money supply grew at nearly 6,000 percent on an annual basis. According to economist Thomas Sargent, 99 percent of the outstanding bank notes had been put in circulation during the previous month. At that point, both prices and the money supply were doubling in a matter of days. Thus the escalating prices were matched by enormous increases in the money supply.
Figure \(4\): Money Growth and Inflation in Germany
At first glance, the German data seem to confirm the idea that large inflation rates are driven by large money growth rates. On closer examination, though, we notice that the inflation rates were greater than the growth rate of the money supply. Yet we said earlier that
\[inflation\ rate = growth\ rate\ of\ money\ supply + growth\ rate\ of\ velocity − growth\ rate\ of\ output.\]
It follows that the velocity of money must have been increasing or output must have been decreasing.
It is plausible, indeed likely, that the velocity of money will increase during a period of very high inflation. If you know that the cash in your pocket will lose its value from one hour to the next, then you want to get rid of it quickly. During the German hyperinflation, anyone with cash wanted to exchange it as quickly as possible for goods and services. Thus money changed hands more and more rapidly: in other words, the velocity of money increased.
Money had ceased to perform one of its key functions. It was no longer a store of value. Even if people were still using money as a medium of exchange, they could no longer rely on money to keep its value. A monetary system is a fragile institution: its success depends on everyone believing in it. See Chapter 24 "Money: A User’s Guide" for more discussion. People are willing to accept money because they think that others will, in turn, be willing to accept it from them. During a hyperinflation, this system breaks down. People are reluctant to accept money because they know that others will not want to accept it from them.
Rapid inflation is also disruptive to the general functioning of the economy. People have to devote much more time and energy to managing their cash. People insist on being paid more frequently and abandon work to shop as soon as they are paid. Furthermore, as discussed later, inflation acts as a tax on work. So higher inflation means a higher tax and thus a reduction in employment and output. Overall, output does tend to decrease during hyperinflation, increasing the inflation rate still further. For Germany, real output decreased by 46 percent in 1923 during the height of the hyperinflation. In contrast, 1924 was a good year for the economy, with real output growing at 35 percent.
So while rapid money growth sets hyperinflation in motion, hyperinflation then becomes self-fueling, powered by increases in the velocity of money and—to a minor extent—decreases in the growth rate of output. In the end, the system can collapse completely, with people no longer being willing to accept money at all. In Germany, this is what eventually happened. There are many anecdotes surrounding the German hyperinflation: children using piles of money as building blocks, households using money as wallpaper, and so forth. Figure 26.3.5 "The Use of Money in a Hyperinflation" shows money being used in a furnace to heat a home.
Figure \(5\): The Use of Money in a Hyperinflatio
In December 1923, the hyperinflation came to an end. Look again at Table 26.3.1 "Prices in Germany". Prices in that month had increased to around a billion times greater than they had been two years previously. But from then the price level stayed roughly steady. In fact, it decreased for the next two months, then fluctuated somewhat. The price level in June 1924 was lower than it was at the start of the year. There is thus a new mystery to solve: what happened to bring the inflation to an end? We return to this question shortly.
Zimbabwe
We discussed the example of Germany in some detail because it is one of the most dramatic hyperinflations ever. But hyperinflations are not simply the stuff of economic history. Indeed, from around 2003 to 2009, the African country of Zimbabwe was embroiled in severe inflation. In 2008, prices were doubling on an almost daily basis. Banknotes were issued in denominations of 100,000,000,000,000 Zimbabwe dollars. “Zimbabwe Hyperinflation ‘Will Set World Record within Six Weeks,’” The Telegraph, November 13, 2008, accessed August 22, 2011, http://www.telegraph.co.uk/news/worldnews/africaandindianocean/zimbabwe/3453540/Zimbabwe-hyperinflation-will-set-world-record-within-six-weeks.html, accessed August 22, 2011; “A Worthless Currency,” The Economist, July 17, 2008, accessed August 22, 2011, http://www.economist.com/node/11751346?story_id=E1_TTSVTPQG, accessed August 22, 2011.
Table 26.3.2 "The Start of the Hyperinflation in Zimbabwe" presents some basic economic facts about Zimbabwe as it entered the hyperinflation; the data come from an International Monetary Fund country report ( http://www.imf.org/external/pubs/ft/scr/2005/cr05359.pdf). Looking at these numbers, one is immediately struck by the severity of the decline in economic activity: real gross domestic product (GDP) decreased every year since 2000, including an 11 percent decline in 2003. At the same time, the country experienced rapid inflation, reaching nearly 600 percent in 2003. As indicated by the third row of the table, the money supply (measured as M1) grew rapidly in 2003 and 2004, fueling the inflation.
Variable 2000 2001 2002 2003 2004
real GDP growth (% change, market prices) −7.3 −2.7 −4.4 −10.9 −3.5
consumer prices (% change) 55.2 112.1 198.9 598.7 132.7
money supply (billions) 52.6 128.5 348.5 2,059.3 6,867.0
Table \(2\): The Start of the Hyperinflation in Zimbabwe
Stories from Zimbabwe resemble the experiences from the 1920s in Germany. The British Broadcasting Company presented some interviews about life during this period of rampant inflation.
THE STUDENT When I go to withdraw my money, I have to wait around 30 minutes because there are so many people waiting.
It’s so difficult.
Maybe you want 10 million but they only give you 2.8, because there is not enough at the bank.
THE LECTURER Children in Harare play in uncollected rubbish. Hyperinflation has meant an end to rubbish collections. It’s a very strange environment.
There are a lot of pay rises, but they are meaningless.
They are always eroded the minute they give us the pay rise.
Also, considering we have so much to pay—we have parents in the countryside, and we have families—it doesn’t work.
People are willing to lend money, but they are not willing to lend it for nothing. It’s usually at a rate of 90 or 100 percent.
Sometimes these are your relatives or people you work with, taking advantage of this.
People are cannibalizing each other.
THE MOTHER Because my income hasn’t risen as much as the prices in the shops, we have had to adjust quite a bit.
The things that we buy—the groceries at home, the things we get for our two children—we have to buy immediately, as soon as we get the money.
We know that if we wait a bit, the prices are going to go up again. If we wait another week, we will not be able to afford anything.
People are taking the money out in suitcases or carrier bags. “Zimbabwe: Living with Hyperinflation,” BBC News, January 31, 2006, accessed July 21, 2011, http://news.bbc.co.uk/2/hi/africa/4665854.stm.
Zimbabwe’s citizens increasingly turned to other currencies to conduct transactions, even though the Zimbabwe dollar was officially the only legal tender in the country. The Zimbabwe hyperinflation eventually ended in January 2009, when the Finance Minister officially permitted citizens to use other currencies in places of the Zimbabwe dollar. “Zimbabwe Abandons Its Currency,” BBC News, January 29, 2009, accessed August 22, 2011, http://news.bbc.co.uk/2/hi/7859033.stm.
Key Takeaways
1. The quote by Milton Friedman that “inflation is always and everywhere a monetary phenomenon” points out the connection between money growth and price growth (inflation). From this perspective, the source of inflation is money growth.
2. Over long periods of time, inflation and money growth are closely linked in the United States.
3. The hyperinflations in many countries, such as Germany and Zimbabwe, were times of rapid growth in prices stemming from rapid expansions of the money supply and subsequently fueled by increases in the velocity of money.
Exercises
1. What happens to the velocity of money during a hyperinflation?
2. What is the difference between a monthly inflation rate and an annual inflation rate? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/26%3A_Inflations_Big_and_Small/26.03%3A_Facts_about_Inflation_and_Money_Growth.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is the inflation tax?
2. How is inflation caused by the central bank’s commitment problem?
3. What happens if there are multiple regions (states or countries) independently choosing how much money to print?
We have argued so far that inflation is caused by excessive money growth, which in turn leads to increases in the velocity of money. But we have also documented that rapid inflations are damaging to the functioning of an economy. There is therefore a deeper question to be asked: why on earth do monetary authorities pursue policies that lead to such disastrous outcomes?
The Inflation Tax
Suppose your country is at war. Wars are expensive. Not only are there soldiers to be paid and kept supplied, but your valuable aircraft and tanks are liable to be destroyed by the enemy while you are in turn throwing costly ammunition and missiles at them. How do governments pay for all these expenses? One thing that the government can do is to tax the population to pay these bills. It may not be feasible to collect enough tax revenue in the time of a war, however. Many governments instead borrow during times of large expenses. This allows the government to spread the tax burdens over time.
So far, taxation and borrowing are the only two possibilities that we have considered. But there is a third possibility: a government can simply print the money it needs. There is a government budget constraint that says the government budget constraint is discussed in Chapter 29 "Balancing the Budget".
$deficit = change\ in\ government\ debt + change\ in\ money\ supply.$
The left side of this equation is the deficit of the government. The deficit is the difference between government outlays and government receipts. The right side of this equation describes how the government finances its deficit. This equation says that the government can finance its deficit by issuing either new government bonds or new money.
Toolkit: Section 31.33 "The Government Budget Constraint"
You can review the details of the government budget constraint in the toolkit.
There is a puzzle here. Money is just a piece of paper with writing on it. The government can print it at will. Yet the government can take these pieces of paper and exchange them for goods and services of real value. It can pay soldiers, or nurses, or construction workers who are building roads. It can print money, hand it over to Airbus or Boeing, and get a new airplane. So who is really paying in this case?
We already know everything we need to know to figure out the answer. When the government prints more money, prices will eventually increase. This comes directly from the quantity equation once we remember that real variables are independent of the money supply in the long run. In the long run, the extra money will just result in higher prices and no additional output. And increased prices mean that existing money becomes less valuable. If the price level increases by 10 percent, existing dollar bills are worth 10 percent less than they were; they will buy (roughly) 10 percent less in terms of goods and services. Inflation is exactly like a tax on the money that people currently hold in their wallets and pocketbooks. Indeed, we say that there is an inflation tax when the government prints money to finance its deficit.
Examine the government budget constraint again. If we write out the deficit in full, the equation says
$government\ purchases + transfers − tax\ receipts = change\ in\ government\ debt+ change\ in\ money\ supply.$
Suppose that government purchases increase, say due to a war, by $100 billion. This equation tells us that, to finance this expense, the government could • increase taxes now by$100 billion,
• increase taxes now by less than $100 billion and sell some government debt, • increase taxes now by less than$100 billion and print some money. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/26%3A_Inflations_Big_and_Small/26.04%3A_The_Causes_of_Inflation.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What are the costs of an excessive inflation tax?
2. When does inflation cause a redistribution?
At the beginning of this chapter, we highlighted President Ford’s campaign to “Whip Inflation Now.” It is clear from that episode that even relatively moderate inflation is perceived as a bad thing. It is even more self-evident that massive inflations, such as those in Germany or Zimbabwe, are highly disruptive. It is hardly surprising that the stated primary objective of most central banks is price stability. All that said, we have not yet really explained exactly why inflation is costly.
An Excessive Inflation Tax
Inflation, used as one tax among many, may be an efficient way of raising some of a government’s revenues. The effects of the inflation tax are like the effects of any tax: people respond by substituting away from the activity being taxed. When the government taxes cigarettes, people smoke less. When the government taxes income, people work less. When the government taxes the money people hold, people hold less money. These changes in behavior are the distortions caused by taxation. People substitute away from holding money in two ways: (1) during moderate inflations, people allocate more of their time to transactions; and (2) during high inflations, people may cease using money altogether.
During high inflations, the real value of money decreases quickly. So if you work and get paid in money, you had better go shopping quickly to make purchases. During hyperinflations, people may literally spend more time trying to get rid of their money than they do earning it in the first place. The same distortion applies, although less dramatically, in times of low to moderate inflation. People respond to inflation by carrying less cash, on average. To do so, they must spend more time standing in line in the bank and at automatic teller machines.
Imagine that ice cream were to be used as money. In a very cold climate, ice cream is just fine as a store of value. In a very hot climate, by contrast, ice cream is a bad store of value. You would probably want to get paid every day, and as soon as you received your ice cream, you would run to the store to buy other goods and services before your money melted. You and everyone else would spend much more time shopping and less time working. Melting ice cream, in this world, is like inflation.
There is a good reason why we do not use ice cream as a medium of exchange. Because it is such a bad store of value, people would quickly abandon it in terms of some other way of trading. During hyperinflations, this is exactly what we see: people substitute away from money completely and instead resort to barter trades. Often, some other commodity, such as cigarettes, starts being generally accepted as an alternative to money. But substitution away from money is costly to the economy. Money facilitates trade. It is generally easier to trade when everyone uses money rather than goods in exchange. When people respond to high inflation by eliminating money from trades, we are observing a distortion from the inflation tax.
Uncertainty and Real Interest Rates
It is the real interest rate that ultimately matters for saving and investment decisions. Yet loans are almost invariably quoted in nominal terms: a loan contract gives the borrower some money with a requirement to pay back that money plus interest in the future. The real and the nominal interest rates are linked by the Fisher equation:
\[real\ interest\ rate ≈ nominal\ interest\ rate − inflation\ rate.\]
To calculate the real interest rate you subtract the inflation rate from the nominal interest rate. So, for example, if the annual interest rate on a car loan is 12 percent and the current inflation rate is 4 percent, then the real interest rate on the car loan is 8 percent.
Toolkit: Section 31.25 "The Fisher Equation: Nominal and Real Interest Rates"
You can review the derivation and uses of the Fisher equation in the toolkit.
The Fisher equation glosses over an important point, however. Suppose you are thinking of taking out a loan this year, allowing you to borrow money now for repayment next year. The inflation rate that matters for this loan is the inflation between this year and next. At the time you sign the contract, you do not know what the inflation rate will be. You must make your decision about the loan without knowing for sure what the real interest rate will be. You have to make a guess:
\[expected\ real\ interest\ rate ≈ nominal\ interest\ rate − expected\ inflation\ rate.\]
Thus when a loan contract is signed, it is based on expectations of what will happen to prices in the future. If a borrower and lender would like to agree on a loan at a 4 percent real interest rate, but both expect 2 percent inflation, then they will agree on a 6 percent nominal interest rate.
What happens if the inflation rate turns out to be different from what the borrower and lender expected? Suppose the actual inflation rate turns out to be 4 percent. This means that the actual real interest rate, from the Fisher equation, is only 2 percent. This is good news for the borrower: he gets a loan at a lower rate than he expected. But it is bad news for the lender: she is repaid at a lower rate than she expected. The opposite is true if the inflation rate is lower than expected. Suppose the actual inflation rate is only 1 percent. Then the real interest rate is higher than anticipated—5 percent instead of 4 percent—which benefits the lender but is costly to the borrower.
Any divergence between actual and expected inflation therefore leads to a redistribution, either from the borrower to the lender or from the lender to the borrower. When inflation is higher than expected, the borrower is better off, and the lender is worse off. The opposite effects occur if inflation is lower than expected: the borrower loses, and the lender wins.
The possibility that the inflation rate will turn out to be unexpectedly high or unexpectedly low means that there is uncertainty whenever people sign loan contracts. A fixed nominal interest rate on a loan exposes both the borrower and the lender to the risk of inflation uncertainty. Uncertainty can prevent beneficial trades from taking place. Imagine that you were thinking of buying a used car, but you had to decide to buy without knowing whether the price was going to be \$1,500 or \$2,000. You might well decide not to buy in the face of this uncertainty. Similarly, people might sometimes decide not to sign loan contracts that would actually be beneficial to them.
The borrower and the lender could always change the form of their contract. Contracts do not have to specify nominal interest rates, and not all of them do. Some loans have interest rates that change with the actual inflation rate. In this way, borrowers and lenders can protect themselves from unexpected inflation. However, such contracts are unusual in practice and are most often seen in countries experiencing high and uncertain inflation. What should we conclude from the fact that loan contracts are rarely protected against inflation? Presumably one of two things is true: either such contracts are expensive to write or the benefit of these contracts is actually small.
Unexpected inflation can also have redistributive effects with other types of contracts. Labor contracts are an example. Although the worker and the firm ultimately care about real wages, most labor contracts are written in terms of nominal wages. That is, most labor arrangements are not indexed and thus leave the parties open to the effects of unanticipated inflation. So, for example, if inflation is higher than anticipated, then the real wage earned by the worker is lower than expected, which is a benefit to the firm.
Economies do respond to inflation, partly through the way in which people write contracts. In countries with high and volatile inflation, labor and other contracts generally provide some form of protection against inflation through indexation. For example, if you agree to a job that pays you \$10 an hour this year, the nominal wage rate next year will change depending on inflation. If, for example, inflation was 20 percent this year, then under an indexed contract your nominal wage would automatically increase by 20 percent to \$12. Under full indexation, the real wage you are paid is constant.
Key Takeaways
1. Inflation can distort choices, such as the holding of money. A small amount of inflation, so that it is one tax among many, makes economic sense, but high inflation leads to significant distortion in the economy.
2. Expected inflation is reflected in the terms of loan agreements. Unexpected inflation leads to a lower real interest rate and thus a redistribution from the lender to the borrower.
Exercises
1. If the inflation rate is lower than expected, who gains and who losses?
2. What costs of inflation are highlighted in our discussion of Zimbabwe in 26.3 Section "Zimbabwe"? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/26%3A_Inflations_Big_and_Small/26.05%3A_The_Costs_of_Inflation.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What actions can governments take to prevent excessive inflation?
2. How can hyperinflations be ended?
3. How do governments overcome the commitment problem?
We have already explained that money is a fragile social institution: money has value only because people believe it has value. Hyperinflations illustrate this fragility. Large inflations are impressive but, fortunately, are also relatively rare. In other words, most of the time monetary authorities are somehow able to maintain confidence in the system. To understand how they do so, we begin by looking at how hyperinflations come to an end.
Ending Big Inflations
As noted in 26.4 Section "The Inflation Tax", the rapid inflation in Germany ended abruptly. Although October 1923 was the month with the highest inflation rate, prices actually decreased in early 1924.
How did the hyperinflation end? The answer has to do with the conduct of fiscal policy. On October 15, 1923, a decree created a new currency from the old one. A key element of the decree was limits imposed on the money creation process by the central bank, particularly the provision of credit to the government. According to economist Thomas Sargent, who has studied how hyperinflations end, “This limitation on the amount of credit that could be extended to the government was announced at a time when the government was financing virtually 100 percent of its expenditures by means of note issue.” Thomas Sargent, “The Ends of Four Big Inflations,” in Inflation: Causes and Effects, ed. Robert Hall (Cambridge, MA: National Bureau of Economic Research, 1982), 83. Prior to October 1923, government spending was financed by printing money. After the decree, the printing presses were effectively turned off. As a consequence, the government’s budget went into surplus starting in January 1924. The hyperinflation was over once the printing presses were quiet.
Other countries that experienced hyperinflation around this time had similar stories: there was an abrupt end to hyperinflation after a regime change in which fiscal imbalances were restored. In Austria, for example, the inflation ended when the government established an independent central bank and adopted a fiscal policy that did not require financing by the central bank. The reforms in these countries had two effects: (1) the fiscal reforms limited the budget deficits, and (2) the monetary restrictions implied that deficits would not be financed by the printing of money.
A natural question is: what took them so long? Given the damage caused by these periods of hyperinflation, why did the countries not adopt these policies earlier? Part of the explanation may lie in political affiliations of the governments in these countries. Or, perhaps, these governments simply did not appreciate the rather complex links between fiscal and monetary policy.
Delegating Monetary Power to Another Country
Sometimes countries take even more drastic measures to shield monetary policy from political pressures. One is to effectively eliminate the monetary authority and delegate monetary policy to another country. Some small countries do this by simply using another country’s currency. Panama, El Salvador, and Ecuador, for example, have used the US dollar as their currency. Zimbabwe effectively did the same in 2009.
Argentina in the 1990s is an interesting example of a country that went almost—but not quite—that far. Figure 26.4.2 "The Price Level in Argentina" shows the price level in Argentina from 1988 to 2005. There are evidently three distinct periods: very high inflation, zero inflation, and then moderate inflation. From 1988 to 1993, there was substantial inflation. The annual inflation rate was about 343 percent in 1988 and was over 2,300 percent in 1990. But by 1993 it was only 10 percent, and from 1994 to 2001 it was effectively zero. Then, starting in 2002, there was a resurgence of inflation. What happened?
As we explained earlier, Argentina suffered from hyperinflation in the late 1980s as a consequence of a weak monetary authority. In 1991, Argentina adopted a novel monetary system called a currency board. Every single peso in circulation was “backed” by a US dollar held by the Central Bank of Argentina. If desired, people had the right to take their pesos to the Central Bank of Argentina and swap them for dollars. Thus Argentina both adopted a fixed exchange rate between the peso and the dollar (1 peso equals \$1) and also made that exchange rate credible by always having enough dollars on hand to exchange for the pesos in circulation. For all intents and purposes, Argentina had switched to using US dollars.
Argentina therefore avoided inflation by ceding control of monetary policy to the United States. Since the central bank in the United States controls the quantity of dollars and Argentina linked pesos to dollars, then, everything else the same, the Fed could change the amount of pesos in Argentina, whereas the Central Bank of Argentina could not. The Central Bank of Argentina could resist pressures to inflate by arguing that it did not control the money supply.
Many observers thought at the time that Argentina’s currency board would ensure price stability in Argentina. They thought that there would no longer be pressure on the monetary authority from the fiscal side of the economy. This proved to be incorrect. Taking advantage of its healthy economy in the early 1990s, Argentina adopted expansionary fiscal policies. A combination of factors then triggered recession in the country. Unemployment increased to 18 percent. It was not possible to expand fiscal policy much further, and Argentina had given up its control over monetary problem. In the late 1990s and early 2000s, the recession became so severe that the political pressure on the monetary authority was insurmountable. Argentina abandoned its currency board. One result was a resurgence of inflation.
Another variation on the delegation of monetary policy is that adopted by many countries in Europe. They decided to abandon their currencies and their monetary autonomy in favor of a new currency called the euro. Monetary policy is run by the European Central Bank, which is highly independent. Independent central banks are better able to resist political pressure, so countries that had previously had weak central banks saw a significant advantage in adopting the euro.
Abandoning one’s currency in favor of a new currency, as occurred throughout Europe, seems like a particularly powerful way for a country to commit to a new monetary regime. It is worth remembering, though, that no monetary system is cast is stone. Just as Argentina’s currency board collapsed despite its apparent credibility, so too could a country decide to abandon the euro and reestablish its own currency. Indeed, following fiscal problems in several countries in Europe (most notably Greece, Portugal, and Ireland), there has been some speculation that some countries might eventually choose to do just that.
Independent Monetary Authorities
Hyperinflations arise when the central bank is weak and unable to resist the pressures put on it by others—notably politicians—to use monetary policy for other purposes. Monetary authorities must be able to “just say no.” This suggests that monetary authorities will be able to do a better job if they are independent of other branches of government.
Economists have studied the relationship between measures of the independence of a country’s central bank and the inflation rate in that country. Economists Alberto Alesina and Lawrence Summers examined both political and economic independence of the monetary authority. By political independence, they meant the process of appointing the leadership of the central bank and the role of government officials in the conduct of monetary policy. By economic independence, they meant the extent to which the monetary authority is under pressure to finance the government’s budget deficit.
Figure 26.6.1 "Central Bank Independence and Inflation" displays data from their research. The horizontal axis shows annual inflation, and the vertical axis is their index of central bank independence, with higher numbers indicating a more independent central bank. The data are averaged over the period 1955–1988. Each point in the figure refers to a particular country. Switzerland and Germany both receive very “high” central bank independence ratings of 4 and have relatively low average inflation. Spain, in contrast, has the second lowest measure of central bank independence and has the highest inflation rate in the study.
Since the work of Alesina and Summers (and other economists), more and more countries have become convinced of the virtues of having an independent central bank. For example, when the Labour Party came to power in Britain during the 1990s, one of their first acts was to make the Bank of England more independent. This was particularly striking because the Labour Party is a center-left political party, yet independent central banks tend to be conservative, focusing primarily on inflation and not worrying so much about employment and output.
Events in Argentina also attest to the value of an independent central bank. In 2003, the Congress in Argentina passed an act stating,
The Argentine Central Bank is a National State self-governed institution, whose primary and fundamental mission is to preserve the value of the Argentine currency.
When formulating and implementing the monetary and financial policy, it is not subject to the orders, guidelines or instructions of the National Executive branch of government.“BCRA Law,” Banco Central de la República Argentina, accessed September 20, 2011, http://www.bcra.gov.ar/institucional/in010000_i.asp.
There are two key elements in this act. First, the stated goal of the Central Bank of Argentina is to preserve the value of the currency. There is no mention of pursuing full employment, just a version of price stability. Second, the central bank is to be independent of the executive branch of the government.
Inflation Targeting
Under a policy regime called inflation targeting, some central banks use their tools to set the inflation rate as close as possible to a target. Just as we know that a monetary authority cannot literally control interest rates, we know it cannot literally set the inflation rate either. Rather, it can use the policy tools at its disposal to influence the economy in an attempt to reach the target inflation rate.
In its simplest form, the target is some publically announced inflation rate—say, 3 percent. If the monetary authority thinks the inflation rate is likely to be higher than 3 percent for the year, it adopts contractionary monetary policy to reduce the inflation rate. If it thinks that the inflation rate is likely to be lower than the target, it adopts an expansionary policy. Inflation in this world is relatively predictable.
What should the target be? If, as one might believe from all the discussion in the press and elsewhere, inflation is a pernicious problem, then perhaps the inflation target should be zero. Yet most central banks following this policy adopt targets with positive inflation rates, based on the belief that a little bit of inflation may be useful in the economy. One argument often heard is that deflation (negative inflation) is problematic. From a historical perspective, a prolonged period of deflation in the Unites States occurred during the Great Depression and coincided with a negative output growth. More recently, Japan experienced both slow real gross domestic product (real GDP) growth and some periods of deflation during the 1990s.
Many policymakers have apparently concluded that deflation is to be avoided because it could underlie a depression. An alternative possibility is that deflation is correlated with periods of low economic activity, but it is unclear whether it is the cause or the consequence of a sluggish economy. Whatever the connection between deflation and depression, the prevailing wisdom of the Fed (and other central banks) is to avoid deflation. Given that the central banks cannot always hit their targets precisely, aiming for zero inflation makes deflation more likely than when central banks adopt a target with positive inflation.
In addition, a little inflation may make it easier for relative prices and wages to adjust in an economy. If the demand for beef decreases and the demand for pork increases, then the price of beef should decrease, and the price of pork should increase. Such adjustment is straightforward. Similar logic says that if the demand for accountants decreases and the demand for systems analysts increases, then the wages of accountants should decrease, and the wages of systems analysts should increase. This may be more problematic. People typically respond very negatively if there is an attempt to cut their wages. It may be easier for employers to let inflation do the job of reducing the real wage instead. (This is an argument that makes some economists uncomfortable since it implies irrationality on the part of workers. Still, the psychological resistance to nominal wage cuts appears to be strong.)
A second issue is whether the inflation target should be allowed to vary. Instead of announcing a 3 percent target for all times, the monetary authority might decide that the target rate should depend on the state of the economy. For example, they could have a higher target rate in recession and a lower target rate in booms. This way monetary policy could still be used to help keep the economy at potential output.
Finally, there is the question of “punishment” for missing a target. If the purpose of inflation targeting is to support a particular (moderate) inflation rate, then a central banker missing the target ought to be fined or even terminated, just like a manager of a store who persistently misses sales targets. Presumably, if a central bank has goals to achieve, it should also have incentives to meet those goals. Central bankers are often called to testify in front of bodies, such as the US Congress, who monitor the progress of the economy relative to particular targets.
Australia is an example of a country that follows an inflation target rule. According to the charter of the Reserve Bank of Australia ( http://www.rba.gov.au/monetary-policy/about.html), the goal of Australian monetary policy is to maintain inflation between 2 and 3 percent annually, on average. The central bank does also recognize of the role of monetary policy for stabilization purposes. Thus even though it has a target range for inflation, it also examines the state of the economy when setting monetary policy. Moreover, the phrase on average means that the central bank has some leeway in the conduct of policy: they can allow inflation to increase above 3 percent for a short while, provided that they eventually take actions to bring the inflation rate back down.
Key Takeaways
1. Governments can take a variety of actions to prevent excessive inflation. These include the delegation of monetary policy to another central bank, the creation of an independent monetary authority, and constraining monetary policy to focus solely on inflation.
2. Historically hyperinflations ended when the government restored fiscal balance by eliminating deficit spending.
3. A government can overcome a commitment problem by delegating the conduct of monetary policy to a more conservative central bank. This can be achieved through a currency board or through joining a monetary union.
Exercises
1. What is the difference between a fixed exchange rate and a currency board?
2. What is an independent central bank? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/26%3A_Inflations_Big_and_Small/26.06%3A_Policy_Remedies.txt |
In Conclusion
We have studied some severe and extreme cases of inflation to reveal the sources of rapid price increases. The quantity equation and the data both clearly indicate that inflation is linked to money supply growth. During periods of rapid inflation, the money supply is growing as well. The velocity of money also increases in times of rapid inflation, reflecting the collapse of confidence in the monetary system.
Money supply growth, in turn, comes about because money creation can help finance government budget deficits. Instead of using taxes to finance government spending, governments just print money. This increases prices and thus acts like a tax on those holding money and other nominal assets. Like all taxes, the inflation tax is distortionary. Used in moderation, there is an argument for using this tax along with others. But for some countries in some time periods, the use of the inflation tax has been excessive and there have been very costly hyperinflations.
The way to avoid excessive inflation is to create fiscal balance and monetary discipline. The big inflations between World War I and World War II ended when fiscal balance was restored. Monetary discipline comes in many forms. It requires an independent central bank, immune from political pressures. It may also require a central bank focused on an inflation target, paying less attention to other macroeconomic issues.
Key Links
exercises
1. What is the difference between the quantity equation and the quantity theory of money?
2. According to the classical dichotomy, what happens to the real money supply if the nominal money supply grows at 10 percent?
3. If you were to draw a line through the points in Figure 26.3.3 "Inflation and Money Growth in Different Countries", it would not pass through the origin. Can you explain why? (Hint: examine the equation for the quantity equation, expressed in growth rates.)
4. Looking at Figure 26.4.2 "The Price Level in Argentina", you might be fooled into thinking that the inflation between 2002 and 2003 was almost as bad as that between 1990 and 1991. Why would this reasoning be a mistake?
5. The chapter contains two perspectives on Germany. The first is the hyperinflation in Germany during the 1920s, and the second is current Germany with low inflation and an independent central bank. How would you describe the differences in economic achievement (inflation, output growth, and unemployment) between these two versions of Germany? What were the institutional differences between these two versions of Germany?
6. Looking at Table 26.3.2 "The Start of the Hyperinflation in Zimbabwe", what happened to the velocity of money in Zimbabwe during the hyperinflation?
7. If the central bank takes the view that producing at potential GDP is efficient, then does it face a commitment problem?
8. In 2010, the state of California faced severe budgetary problems. If the state could print dollars, how would that relieve its budget problems? Who would pay the inflation tax?
Economics Detective
1. In the United States, how many central banks are there?
2. In note 5, we mention a measure of the money supply called “M2.” There are other measures of the money supply. For example, “M1” refers to currency and other assets that are immediately available for spending purposes. Find the most recent measure of the stocks of M1 and M2 for the United States.
3. Calculate the velocity of money for a country other than the United States.
4. The chapter did not present data on other recent periods of high inflation in countries such as Argentina, Brazil, Israel, and others. Search the Internet to find data on the inflation experiences of these countries. Create a graph of the growth rates of inflation and money in one of these countries.
5. It might be that countries have high money growth and thus high inflation because these are the goals of their monetary authority. See whether you can find a monetary authority with a stated goal of high inflation. If not, then think about why countries experience inflation if that is not the objective of the monetary authority?
6. What countries are dollarized in the world economy? Try to find out how dollarization influenced the inflation rate in that country.
7. Try to find a statement of the objectives of the Central Bank of Argentina. Part of independence is the way in which the decision makers at the central bank are appointed. How are these appointments made in Argentina?
8. Go to the web page for the Bank of Australia to learn about inflation targeting. What is their inflation target? How is it determined? What happens if they miss the target? Compare this to the objective and policy decisions of the Fed in the United States. What other central banks follow an inflation-targeting rule?
9. Is monetary policy in the United States guided by an inflation target? Does the European Central Bank use an inflation target?
Spreadsheet Exercise
1. Create a version of Table 26.3.1 "Prices in Germany" using a spreadsheet. Examine quarterly data for the United States or another country for the years 2007 to 2009. For prices, use the GDP implicit price deflator. Use the spreadsheet to calculate the inflation rate. Then put in a measure of the money supply and real GDP. Use the spreadsheet to calculate the velocity of money. Is the velocity of money approximately constant? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/26%3A_Inflations_Big_and_Small/26.07%3A_End-of-Chapter_Material.txt |
Every year, in the middle of April, US citizens and residents are required to file an income tax form. The following figure shows the 1040EZ tax form, which is the simplest of all these tax forms. For the majority of us, this is one of the most direct pieces of contact that we have with the government. Based on the declarations we file, we are required to pay taxes on the income we have earned over the year. These tax revenues are used to finance a wide variety of government purchases of goods and services and transfers to households and firms. Of course, income taxes are not unique to the United States; most other countries require their residents to complete a similar kind of form.
Figure \(1\): Easy Tax Form
From the perspective of a household or a firm, the tax form is a statement of financial responsibility. From the viewpoint of the government, the 1040 tax form is an instrument of fiscal policy. The 1040 form is based on the US tax code, and changes in that code can have profound effects on the economy—both in the short run and in the long run.
In this chapter, we study the various ways in which income taxes affect the economy. An understanding of taxes is critical for policymakers who devise tax policies and for voters who elect them. Tax policies are often controversial, in large part because they affect the economy in several different ways. For example, in the 2004 and 2008 US presidential campaigns, one of the most contentious economic policy issues was an income tax cut that President George W. Bush had initiated in his first term and that the Republican Party wished to make permanent. That issue returned to the forefront of political discussion in 2010, when these tax cuts were renewed.
Politicians have argued about such matters since the country was founded. Should the government ensure it has enough tax revenue to balance its budget? How should we raise the revenues to pay for our government programs? What is the appropriate tax on the income received by individuals and corporations? Fiscal policy questions like these are debated in the United States and other countries throughout the world. They are tough questions for politicians and economists alike.
Politicians focus largely on who wins and loses—which groups will bear the burden of taxes and receive the benefits of government spending and transfers? They do so for political reasons and because one goal of a tax system is to redistribute income. Economists emphasize something rather different. Economists know that taxes are necessary to finance government expenditures. At the same time, they know that taxes can have the negative effect of distorting people’s decisions and lead to inefficiency. Hence economists focus on designing a tax system that achieves its goals of raising revenue and redistributing income, without distorting the decisions of individuals and firms too much.
In addition, macroeconomists have observed that taxes significantly affect overall economic performance, as measured by variables such as real gross domestic product (real GDP) growth or the unemployment rate. The government can use changes in taxes as a means of influencing aggregate spending in the economy. In the United States, the federal government has often changed income taxes to affect overall economic performance. In this chapter, we examine two examples: the tax policies of the Kennedy administration of 1960–63 and the Reagan administration of 1980–88.
Our discussion of the Kennedy tax cut experience highlights the way in which variations in income taxes are used to help stabilize the macroeconomy. We use the Reagan tax cuts of the early 1980s to explore the growth implications of income taxes, which are often called “supply-side effects.”
Road Map
Our approach to understanding the effects of income taxes on the economy is summarized in Figure 27.1.2 "Macroeconomic Effects of Tax Policy":
• Taxes affect consumption and hence aggregate expenditure and output.
• Taxes affect saving and hence the capital stock and output.
• Taxes affect labor supply and hence output.
Any change in the income tax regime affects both the spending and the supply sides of the economy. Our reason for thinking separately about the Kennedy and Reagan tax experiments is to isolate the spending effects and the supply effects. Once you understand these different channels, you will be equipped to evaluate other tax policies, such as those adopted later by President George W. Bush. Finally, the figure reveals that the choice between consumption and saving and the choice between work and leisure are at the heart of our analysis. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/27%3A_Income_Taxes/27.01%3A_Tax_Day.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is the difference between a marginal and an average tax rate?
2. How does the tax system redistribute income?
Before delving into the details of President Kennedy’s tax policy, we review the basics of personal income taxation. This review is not only helpful for your study of economics but also may be useful when you have to fill out your own income tax form. Even a quick glance at the 1040EZ form in Figure 27.1.1 "Easy Tax Form" suggests that taxes are a very complex topic. Indeed, the US federal tax code governing income taxes alone runs to thousands of pages. The taxes that you pay depend on your adjusted gross income (line 4), which is the income you receive from a variety of sources (the main components noted on the return are wages, interest income, and unemployment compensation). But there is also a “standard deduction” and an “exemption” (line 5)—for a single person in 2010, these totaled $9,350. For the EZ form, your taxable income is given as the following: $taxable\ income = adjusted\ gross\ income − (deduction + exemption).$ If your financial situation is very simple, you can file this EZ form. However, if you receive income from other sources (such as dividends on stocks), or if you wish to “itemize” your deductions (for payments of interest on home mortgages, dependent children, property taxes, and so forth), you have to file a more complicated form, often with several other forms containing supplementary information. Thus the calculation of adjusted gross income and deductions can be quite complex. For all individuals, however, the basic relationship still holds: $taxable\ income = adjusted\ gross\ income − (deductions\ and\ exemptions).$ Once you know your taxable income, there are then different tax rates for different income levels.Even this is not quite the whole story. There are various tax credits for which some individuals are eligible, and there is also something called the alternative minimum tax, which must be calculated. Marginal and Average Tax Rates From the perspective of macroeconomics, this complexity is daunting, particularly when we remember that the details of the tax system vary from country to country and year to year. The income tax is evidently not a simple thing that can be incorporated in a straightforward way into our frameworks. We cannot hope to incorporate all these features of the tax code into our theory without getting completely bogged down in the details. If we are going to make sense of how taxes affect consumption behavior, we must leave out most of these complicating elements. The challenge for economists is to decide which features of the tax system are critical for our analysis and which are peripheral and can be safely ignored. One noteworthy feature of the income tax system is that not everyone pays the same amount of tax. Table 27.2.1 "Revised 2010 Tax Rate Schedules" shows the income tax schedule for the year 2010 for a single taxpayer.There are other schedules for members of a household filing jointly. These and related tables are available from “Forms and Publications,” Internal Revenue Service, accessed September 20, 2011, http://www.irs.gov/formspubs/index.html. It indicates how much tax a must be paid for a given level of taxable income. If Taxable Income The Tax Is Then Is Over (in US$) But Not Over (in US$) This Amount (in US$) Plus This (%) Of the Excess Over (in US$) 0 8,375 0 10 0 8,375 34,000 837.50 15 8,375 34,000 82.400 4,681.25 25 34,000 82.400 171,850 16,781.25 28 82.400 171,850 373,650 41,827.25 33 171,850 373,650 108,421.25 35 373,650 Table $1$: Revised 2010 Tax Rate Schedules To use this table, you must first find your taxable income. Suppose it is$20,000. Your tax is then determined from the second row of the table. You would owe $837.50 + 0.15 \times (20,000 − 8,375)$, which is $2,581.25. Figure 27.2.1 shows the relationship between taxes and income implicit in the tax schedule summarized in Table 27.2.1 "Revised 2010 Tax Rate Schedules". This figure shows the amount of tax you must pay given your adjusted gross income (upper panel) and your taxable income (lower panel). We see two key facts: 1. As an individual’s income increases, he or she pays more in tax (the line slopes upward). 2. As an individual’s income increases, he or she pays a larger fraction of additional income in tax (the line becomes steeper at higher levels of income). This leads us to two ways to think about the tax schedule a household faces. The figure shows the amount of tax owed by a single individual in the United States who takes the “standard deduction.” The upper panel has adjusted gross income on the horizontal axis, whereas the lower panel has taxable income on the horizontal axis. As shown in Table 27.2.1 "Revised 2010 Tax Rate Schedules", there were six different tax rates in effect in 2010, ranging from 10 percent for low-income individuals to 35 percent for high-income individuals. The tax rates in the fourth column are the marginal tax rates since they represent the tax rate paid on marginal (that is, additional) income. Thus higher income households pay higher marginal tax rates. The marginal tax rate can be seen graphically as the slope of the line in Figure 27.3.1. We are often interested in knowing what fraction of an individual’s income goes to taxes. This is called the average tax rate. Returning to the example we calculated earlier, if you have an income of$20,000 and thus pay taxes of $2,581.25, your average tax rate is equal to , or 12.9 percent. The marginal tax rate of 15 percent is greater than the average tax rate of 12.9 percent. There is a difference between the tax you pay on average and the tax rate charged on the last dollar of income.The average tax rate can also be given a graphical interpretation. It is the slope of a line from the origin to the point on the graph. Leaving aside the details of exemptions and deductions, the essence of the income tax code is captured in the table and figures we have just presented. Even these, however, are quite complicated. We want to build income taxes into our framework of the economy, so it would be nice if we could decide on a simpler way to represent the tax code. The art of economics lies in deciding how to take something complicated, like the US income tax code, and represent it in as simple a way as possible while still retaining the features that matter to the problem under discussion. Looking at Figure 27.2.1, we can see that the relationship between taxes paid and taxable income looks approximately like a straight line. It is not exactly a straight line because it becomes steeper as marginal tax rates increase. For our purposes in this chapter, however, it is a reasonable simplification to represent this relationship as a line—that is, to suppose that the marginal tax rate is constant. In addition, we ignore the standard deduction and exemption. That is, we suppose that people start paying taxes on their very first dollar of income. Thus we suppose that $taxes\ paid = tax\ rate \times income.$ Representing the tax schedule this way is fine if we want to examine the economy as a whole and are not particularly concerned with the way in which taxes affect different households. We use this simplified model of the tax system at various times in this chapter. Effects of Changes in Tax Rates We can use this simple model of the tax system to see how a change in the income tax rate affects both individuals and the economy as a whole. Suppose there is a cut in the tax rate. Since $taxes\ paid = tax\ rate \times income$, the immediate impact is to reduce the amount of taxes households pay: for a given income, a reduction in the tax rate reduces taxes paid. This means that disposable income, which is the income left over after paying taxes and receiving transfers, increases. What do households do with the increase in disposable income? A likely answer is that a typical household spends some of this extra income and saves the remainder. If all households follow this pattern, then the increased spending by each household translates into larger consumption in the aggregate economy. At this point, the power of the circular flow of income will take over, and the level of income and output in the economy will increase even further. Toolkit: Section 31.27 "The Circular Flow of Income" You can review the circular flow of income in the toolkit. As the economy expands, the amount of taxes paid starts to increase. In other words, one consequence of a tax cut is that the tax base (income) expands. The ultimate effect of a tax cut on the overall amount of taxes paid depends on both this expansion of the tax base (income) and the reduction of the tax rate. Taxes and Income Distribution The effects of a tax cut are not the same for everyone. Changes in the tax code affect the distribution of income. If we want to understand such effects, however, it is a mistake to use our simple model of the tax system. We must instead examine how marginal tax rates are different at different levels of income. Suppose that marginal tax rates increase with income, which means that average tax rates increase with income. Higher income households then pay a larger fraction of their income as taxes to the government. As a result, the distribution of income after taxes is more equal than the distribution of income before taxes. Imagine that we take two individuals with different levels of income and calculate their tax payments and after-tax income. Suppose that the first individual earns$20,000 per year and the other earns $200,000. Table 27.2.2 "The Redistributive Effects of Taxation (in US$)" shows the amount of tax each pays and their income after taxes, based on the tax schedule from Table 27.2.1 "Revised 2010 Tax Rate Schedules". Notice from the table that the marginal tax of the high-income household is 33 percent, compared with the 15 percent marginal tax of the low-income household. The total tax paid by the high-income individual is $51,116.75, which is almost 20 times the tax paid by the low-income household. Whereas the pre-tax income of the richer household was 10 times greater than that of the poorer household, its after-tax income is 8.5 times greater. Income Tax Paid Income after Taxes 20,000 2,581.25 17,418.75 200,000 51,116.75 148,883.25 Table $2$: The Redistributive Effects of Taxation (in US$)
This example shows that the tax code redistributes income from high-income to low-income households. What is more, the redistribution does not necessarily stop here. We have not said anything about what the government does with the tax revenues it receives. If the government transfers all those revenues to low-income households, then the combined redistributive effect of taxes and transfers is even stronger.
When we talk about the effects of taxes on labor supply and disposable income, keep in mind that the size of these effects is different for households at different levels of income. These varying effects matter for the politics of tax cuts because lawmakers pay close attention to which income groups are affected by tax policy.
Key Takeaways
1. The marginal tax rate is the rate paid on an additional dollar of income, and the average tax rate is the ratio of taxes paid to income.
2. When the marginal tax rate is increasing in income, then the tax system redistributes from richer households to poorer households. In this case, after-tax income is more equal than income before taxes are paid.
Exercises
1. Use Table 27.2.1 "Revised 2010 Tax Rate Schedules" to calculate the tax you would pay if your income were \$30,000.
2. If taxes paid equal the tax rate times income, what happens to the average tax rate when the marginal tax rate changes? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/27%3A_Income_Taxes/27.02%3A_Basic_Concepts_of_Taxation.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What was the state of the economy prior to the Kennedy tax cut of 1964?
2. What framework did economists at that time use to predict the effects of this tax cut?
3. What was the response of the economy to this tax cut?
Now that we have some basic idea of how income taxes work, we turn to the Kennedy tax cut of 1964. We begin with some background information; we then develop the economic tools needed to analyze the effects of the tax policy on household consumption and thus on real gross domestic product (real GDP).
The Scenario
In his inaugural presidential address, President Kennedy famously said, “My fellow Americans, ask not what your country can do for you; ask what you can do for your country.” The Kennedy administration recruited top individuals in all fields (“the best and the brightest”) to come to Washington in this new spirit of commitment to public service.See David Halberstam, The Best and the Brightest (New York: Ballantine Books, 1972).
Every president has a group of economists, known as the Council of Economic Advisors (CEA; http://www.whitehouse.gov/cea), that provides advice on economics and economic policy. The list of members and staff of the 1961 CEA reads today like a “who’s who” of economics. James Tobin and Robert Solow were prominent members of the economics team; both went on to win Nobel Prizes in Economics. The chairman of the CEA was Walter Heller, an economist known for a wide variety of contributions on the conduct of macroeconomic policy.
The economists in the Kennedy administration observed that there had been three recessions in the two Eisenhower administrations (1952–1960): one from 1953 to 1954 after the Korean War, one from 1957 to 1958, and one in 1960. You can see these in Figure 27.3.1 "Real GDP in the 1950s". The CEA members and staff thought that more aggressive fiscal and monetary policies could be used to keep the economy more stable and prevent such recessions. Their goal of moderating fluctuations in the economy was based on the framework of the basic aggregate expenditure model, which had been developed in the aftermath of the Great Depression, augmented by some developments in economic thinking from the 1940s and 1950s. Based on that analysis, they believed that fiscal and monetary policies could be used to control aggregate spending and hence real GDP.
Toolkit: Section 31.30 "The Aggregate Expenditure Model"
You can review the aggregate expenditure model in the toolkit.
The chart shows real GDP in the United States between 1952 and 1960, measured in billions of year 2000 dollars.
Source: Bureau of Economic Analysis.
This group of economists had, on one hand, a clearly defined goal of stabilizing the macroeconomy and, on the other hand, a set of policy instruments—economic variables such as taxes, government spending, and interest rates—that were under the control of policymakers. They also had a framework of analysis (the aggregate expenditure model) that explained how these instruments could be used to achieve their goals. Finally, they had a president who was willing to listen and take their advice. Never before had economists had such tools and wielded such influence.
The opportunity to test their ideas arose toward the middle of the Kennedy presidency. In the middle of 1962, it was apparent to the Kennedy administration economists that the economy was beginning to sputter. The growth rate of real GDP was 7.1 percent in 1959 but decreased to 2.5 percent and 2.3 percent in 1960 and 1961, respectively.Economic Report of the President (Washington, DC: GPO, 2005):table B-2, GPO Access, accessed September 20, 2011, www.gpoaccess.gov/eop/2005/2005_erp.pdf. Their response was to initiate a tax cut.
As is usually the case when a major fiscal policy action is under consideration, there was a lengthy time lag between the initiation of the policy and its implementation. Even though the tax cut was proposed in 1962, President Kennedy never saw it put into effect. He was assassinated in November 1963; the tax cut for individual households and corporations was not enacted until early 1964. For households, tax withholding rates decreased from 18 percent to 14 percent, leading to an estimated tax reduction of about $6.7 billion. Taxes on corporations were also decreased; the reduction in taxes for 1964 was expected to be about$1.7 billion. By 1965, the economists expected that taxes would be lower by $11 billion. In 1965, nominal GDP was about$719 billion, so these changes were about 1.5 percent of nominal GDP.
For many observers of the macroeconomy, this was a watershed event. The Economic Report of the President proclaimed 1965 the “Year of the Tax Cut.” In retrospect, these years were the heyday of Keynesian macroeconomics: for the first time, the government was using tax policy in an attempt to fine-tune the economy.
Personal Income and Disposable Income
The most basic measure of aggregate economic activity is real GDP, which is the total amount of final goods and services produced in our economy over a period of time, such as a year. The rules of national income accounting mean that real GDP measures three different things at once: the production or output of the economy, the spending in the economy; and the income generated in the economy. We use real GDP as our most general measure of income.
We work in this chapter with two further concepts of income from the national accounts: personal income and disposable income. Some of the income generated in the economy is retained by firms to finance new investment, so it does not go to households. Personal income refers to that portion of GDP that finds its way directly into the hands of households. (At the level of an individual household, it corresponds closely to adjusted gross income on the tax form.) Disposable income is what remains after we subtract from personal income the taxes paid by households to the government and add to personal income the transfers (such as welfare payments) received by households from the government. For a household, disposable income measures its available resources after taxes have been paid and transfers received.
Consumption Smoothing
Our starting point for understanding consumption choices is the household budget constraint for a typical household. The household receives income from working and other sources and pays taxes to the government. The remainder is the household’s disposable income. The household budget constraint reminds us that, ultimately, you must either spend the income you receive or save it; there are no other choices. That is,
$disposable\ income = consumption + saving.$
A theory of consumption is a theory of how households decide to divide their income between consumption and saving. Saving is a way to convert current income into future consumption. A theory of consumption is equivalently a theory of saving. A fundamental idea about household behavior is that people do not wish their consumption to vary a lot from month to month or year to year. This principle is so important that economists give it a special name: consumption smoothing. Households use saving and borrowing to smooth out fluctuations in their income and keep their consumption relatively smooth. People will tend to save when their income is high and will dissave when their income is low. (Dissave is the word economists use to mean either running down one’s existing wealth or borrowing against future earnings.)
Toolkit: Section 31.32 "Consumption and Saving"
You can review the consumption-saving decision in the toolkit.
Perfect consumption smoothing means that the household consumes exactly the same amount in each period of time (for example, a month or a year). If a construction worker earns $10,000 per month working from May to October but nothing for the rest of the year, we do not expect that he will spend$10,000 per month in the summer and then starve in the winter. It is much more likely that he will save half of his income in the summer and spend those savings in the winter, so that he spends about $5,000 per month throughout the year. The logic of consumption smoothing is the same as the argument for why households buy many different goods rather than one single good. Households typically take their income and spend it on a wide variety of products. Furthermore, when income increases, the household will spread this extra income across the spectrum of goods it consumes; not all of it is spent on one good. If you obtain more income, you do not spend all this extra income on ice cream, for example. You buy more of many different goods. The Consumption Function One way to represent consumption smoothing is by means of a consumption function. This is an equation that relates current consumption to current disposable income. It allows us to go from an abstract idea about consumption behavior—consumption smoothing—to a specific formulation of consumption that we can use in a model of the aggregate economy. We suppose the consumption function can be represented by the following equation: $consumption = autonomous\ consumption + marginal\ propensity\ to\ consume \times disposable\ income.$ • We make three assumptions: 1. Autonomous consumption is positive. Households consume something even if their income is zero. If the household has accumulated a lot of wealth in the past or if the household expects its future income to be larger, autonomous consumption will be larger. It captures both the past and the future. 2. We assume that the marginal propensity to consume is positive. The marginal propensity to consume captures the present; it tells us how changes in current income lead to changes in current consumption. Consumption increases as current income increases; the larger the marginal propensity to consume, the more sensitive current spending is to current disposable income. By contrast, the smaller the marginal propensity to consume, the stronger is the consumption-smoothing effect. 3. We also assume that the marginal propensity to consume is less than one. This says that not all additional income is consumed. When the household receives more income, it consumes some and saves some. The marginal propensity to save is the amount of additional income that is saved; it equals (1 – marginal propensity to consume). Table 27.3.1 "Consumption, Income, and Saving" contains an example of a consumption function where autonomous consumption equals 10,000 and the marginal propensity to consume equals 0.8. If the household earns no income at all (disposable income =$0), it still spends $10,000 on consumption. In this case, savings equal −$10,000. This means the household is either drawing on existing wealth (accumulated savings from the past) or borrowing against income expected in the future. The marginal propensity to consume tells us how the household divides additional income between consumption and saving. In our example, the household spends 80 percent of any additional income and saves 20 percent.
Disposable Income ($) Consumption ($) Saving ($) 0 10,000 −10,000 10,000 18,000 −8,000 20,000 26,000 −6,000 30,000 34,000 −4,000 40,000 42,000 −2,000 50,000 50,000 0 60,000 58,000 2,000 70,000 66,000 4,000 80,000 74,000 6,000 90,000 82,000 8,000 100,000 90,000 10,000 Table $1$: Consumption, Income, and Saving For example, when income is equal to$20,000, consumption can be calculated as follows:
$consumption = 10,000 + 0.8 \times 20,000= 10,000 + 0.8 \times 20,000 = 26,000.$
The household is still dissaving but now only by $6,000. Table 27.3.1 "Consumption, Income, and Saving" also shows that when income equals$50,000, consumption and income are equal, so savings are exactly zero. At income levels above $50,000, the household has positive savings. Figure 27.3.3 "Consumption, Saving, and Income" shows the relationship between consumption and income graphically. We also graph the savings function in Figure 27.3.3 "Consumption, Saving, and Income". The savings function has a negative intercept because when income is zero, the household will dissave. The savings function has a positive slope because the marginal propensity to save is positive. Figure $3$: Consumption, Saving, and Income The graph shows the relationship between consumption and disposable income, where autonomous consumption is$10,000 and the marginal propensity to consume is 0.8. When disposable income is below $50,000, savings are negative, whereas at income levels above$50,000, savings are positive.
As well as the marginal propensity to consume and the marginal propensity to save, we can examine the average propensity to consume, which measures how much income goes to consumption on average. It is calculated as follows:
When disposable income increases, consumption increases but by a smaller amount. This means that when disposable income increases, people consume a smaller fraction of their income: the average propensity to consume decreases.In terms of mathematics, we are saying that, if we divide through the consumption function by disposable income, we get an increase in disposable income reduces the first term and the average propensity to consume. Meanwhile, the ratio of saving to disposable income is called the savings rate. For example,
The savings rate and the average propensity to consume together sum to 1. In other words, a decline in the average propensity to consume equivalently means that households are saving a larger fraction of their income.
Because the consumption and savings relationships are two sides of the same coin, economists wishing to find the actual values of autonomous consumption and the marginal propensity to consume can examine data on consumption, savings, or both. If the data were perfect, we would get the same answer either way. For the United States, both consumption and savings data are readily available, but in some countries the data on savings may be of higher quality than the consumption data, in which case economists use savings data to understand consumption behavior.
Some Warnings about the Consumption Function
The consumption function is useful because it captures two fundamental insights: households seek to smooth their consumption, but consumption nonetheless responds to current income. But the consumption function is really too simple.Refining our theory of consumption is a subject for Chapter 28 "Social Security".
First, it ignores the role of accumulated wealth. If you consider two households with the same level of current income but different amounts of accumulated wealth, the one with higher wealth will probably consume more. Second, the consumption function does not explicitly include the role of expectations. A household’s consumption reflects not only income today and the accumulation of income in the form of wealth but also anticipated income. So, for example, if a government announces that it will increase income tax rates in two years, we expect that households will respond immediately to smooth out the effects of these future taxes. The only way the consumption function allows us to capture wealth or expectations of future income is through autonomous consumption. This is fine as far as it goes, but it means that we are taking too many aspects of consumption as given, rather than explaining them with our theory.
Another complication is that changes in income today are often correlated with changes in income in the future. If your income increases today, is this an indication that your income will also be higher in the future? To see why this matters, consider two extreme examples. First, suppose that you receive a one-time inheritance of $10 million. What will you do with this income? According to the consumption smoothing argument, you will save some of this income to increase your consumption in the future. Roughly speaking, if you thought you had 10 years left to live, you might increase your consumption by about$1 million per year. In this case your marginal propensity to consume would be only 0.1.
Now suppose that instead of a $10 million windfall, you learn you will receive$1 million each year for the next 10 years. In this case, your income is already spread out over your lifetime. So, in this second case, you will again want to smooth your consumption. But since the increase in income will be maintained for your lifetime, you can increase your consumption by an amount equal to the increase in your income. Your marginal propensity to consume will be 1.0.
The difference between these two situations is that in the first case the income increase is temporary, and in the second it is permanent. The logic of consumption smoothing implies that the marginal propensity to consume is near 1 for permanent changes in income but much smaller for temporary changes in income.
The Effects of a Change in Income Taxes
We can now figure out the effects of a cut in taxes on consumption and saving. A reduction in taxes will increase disposable income. From the consumption function, this results in an increase in consumption equal to the marginal propensity to consume times the increase in disposable income. The average propensity to consume decreases. To summarize, if taxes are cut in the economy, we expect to see the following:
• An increase in disposable income
• An increase in consumption that is smaller than the increase in disposable income (that is, a marginal propensity to consume less than 1)
• A decline in the average propensity to consume
When natural scientists such as molecular biologists or particle physicists want to see how good their theories are, they conduct experiments. Economists and other social scientists have much less ability to carry out experiments—certainly at the level of the macroeconomy. The Kennedy tax cut, however, is like a “natural” experiment in that there was a major policy change that we can think of as a change in an exogenous variable. It is not, in truth, completely exogenous. We already explained that the tax cut was enacted in response to the poor performance of the economy. We are not badly misled by thinking of it as an exogenous event, however. We can therefore use it to see how well our theory performs. Specifically, we can look to see whether disposable income and consumption do behave as we have predicted.
Empirical Evidence on Consumption
Before we turn to those specific questions, let us examine some data on consumption. Figure 27.3.4 "Consumption and Income" shows the behavior of consumption and disposable income from 1962 to 2010. The measures of both income and consumption are in year 2005 dollars. This means that the nominal (money) levels of income and consumption for each of the years have been corrected for inflation, so that we can see how the real level of consumption relates to the real level of income.
The charts show consumption and personal disposable income (in billions of year 2005 dollars) from 1962 to 2010. Consumption and disposable income grew substantially over this time (a) and there is a close relationship between consumption and income (b).
Source: Economic Report of the President (Washington, DC: GPO, 2011), table B-31, accessed September 20, 2011, www.gpoaccess.gov/eop/tables11.html.
Toolkit: Section 31.8 "Correcting for Inflation"
You can review how to correct for inflation in the toolkit.
The first thing we see in Figure 27.3.4 "Consumption and Income" is that both consumption and disposable income grew substantially over the 1962–2010 period. This should come as no surprise. We know that the US economy grew over this period, so we would expect that disposable income and consumption would also grow. Figure 27.3.4 "Consumption and Income" reveals that, as a consequence, there is a close relationship between consumption and income, and consumption expenditures are, on average, about 91 percent of disposable income. Although Figure 27.3.4 "Consumption and Income" looks something like a consumption function, we should not take this relationship as strong evidence for our theory because it is primarily caused by the fact that both variables grew over time.
Consumption Response to the Kennedy Tax Cut
Now we return to the Kennedy tax cut. How well does our model perform in predicting the effects of the tax changes on consumption? Superficially, this seems like an easy question. We can examine the changes in consumption and income that arose after the tax changes and see whether these changes are consistent with the model.
There is a critical difference between our theory and reality, however. When we discussed the effects of a tax cut using our theory, we implicitly held everything else constant. We presumed that there was a change in taxes and no change in any other variable. For example, we assumed that government spending, investment spending, and net exports all did not change. In fact, other economic variables were changing at the same time that the new tax policy went into effect; these changes could also have affected consumption and disposable income. Looking at particular tax experiments is a messy business.
Taxes were cut in February 1964, and (real) disposable income increased by $430 billion, a much larger increase than in previous time periods. Consumption expenditures increased considerably during this period. Table 27.3.2 "Consumption and Income in the 1960s (Seasonally Adjusted, Annual Rates)" summarizes the behavior of GDP, disposable income, consumption, and the average propensity to consume over the 1960–68 period. Remember that these are real variables, measured in year 2000 dollars. The average propensity to consume is calculated as consumption divided by disposable income, and the marginal propensity to consume is calculated as the change in consumption divided by the change in disposable income. Year Real GDP ($) Disposable Income ($) Consumption ($) APC MPC
1960 2,501.8 1,759.7 1,597.4 0.91
1961 2,560.0 1,819.2 1,630.3 0.90 0.55
1962 2,715.2 1,908.2 1,711.1 0.90 0.91
1963 2,834.0 1,979.1 1,781.6 0.90 0.99
1964 2,998.6 2,122.8 1,888.4 0.89 0.74
1965 3,191.1 2,253.3 2,007.7 0.89 0.97
1966 3,399.1 2,371.9 2,121.8 0.89 0.96
1967 3,484.6 2,475.9 2,185.0 0.88 0.61
1968 3,652.7 2,588.0 2,310.5 0.89 1.11
APC, average propensity to consume; MPC, marginal propensity to consume.
Table $2$ Consumption and Income in the 1960s (Seasonally Adjusted, Annual Rates)
Source: Economic Report of the President (Washington, DC: GPO 2004), accessed September 20, 2011, www.gpoaccess.gov/eop.
Disposable income increased as did consumption, in accordance with the predictions of our theory. As the theory predicts, the average propensity to consume decreased for most of this period. Likewise, in line with the theory, the marginal propensity to consume was less than 1 (in all years except 1968). Thus the evidence from this period is broadly consistent with the predictions that we made on the basis of our model.
Aggregate Income, Aggregate Consumption, and Aggregate Saving
The 1964 tax cut was not designed to influence consumption in isolation but rather to have an impact on the overall economy via its effect on consumption. So far, we have argued that a change in taxes leads to a change in disposable income and hence a change in consumption. Now we complete the story, noting that a change in consumption will itself affect the level of real GDP and hence have further effects on the level of disposable income.
In the case of the Kennedy tax cut of 1964, the economists advising the administration at that time had a fairly specific idea of how changes in consumption would affect the overall economy. They argued that the $10 billion tax cut would lead to an increase in GDP of about$20 billion each year. How did they create this estimate? To answer this question, we need to embed our theory of consumption in the aggregate expenditure model.
We motivated our consumption function by thinking about the behavior of an individual household. We now presume that our household is in some sense average, or representative of the entire economy, so the consumption relationship holds at an economy-wide level. Different households might actually have different consumption functions, but when we add them together, we still expect to find an aggregate relationship similar to the one we have described.
The economists of the time used a framework that was closely based on the aggregate expenditure model. When prices are sticky, the level of GDP is determined in that model by the condition that planned spending and actual spending are equal. The model tells us that the level of real GDP depends on the level of autonomous spending and the multiplier,
$real\ GDP = multiplier \times autonomous\ spending,$
where the multiplier is calculated as Given the level of autonomous spending in the economy and given a value for the marginal propensity to spend, we can calculate the equilibrium level of real GDP.
The marginal propensity to spend is not the same thing as the marginal propensity to consume, although they are connected. The marginal propensity to spend tells us how much total spending changes when GDP changes. Total spending includes not only consumption but also investment, government purchases, and net exports, so if any of these are responsive to changes in GDP, then the marginal propensity to spend is affected. Likewise, autonomous spending is not the same as autonomous consumption. Autonomous spending is the sum of autonomous consumption, autonomous investment, autonomous government purchases, and autonomous net exports. Finally, the marginal propensity to consume measures how consumption responds to changes in disposable income, not GDP.
Toolkit: Section 31.30 "The Aggregate Expenditure Model"
You can review the aggregate expenditure model and the multiplier in the toolkit.
In our analysis here, we continue to focus on consumption and suppose that the other components of spending—government spending, investment, and net exports—are exogenous. That is, these variables are all unaffected by changes in income and so are all included in autonomous spending. In addition, we presume that the amount that the government spends is not affected by the amount that it receives in tax revenue.
To find out the effects on the economy of a change in income taxes, we take the equation for real GDP and write it in terms of changes:
$change\ in\ real\ GDP = multiplier \times change\ in\ autonomous\ spending.$
This equation tells us we need two pieces of information to work out the effect of a tax change:
1. The marginal propensity to spend because this allows us to calculate the multiplier
2. The effect of a tax change on autonomous spending
Let us think about the marginal propensity to spend first. We want to know the answer to the following question: if GDP changes by some amount (say, $100), what will happen to spending? There are three pieces to the answer. 1. A change in GDP leads to a change in personal income. Remember from the circular flow of income that GDP measures production, income, and expenditure in the economy. Firms receive income when they sell their products. Most of that income finds its way into the hands of households in the form of wage and salary payments or dividend payments. Firms hold onto some of the income that they generate, however, to replace worn-out capital goods and finance new investments. In the early 1960s, personal income was about 78 percent of GDP. So if GDP increased by$100, we would expect personal income to increase by about $78. 2. A change in personal income leads in turn to a change in disposable income. As we explained at length, personal income is taxed, so disposable income is less than personal income. Since we are considering the effects of a change in taxes, we need an estimate of the marginal tax rate facing consumers. We know from Figure 27.2.1 that this varied across individuals, but researchers have estimated that, for the economy as a whole, the marginal tax rate in 1964 was about 22 percent.Robert J. Barro and Chaipat Sasakahu provide estimates of the “average marginal tax rate.” Barro and Sasakahu, “Measuring the Average Marginal Tax Rate from the Individual Income Tax” (NBER Working Paper No. 1060 [Reprint No. r0487], June 1984), http://www.nber.org/papers/w1060. To put it another way, households would keep about 78 percent (= 100 percent – 22 percent) of their personal income. So if personal income increased by$78, disposable income would increase by about $61 (= 0.78 ×$78). (It is a meaningless coincidence that these two numbers are both 78 percent.)
3. Finally, a change in disposable income leads to a change in consumption. According to the 1964 Economic Report of the President, the CEA thought that the marginal propensity to consume was about 0.93. So if disposable income increased by $61, we would expect consumption to increase by about$57 (= 0.93 × $61). Putting these three together, therefore, we see that an increase in GDP of$100 causes consumption to increase by $57. The marginal propensity to spend in this economy was equal to about 57 percent. It follows that the CEA thought that the multiplier was equal to about 2.3 because Now let us think about the change in autonomous spending. We have said that taxes were cut by about$10 billion. We expect that most of this tax cut ended up in the hands of consumers. Based on the marginal propensity to consume of 0.93, we would therefore expect there to be an increase of about $9.3 billion in autonomous consumption, $change\ in\ autonomous\ spending = 9.3 billion.$ Putting these two results together, we find that our prediction for the change in GDP as a result of the tax cut is $change\ in\ real\ GDP = multiplier \times change\ in\ autonomous\ spending = 2.3 \times 9.3 billion = 21.4 billion.$ Our answer is not exactly equal to the$20 billion predicted by the CEA, but it is very close. As you might expect, the CEA was working with a more complicated model than the one we have explained here, and, as a result, they came up with a slightly smaller number for the multiplier.
A Word of Warning
All our analysis so far has ignored the fact that, through the price adjustment equation, increased real GDP causes the price level to rise. This increase in prices serves to choke off some of the effects of the increase in spending. In effect, we have ignored the supply side of the economy. It is not that the Kennedy-Johnson administration economists were naïve about the supply side, but they thought the demand side movements were much more relevant for short-run policymaking purposes. More recent economic experience has convinced economists that we ignore the supply side of the economy at our peril. Modern macroeconomists would be careful to augment this story with a discussion of price adjustment.
Toolkit: Section 31.31 "Price Adjustment"
You can review price adjustment in the toolkit.
Key Takeaways
1. Beginning in the early 1960s, growth of real GDP began to slow. This provided the basis for the tax cut of 1964.
2. The CEA economists used the aggregate expenditure model as the basis for their analysis of the effects of the tax cut.
3. In response to the tax cut, consumption and real GDP both increased. This fits with the prediction of the aggregate expenditure model.
checking you understanding
1. Is the marginal propensity to consume independent of whether an income increase is viewed as temporary or permanent?
2. If autonomous consumption is positive, is the level of savings at zero disposable income positive or negative? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/27%3A_Income_Taxes/27.03%3A_The_Kennedy_Tax_Cut_of_1964.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. When income taxes are cut, what happens to private savings?
2. When income taxes are cut, what happens to national savings?
Look back at Figure 27.1.2 "Macroeconomic Effects of Tax Policy". We explained that there are three channels through which income taxes affect the economy. In 27.3 Section "The Kennedy Tax Cut of 1964", we discussed the first of these in some depth: a cut in income taxes can stimulate consumption and increase aggregate spending. Figure 27.1.2 "Macroeconomic Effects of Tax Policy" reveals that taxes can also affect potential output, both through their influence on saving (and hence capital accumulation) and through their effect on labor supply. We turn next to the savings channel.
Tax Cuts and Private Saving
We have already conducted most of the analysis we need to examine the effects of tax cuts on saving. We know that a tax cut increases disposable income. Our theory of consumption smoothing tells us that households will respond by increasing consumption and savings. Specifically, we predict that a dollar’s worth of tax cuts will cause saving to increase by \((1 − marginal propensity to consume)\).
It is tempting to conclude that tax cuts therefore will lead both to higher consumption, increasing output now, and to higher saving, increasing output in the future. Such an argument is not right because it looks only at saving by households. We also need to look at the effect of the tax cut on the government surplus or deficit.
Tax Cuts and National Saving
If the government is spending more than it receives in tax revenues, then it is running a deficit. Conversely, if it is spending less than it receives in tax revenues, it is running a surplus. National savings is the combined savings of the government and the private sector. If the government is running a deficit,
\[national\ savings = private\ savings − government\ deficit,\]
and if the government is running a surplus,
\[national\ savings = private\ savings + government\ surplus.\]
These are just two different ways of saying the same thing because, by definition, the government surplus equals minus the government deficit.
What happens if the government cuts taxes? If there are no associated changes in government spending, then tax cuts translate dollar for dollar into the government budget. One million dollars worth of tax cuts will increase the deficit (or decrease the surplus) by exactly \$1 million. So even though a tax cut of a dollar increases private savings by \$\((1 − marginal propensity to consume)\), it costs the government \$1. The net effect (to begin with) is to reduce national savings by an amount equal to the marginal propensity to consume.
If the tax cut succeeds in increasing income, there is additional savings resulting from the multiplier process. Still, we expect the overall effect is a decrease in national savings. For example, consider the Kennedy tax cut again. Taxes were cut by \$10 billion. The resulting change in income was roughly \$20 billion. With the marginal propensity to save equal to 0.07, the offsetting increase in private savings would have been about \$1.4 billion. Evidently, the result was a large decrease in national savings.
Here we see one of the biggest problems with tax cuts. They are attractive in the short run because they stimulate aggregate demand and increase output. They are also attractive politically, for obvious reasons. Unfortunately, they have the adverse long-run consequence of reducing national savings. When national savings decreases, the economy does not build up its capital stock so quickly, so future living standards are lower than they would otherwise be.
Key Takeaways
1. Since the marginal propensity to consume is less than 1, a tax cut will lead to a household to consume more and save more.
2. National savings, the sum of public and private savings, will generally decrease when there is a tax cut.
Exercises
1. If the marginal propensity to consume from a tax cut is zero, what will happen to national savings when taxes are cut?
2. If income taxes increase, what happens to the incentive of an entrepreneur to start a new business? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/27%3A_Income_Taxes/27.04%3A_Income_Taxes_and_Saving.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What was the state of the economy at the time of the Reagan tax cut?
2. What framework was used for analyzing the effects of this tax cut?
3. What were the effects of the tax cut?
When Ronald Reagan was elected US president in 1980, the US economy was not in very good shape. The 1970s had been a very difficult time for economies throughout the world. The oil-producing nations of the world, acting as a cartel, had increased oil prices substantially, and, as a result, energy costs had increased. These energy prices triggered a severe recession in the mid 1970s and a smaller recession in the late 1970s. Figure 27.5.1 "Real GDP in the 1970s" shows the US real gross domestic product (GDP) for this period. As well as recessions, the United States was suffering from inflation that was very high by historical standards: prices were increasing by more than 10 percent a year.
The figure shows real GDP in the 1970s. There was a protracted recession in the mid-1970s and a smaller recession toward the end of the decade.
Source: Bureau of Economic Analysis.
President Reagan and his economic advisors argued that high taxes were one of the causes of the relatively poor performance of the US economy. In particular, they claimed that taxes on income were deterring people from working as hard as they would otherwise. Unlike President Kennedy’s advisors, who had argued that income tax cuts would increase real GDP by stimulating aggregate expenditure, Reagan’s advisors said that tax cuts would increase potential output. Proponents of this economic view became known as supply siders because their focus was on the production of goods and services rather than the amount of spending on goods and services.
After his inauguration, President Reagan pushed hard for changes in the tax code, and Congress enacted the Economic Recovery Tax Act (ERTA) in 1981. This law reduced tax rates substantially: Figure 27.9 "Marginal and Average Tax Rates, 1982 to 1984" shows marginal and average tax rates for 1982, 1983, and 1984. The marginal tax rates are shown in part (a) in Figure 27.9 "Marginal and Average Tax Rates, 1982 to 1984": marginal rates decreased significantly for taxable income up to about $80,000.In contrast to Figure 27.2.1, no tax was payable until taxable income was$2,300. This is because the definition of taxable income at that time included the exemption. As a consequence, average tax rates also decreased significantly between 1982 and 1984 (part (b) in Figure 27.9 "Marginal and Average Tax Rates, 1982 to 1984").
The figure shows marginal (a) and average (b) tax rates from 1982 to 1984, the period of the Reagan tax cuts. Both marginal and average rates decreased substantially.
Source: Department of the Treasury, IRS 1987, “Tax Rates and Tables for Prior Years” Rev 9-87
The main mechanism that the supply siders proposed was that lower income taxes would increase the incentive to work. To analyze this claim, we need to investigate how the decision to supply labor depends on income taxes. As with our analysis of consumption, we look at labor supply by thinking about the behavior of a single household. We then suppose that the household can be taken as representative of the entire economy.
Labor Supply
Each individual faces a time constraint: there are only 24 hours in the day, which must be divided between working hours and leisure hours. An individual’s time budget constraint says that, on a daily basis,
$leisure\ hours + working\ hours = 24 hours.$
The labor supply decision is equivalently the decision about how much leisure time to enjoy. This decision is based on the trade-off between enjoying leisure and working to purchase consumption goods. People like having leisure time, and they prefer more leisure to less. Leisure can be thought of as a “good,” just like chocolate or blue jeans or cans of Coca-Cola. People sacrifice leisure, working instead, because the money they earn allows them to purchase goods and services.
To see this, we first rewrite the time budget constraint in money terms. The value of an hour of time is given by the nominal wage. Multiplying through the time budget constraint by the nominal wage gives us a budget constraint in dollars rather than hours:
$(leisure\ hours \times nominal\ wage) + nominal\ wage\ income = 24 \times nominal\ wage.$
The second term on the left-hand side is “nominal wage income” since that is equal to the number of hours worked times the hourly wage.
Because wage income is used to buy consumption goods, we replace it by total nominal spending on consumption, which equals the price level times the quantity of consumption goods purchased:
$(leisure\ hours \times nominal\ wage) + (price level \times consumption) = 24 \times nominal\ wage.$
This is the budget constraint faced by an individual choosing between consuming leisure and consumption. Think of it as follows: it is as if the individual first sells all her labor at the going wage, yielding the income on the right-hand side. With this income, she then “buys” leisure and consumption goods. The price of an hour of leisure is just the wage rate, and the price of a unit of consumption goods is the price level. Finally, if we divide this equation through by the price level, we see that it is the real wage (the wage divided by the price level) that appears in the budget constraint:
$leisure\ hours \times real\ wage + consumption = 24 \times real\ wage.$
It is the real wage, not the nominal wage, that matters for the labor supply decision.
Toolkit: Section 31.3 "The Labor Market"
You can review the labor market in the toolkit.
Changes in the Real Wage
What happens if there is an increase in the real wage? There are two effects:
1. There is a substitution effect. An increase in the real wage means that leisure has become relatively more expensive. You have to give up more consumption goods to get an hour of leisure time. If leisure becomes more expensive, we would expect the household to “buy” fewer hours of leisure and more consumption goods—that is, to substitute from leisure to consumption. This effect predicts that the quantity of labor supplied will increase.
2. There is an income effect. An increase in the real wage makes the individual richer—remember that we can think of income as equaling 24 × the real wage. In response to higher income, we expect to see the household increase its consumption of goods and services and also increase its consumption of leisure. This effect predicts that the quantity of labor supplied will decrease.
Putting these predictions together, we must conclude that we do not know what will happen to the quantity of labor supplied when the real wage increases. On the one hand, higher real wages make it attractive to work more since you can get more goods and services for each hour of time that you give up (the substitution effect). On the other hand, you can get the same amount of consumption goods with less effort, which makes it attractive to work less (the income effect). If the substitution effect is stronger, the labor supply curve has the standard shape: it slopes upward, as in Figure 27.5.3 "Labor Supply".
The response of the quantity of labor supplied to the real wage depends on both an income effect and a substitution effect. When the substitution effect is larger than the income effect, the supply curve has the “normal” upward-sloping shape.
In the end, the shape of the labor supply curve is an empirical question; we can answer it only by going to the data. And as you might be able to guess, it turns out to be a difficult question to answer, once we start dealing with the complexities of different kinds of labor. The view of most economists who have studied labor supply is that higher real wages do lead to a greater quantity of labor supplied, but the effect is not very strong. The income effect almost cancels out the substitution effect. This means that the labor supply curve slopes upward but is quite steep.
The Effect of the Reagan Tax Cuts on the Supply of Labor
Suppose an individual knows the nominal wage but also knows that she is going to be taxed on any income that she earns at the going income tax rate. The wage rate that matters for her decision is the after-tax real wage. Her real disposable income is
All our discussion of labor supply continues to hold in this case, except that we need to replace the real wage with the after-tax real wage since it is the after-tax wage that matters to the individual.
Figure 27.5.4 "Labor Supply Response to Tax Cut" shows the effect of a cut in taxes. If the labor supply curve slopes upward, the tax cut leads to an increase in the quantity of labor supplied. And if labor supply increases, then potential output also increases. In other words, one effect of tax cuts is to induce people to work harder and produce more real GDP. To keep things simple, Figure 27.5.4 "Labor Supply Response to Tax Cut" is drawn supposing that there is no change in the equilibrium real wage as a result of the tax cut. In fact, we would expect the real wage to decrease somewhat as well. Buyers of labor as well as sellers of labor would benefit from the tax cut. Indeed, it is this decrease in the real wage that induces firms to purchase the extra labor that individuals wish to supply. (If we included this in our picture, then the after-tax real wage would still increase but by less than shown in the figure.)
Figure $4$: Labor Supply Response to Tax Cut
The wage that matters for labor supply decisions is the after-tax real wage. If income taxes are cut, and the real wage is unchanged, then households will supply more labor.
The Laffer Curve
Supply-side economics was controversial and generated a great deal of debate back in the 1980s and since. Yet the argument that we have just presented is not really controversial at all. Almost all economists agreed that as a matter of theory, cuts in taxes could lead to increases in the quantity of labor supplied. The disagreements concerned the magnitude of the effect.
Some proponents of supply-side economics made a much stronger claim. They said that the positive effects on labor supply could be so large that total tax revenues would increase, not decrease. They argued that even though the government would get less tax revenue on each dollar earned, people would work so much harder and generate so much more taxable income that the government would end up with more revenue than before.
This argument was encapsulated in the so-called Laffer curve. Economist Arthur Laffer asked what would happen if you graphed tax revenues as a function of the tax rate. Obviously (he observed) if the tax rate is zero, then tax revenues must be zero. And, Laffer argued, if the tax rate were 100 percent, so the government took every penny you earned, then no one would have an incentive to work at all, and the quantity of labor supplied would drop down to zero. Once again, income tax revenues would be zero. In between, tax revenues are positive.
Figure 27.5.5 "Laffer Curve" shows an example of a Laffer curve. There is some tax rate that will lead to the maximum possible revenue for the government. This itself is not that interesting: the goal of the government is not to raise as much tax revenue as possible. But if the tax rate lies to the right of that point, then—as the picture shows—a cut in taxes will increase tax revenues.
Figure $5$: Laffer Curve
The Laffer curve says that it is possible for a reduction in the tax rate to lead to an increase in tax revenues. Although this is a theoretical possibility at very high tax rates, most economists view the Laffer curve as a theoretical curiosity with limited applicability to real economies.
Just as almost all economists agreed that there would be some supply-side effects of income tax cuts, almost all economists agreed that the Laffer curve argument was inapplicable to the US economy (or indeed any other economy). The evidence indicated that the effects of tax cuts on hours worked were likely to be relatively small. Almost no economists actually believed that the economy was on the wrong side of the Laffer curve, where tax cuts could pay for themselves.
Unfortunately, the Laffer curve argument was politically appealing, even though it was not supported by economic evidence. Buoyed by this argument, President Reagan oversaw both tax cuts and big increases in government spending. As a result, the US government ran large budget deficits. Following on from the ERTA, President Reagan and President George H. W. Bush after him were both forced to increase taxes to bring the budget back under control.The economic history of the United States in the 1980s was quite complex. Because this chapter concerns income taxes, we have considered only one of the policy changes of the Reagan administration. Other changes in tax policy were designed to promote savings. We have not discussed other aspects of President Reagan’s fiscal policy (there were large increases in government purchases), the tight monetary policy pursued by the Federal Reserve, or the behavior of interest rates and exchange rates. All these are matters for other chapters.
Key Takeaways
1. Prior to the Reagan tax cut, the US economy was experiencing both low growth in real GDP and high inflation.
2. Reagan’s economic advisors stressed the effects of taxes on the supply side of the economy, and in particular the incentive effects of taxes on labor supply and investment.
3. The Reagan tax cuts led to considerably higher deficits in the United States.
Exercises
1. What matters for labor supply decisions—the marginal tax rate or the average tax rate?
2. According to the Laffer curve, does a tax cut always increase tax revenues? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/27%3A_Income_Taxes/27.05%3A_The_Reagan_Tax_Cut.txt |
In Conclusion
Our goal in this chapter was to understand the effects of tax changes on aggregate consumption and aggregate output. A tax cut puts more income in the hands of households, and thus consumption increases. The increase in consumption in turn leads to an expansion in the overall level of economic activity. The framework does a good job of describing and explaining actual economic outcomes during the Kennedy tax cut. We can thus have some faith that our basic framework is reasonably sound. Having said that, it is a very simple model that does have some deficiencies, most notably its neglect of the supply side of the economy.
Income tax cuts also decrease overall national saving. Income tax cuts increase household disposable income and lead to increased saving by households (as well as increased consumption). At the same time, however, income tax cuts mean that the government is saving less (or borrowing more). The net effect is to decrease national saving. The theory of economic growth tells us that reduced saving has the effect of decreasing future standards of living.
We then examined the Reagan tax cuts of the 1980s. These tax cuts were aimed at stimulating employment and output by encouraging people to work more. The belief that tax cuts lead to an increase in the quantity of labor supplied is consistent with basic microeconomic principles, but there is disagreement about the likely size of the effect.
Although we cast our discussion of the effects of taxes on spending using the tax cuts of the Kennedy and Reagan administrations, the lesson is more general. It is common for the United States and other countries to use variations in income tax rates as a tool of intervention. We highlighted several effects of such interventions. Income tax changes alter the level of household disposable income and thus influence consumption expenditures; they affect saving and capital accumulation; and they affect labor supply. This policy tool therefore gives the government considerable influence on the aggregate economy.
Indeed, when the crisis of 2008 hit the world’s economies, many countries responded by implementing expansionary fiscal policies, including cuts in taxes. Australia, the United Kingdom, Singapore, Austria, and Brazil are just a few of the countries who cut taxes in response to the crisis.
We used the Kennedy tax cut to illustrate demand-side effects and the Reagan tax cut to illustrate supply-side effects because those were the channels emphasized by the economic advisors at the time. Just about every change in the income tax code, however, has effects on consumption, saving, and labor supply. Every change in the code has short-run effects and long-run effects, and, as we have seen, these effects can be contradictory. Thus whenever you hear or read about proposed changes in taxes, you should try to remember that all these different stories will be in operation. The politicians and pundits who are supporting or opposing the change will typically talk about only one of them, depending on the spin they wish to convey. The analysis of this chapter should help you always see the bigger picture.
Finally, remember that tax changes will typically have major effects on the distribution of income. There are winners and losers from every change in the tax code. This, above all, is why changes in the tax code are an endless source of political debate.
Key Links
exercises
1. Suppose that your income level is \$55,000. Using the tax table for 2010 ( Table 27.2.1 "Revised 2010 Tax Rate Schedules"), what are your marginal and average tax rates?
2. Suppose that taxes paid were equal to a constant plus a tax rate times income. Devise a tax schedule such that the marginal tax rate is 25 percent and the average tax at \$10,000 is \$2,000. What is the constant?
3. In times of inflation, the nominal income of households increases. What happens over time to their marginal and average tax rates?
4. Our tax function has a constant marginal tax rate at all levels of income. Explain why this means that the average tax rate is also constant. Is the average tax rate higher, lower, or equal to the marginal tax rate in this case?
5. We noted earlier that the average tax rate for someone earning \$100,000 was 67 percent in 1963. However, there has been considerable inflation between 1963 and the present day. What is the equivalent in current dollars of an income of \$100,000 in 1963? (Look at the toolkit if you need a reminder of how to convert from nominal to real variables.)
6. Suppose that autonomous consumption is 600 and the marginal propensity to consume is 0.9. Graph the consumption and savings functions first with disposable personal income on the horizontal axis and then with GDP on the axis. If there is a change in taxes, how would that affect these graphs?
7. What is the difference between the marginal propensity to consume and the marginal propensity to spend?
8. Why is a temporary tax cut likely to have a smaller impact on real GDP than a permanent tax cut?
9. Using the logic of consumption smoothing, if a tax cut from 10 years ago will expire next year, what will a household do now in anticipation of the coming tax change?
10. If labor supply is known to be relatively insensitive to changes in the real wage, what does this imply about the argument that cuts in tax rates can lead to revenue increases?
Economics Detective
1. Pick some country other than the United States. Can you find the income tax rates for that country? How do they compare with those in the United States?
2. Go to the IRS web page. Suppose that you are a member of a married household with total household income of \$55,000. What are your marginal and average tax rates? Compare these to the tax rates on individuals. Which group faces the higher marginal income tax rate? What effects might this have on their behavior?
3. In the summer of 2010, the George W. Bush tax cuts were about to expire. What would the change in tax rates be if the tax cuts had been allowed to expire?
4. Go to the Bureau of Economic Analysis website ( http://www.bea.gov). Click on the link “Personal Income and Outlays” and find out what has happened recently to personal income and disposable income. Have they been increasing or decreasing?
Spreadsheet Exercises
1. Using a spreadsheet, enter the data for disposable income and consumption from Table 27.3.2 "Consumption and Income in the 1960s (Seasonally Adjusted, Annual Rates)". Now enter a formula to calculate the average propensity to consume and another to calculate the marginal propensity to consume. Check that your answers are the same as in Table 27.3.2 "Consumption and Income in the 1960s (Seasonally Adjusted, Annual Rates)".
2. Suppose autonomous consumption is 6000 and the marginal propensity to consume is 0.9. Furthermore, suppose the tax rate is 30 percent. Create a spreadsheet where the first column is income, ranging from \$0 to \$100,000, by increments of \$1,000. Create columns showing the taxes paid at each income level, the level of disposable income at each income level, and consumption at each income level. Graph the relationship between consumption and income. What is the slope of the line? Experiment with changing the marginal propensity to consume and the tax rate. Explain how changing these parameters affect the relationship between consumption and income. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/27%3A_Income_Taxes/27.06%3A_End-of-Chapter_Material.txt |
Benjamin Franklin famously wrote that “in this world nothing is certain but death and taxes.” The current chapter is about both.
If you are like most readers of this book, you are at the very beginning of your working life, and you have probably given little thought to your retirement. In the early years of work, you might be asked to make some decisions regarding a company pension plan, but it is still unlikely that you will spend much time thinking about how you will live when your working life is over. This is normal; none of us is very good at imagining at the age of 20 what our life will be like when we are 70. (Even at the age of 30, or 40, or 50, it is hard to imagine life at age 70.)
One message of this chapter, though, is that even though it is hard to think that far ahead, it is also smart to try to do so. From the very beginning of your working life, you will be making decisions that affect your life in retirement. And from the very beginning of your working life, those decisions will—or should—be influenced by something called the Social Security system.
Social Security was born in the Great Depression. Many people suffered tremendous economic hardship in the 1930s. As part of President Franklin D. Roosevelt’s New Deal in the 1930s, the US government established several systems to alleviate such hardships. Social Security—one of the most important—was designed to provide financial assistance to the elderly. More than 170 other countries, big and small, rich and poor, also have social security systems. To take a few random examples, you will find social security in operation in Mexico, France, the United Kingdom, Kiribati, Laos, Azerbaijan, Chile, Andorra, Burkina Faso, Egypt, Cyprus, Paraguay, and Slovenia.
The Social Security system will give you money when you are older, but it takes money from you when you are working. So even if it is hard to think about the effect that Social Security will have on your income in the distant future, it is very easy to see the effect it has when you are working. Workers are required to make Social Security contributions—one of the many kinds of tax that we all pay—with the promise that they will receive reimbursement from the system when they are older. The state of the US Social Security system is therefore something that you should think about long before you receive payouts. Decisions about your personal saving and consumption right now are, or at least should be, directly influenced by your current tax contributions and expectations of your future Social Security payouts.
Opinion polls reveal that Social Security is one of the most well-supported government programs in the United States. Yet the casual reader of the newspapers could be forgiven for thinking that the system is perpetually in crisis. In the 1980s, for example, there was discussion of serious difficulties with the funding of Social Security. A commission headed by Alan Greenspan (who later became chairman of the Federal Reserve Bank) identified problems with the system and recommended a large number of changes, including some increases in Social Security tax rates. These reforms were supposed to ensure the solvency of Social Security well into the future. Yet, a few decades later, proposals for major reforms of Social Security are back under discussion. The exact form that Social Security will take in the coming decades is an open question that will continue to play a major role in political debate.
We explain the details of the system more carefully later in this chapter, but the basic idea is the following. The government taxes current workers and uses those revenues to pay retired workers. When the system was originally set up, the idea was that payments to retired people in a given year would be (approximately) funded by taxes on those working during that year, so the system would be roughly in balance. For many years, this “pay-as-you-go” structure worked fine. In some years, payments to workers were larger than tax receipts, and in some years, they were smaller, but on the whole there was an approximate match between payments and receipts.
In the 1980s, policymakers first began to pay serious attention to the fact that there was a problem with the pay-as-you-go structure. Demographic changes mean that the system is not balanced in the very long run. The number of retirees relative to the number of workers will increase substantially over the next two decades, and without changes, the time will come when tax revenues will no longer be sufficient to match the obligations of the system.
This is not a looming crisis. The best estimates suggest that the system will no longer be able to pay the full amount of benefits near the middle of the century, although there is disagreement on the exact date. The most recent Social Security Trustees report ( http://www.ssa.gov/OACT/TRSUM/index.html) predicted this date as 2036, whereas in 2005 the Congressional Budget Office ( www.cbo.gov/ftpdocs/60xx/doc6074/02-09-Social-Security.pdf) gave a date of about 2054.See the discussion at Charles P. Blahous III and Robert D. Reischauer, “Status of the Social Security and Medicare Programs,” Social Security Administration, 2011, accessed July 20, 2011, http://www.ssa.gov/OACT/TRSUM/index.html; Douglas Holtz-Eakin, “CBO Testimony,” Congressional Budget Office, February 9, 2005, accessed July 20, 2011, www.cbo.gov/ftpdocs/60xx/doc6074/02-09-Social-Security.pdf. Of course, changes will almost certainly be made well before this crisis point. But what form should those changes take?
How should we reform Social Security?
This question matters to every single one of us. As workers, we all pay into the Social Security system, and we all anticipate receiving benefits when we are retired. The current discussion will determine both the level of taxes we pay now and the benefits we will receive in the future.
The average person could be forgiven for thinking that the debate over Social Security is complicated, arcane, and impossible to understand without an immense amount of study. In fact, the basics of the system are quite straightforward, and the most important elements of the discussion can be understood using very little economics. In this chapter, we demystify the arguments about Social Security. This will make it easier for you to understand why you pay Social Security contributions, what you can expect to get in the future, and whether the politicians and talking heads are making any sense when they discuss various reforms.
Road Map
At the heart of the economic analysis of Social Security is a very straightforward idea: “forced saving.” Individuals are required to give up some of their income now—income that they could, if desired, have used for current consumption—and, in return, they are promised income in the future. Understanding Social Security from the individual perspective means understanding the impact of this forced saving on individual choices.
Meanwhile, we also need to understand how Social Security looks from a government perspective. Social Security contributions are a source of government revenue, and Social Security payments are an example of a government transfer. These revenues and payments enter into the government’s budget constraint.
From the perspective of an individual, there is a disconnect in time between taxes and payments. Individuals pay taxes during their working years and receive transfers during their retirement years. But from the perspective of the government, taxes and payments take place at the same time. In any given year there are some individuals who are working and paying taxes, and the money they pay into the system is paid right back out to others who are in retirement.
To address questions about reforming the Social Security program, we therefore need to understand (1) the structure of the program and (2) how it interacts with individual choices about consumption and saving. We study how individuals respond to Social Security by using a model of consumption and saving that applies over an individual’s lifetime. Once we understand how individuals make these choices, we ask how Social Security affects their decisions. Then we think about how the government fits into the picture. We study these flows into and from the Social Security program using the government budget constraint, to link changes in the program with changes in taxes.This tool is used elsewhere in the book in other applications, such as Chapter 27 "Income Taxes" and Chapter 29 "Balancing the Budget". In the end, we are able to see how individuals’ consumption and saving decisions are influenced by their beliefs about government behavior. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/28%3A_Social_Security/28.01%3A_Death_and_Taxes.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. How do households respond to variations in income over their lifetime?
2. What is the government’s budget constraint in a pay-as-you-go system?
3. What is the effect of Social Security on lifetime income?
We begin with the individual perspective on Social Security.
Social Security: The Individual’s View
Household incomes tend to vary quite a lot, but households like their consumption to be approximately constant over time. Households therefore use their savings to smooth out the variations in their income.We also discuss consumption smoothing in Chapter 27 "Income Taxes". For the purposes of understanding Social Security—both its problems and its reforms—we need to examine this idea of consumption smoothing more rigorously. Because Social Security is a program to provide for consumption in retirement, we must carefully lay out the decisions of a household over the entire lifetime of its members. By so doing, we can determine the likely effect of a promise of a transfer in the future on behavior today. Bear in mind that these transfers may be far in the future: for a 25-year-old worker, we are thinking about money that won’t be received for another 40 years or so.
As is often the case in economics, we start by looking at the simplest setup we can imagine. We do this not because we think we can answer every question with a simple model, but because we must make sure we understand the fundamentals of Social Security before we worry about the complexities. So, to keep things simple, we examine the life of a single individual—that is, think of the household as containing just one person. Hence we do not have to worry about multiple wage earners (who might be of different ages), and we do not have to worry about how to incorporate children (who grow up and leave the household) into our story. In this chapter, we use the terms individual and household interchangeably. We call our individual Carlo.
Carlo thinks about his income and consumption over his entire lifetime. Because he has the possibility of saving and borrowing, his income and consumption need not be equal in any given year. Carlo faces a lifetime budget constraint, however; in the end, his lifetime spending is limited by his lifetime income. The life-cycle model of consumption examines Carlo’s decisions about how much to consume each year, given this budget constraint.
We begin with a simple numerical example. Suppose Carlo is 20 years old and very well informed about his future. He knows that he is going to work for 45 years—that is, up to age 65. He knows that, every year, he will receive income of $40,000, excluding Social Security contributions. He has to pay Social Security contributions on this income at a rate of 15 percent. Thus he knows he will pay$6,000 each year to Social Security, and his after-tax income is $40,000 − 6,000 = 34,000.$ After he retires at age 65, he knows he will receive a Social Security payment of $18,000 each year until he dies, 15 years later, on his 80th birthday (of heart failure, brought on by the exertion of blowing out all those candles). To decide on his lifetime consumption and saving patterns, Carlo needs to know what his lifetime resources are. We know that, in general, a dollar today is not worth the same amount as a dollar next year—or 60 years from now—because of interest rates and inflation. We sidestep that problem for the moment by imagining that the real interest rate is zero. In this case, it is legitimate to add together dollars from different time periods. So Carlo earns$34,000 per year for each of his 45 working years and obtains $18,000 per year for his 15 retired years. His total lifetime resources are as follows: $lifetime\ income = income\ during\ working\ years + income\ during\ retirement\ years = (34,000 \times 45) + (18,000 \times 15)= 1,530,000 + 270,000 = 1,800,000.$ Over his life, therefore, he has$1.8 million to spend. Figure 28.2.1 "Lifetime Income" shows his lifetime income. His total lifetime resources are obtained by adding together the two rectangles labeled “Lifetime Income from Working” and “Lifetime Social Security Income.” The height of each rectangle gives his income, and the width of each rectangle gives the number of years for which he earns that income.
For 45 years, Carlo earns $34,000 per year (for a total of$1,530,000), and for 15 years, Carlo receives $18,000 per year in Social Security payments (for a total of$270,000). His total lifetime income is $1,800,000. Carlo’s lifetime budget constraint says that his lifetime consumption must equal his lifetime income, $lifetime\ consumption = lifetime\ income.$ If Carlo wants to keep his consumption perfectly smooth, he will consume exactly the same amount in each of his 60 remaining years of life. In this case, his consumption each year is given by the following equation: Figure 28.2.2 "Lifetime Consumption" shows Carlo’s consumption. The area of the rectangle is a measure of Carlo’s lifetime consumption since—as before—the height of the rectangle is his consumption per year, and the width is the number of years. For the 60 years of his remaining life, Carlo spends$30,000 per year, making a total of $1,800,000 during his working years. In each of his working years, Carlo earns$34,000 but consumes only $30,000. Thus he saves$4,000 every year. When he is 21 years old, he therefore has $4,000 in the bank. When he is 22 years old, he has$8,000 in the bank. By the time he retires at age 65, he has saved $180,000 (= 45 ×$4,000).
During his retirement years, Carlo starts to draw on his savings. Social Security pays him $18,000, so he needs to take an additional$12,000 from his savings to have $30,000 in consumption. At age 66, therefore, he has savings of$180,000 − $12,000 =$168,000. For each of his retirement years, his savings are reduced by a further $12,000. After his 15 years of retirement, he has reduced his savings by$12,000 × 15 = $180,000 and dies at the age of 80 with exactly zero in the bank. Figure 28.2.3 "Lifetime Consumption and Saving" combines Figure 28.2.1 "Lifetime Income" and Figure 28.2.2 "Lifetime Consumption" and shows Carlo’s income and consumption. The difference between income and consumption in Carlo’s working years is his saving. Notice the rectangles labeled “saving” and “dissaving.” One way of understanding his lifetime budget constraint is that these two rectangles must be equal in area. Figure $3$: Lifetime Consumption and Saving During his 45 working years, Carlo saves$4,000 per year. During his 15 retirement years, Carlo dissaves at a rate of $12,000 per year. Figure 28.2.4 "Lifetime Wealth Accumulation" shows his wealth over his lifetime. It increases from zero to$180,000 and then decreases again to zero. The fact that he ends his life with exactly zero wealth is just another way of saying that he exactly satisfies his lifetime budget constraint.
Over his working life, Carlo builds up his stock of wealth, so he has $180,000 in his bank account when he retires. During retirement, he dissaves, exactly using up the$180,000 he accumulated while working.
Social Security: The Government’s View
Now let us shift perspective and examine the Social Security system from the perspective of the government. The original intention was that Social Security would be (approximately) pay-as-you-go. Under a strict pay-as-you-go system, the inflows to the government in the form of tax revenues are exactly balanced by outflows to retired people. In any given year, in other words, the government takes money from those that are working and transfers all that money—not a cent more, not a cent less—to those who are retired.
Under this system the government does not maintain any kind of “savings accounts” for individuals: it taxes you when you work and transfers the revenues to retirees at the same time. The government promises to make payments to you after you retire, with these payments being financed by those who will then be working.
Let us pause for a moment here. We have to determine how to capture transfers across different generations in the economy in as simple a setup as possible. The easiest way to do this is to suppose that everyone in the economy is just like Carlo. That is, every working person in the economy earns $40,000 and pays$6,000 into the Social Security system. Every retired person receives a Social Security payment of $18,000 per year. Let us further suppose that there is the same number of people of every age in the economy. In each year the same number of people is born, and—like Carlo—they all live to exactly the age of 80. Like Carlo, everyone works for 45 years (from age 20 to 65) and is retired for 15 years (from age 65 to 80). If we wanted to calibrate this roughly to the US economy (that is, make the numbers in the example a bit more realistic), we might suppose that there are 4 million people born every year. Since everyone lives to the same age, this means that there are 4 million 20-year-olds, 4 million 21-year-olds, and so forth, up to 4 million 79-year-olds. (This implies a total population of 320 million, which is close to the size of the actual US population.) Having made these simplifications, it is a short step to realize that we might as well just suppose that there is only one person of each age. The basic structure of the economy will be the same, but the math will be much easier. (If you can prefer, though, you can multiply both sides of every equation that follows by 4 million.) Given this demography, what do the government finances look like? Every year, the government collects$6,000 each in Social Security revenues from 45 working people, so that the total revenues are given by the following equation:
$Social\ Security\ revenues = 45 \times 6,000 = 270,000.$
Meanwhile, the government pays out $18,000 each year to 15 people: $Social\ Security\ payments = 15 \times 18,000 = 270,000.$ You can see that we have chosen the numbers for our example such that the Social Security system is in balance: revenues equal receipts. A system like this one would indeed be pay-as-you-go. The Effect of a Change in Social Security Benefits Now, what would happen in this example if the government decided it wanted to increase Social Security payments by$3,000 per year? The total increase in payments would equal $45,000 since all 15 retired individuals would receive the extra$3,000. If the government is required to keep the Social Security system in balance, then it would also be obliged to increase Social Security contributions by $1,000 per worker (since there are 45 workers). How would Carlo (and everybody else like him) feel about this change? Remember that Carlo had income before Social Security of$40,000 per year and had to pay $6,000 per year in Social Security contributions. Now he will have to pay$7,000 in contributions, so his income after tax is equal to $33,000. In his retirement years, however, Carlo will now get$21,000 a year instead of $18,000. His lifetime resources are therefore as follows: $lifetime\ income = (33,000 \times 45) + (21,000 \times 15) = 1,485,000 + 315,000= 1,800,000.$ Carlo’s lifetime resources are exactly the same as they were before. Of course, this means that Carlo would choose exactly the same amount of consumption as before:$30,000 a year. However, his saving behavior would be different. He would now only save $3,000 a year. At the time of retirement, he would have saved a total of$135,000. Over the remaining 15 years of his life, Carlo would draw on his savings at the rate of $9,000 per year, which—combined with his Social Security payment of$21,000—would ensure that he had $30,000 to spend in his retirement years. His saving and dissaving are illustrated in Figure 28.2.5 "Lifetime Consumption and Saving". For his 45 working years, Carlo saves$3,000 a year. For his 15 retirement years, Carlo dissaves at a rate of $9,000 a year. We have discovered a rather remarkable conclusion: the change in the government’s Social Security scheme has no effect on Carlo’s lifetime resources or lifetime consumption. From Carlo’s point of view, the change means that the government is saving more on Carlo’s behalf, and therefore he does not need to save so much for himself. Carlo’s saving declines by exactly the same amount as the increase in Social Security taxes ($1,000) per year; likewise, his dissaving declines by exactly the same amount as the increase in Social Security payments.
Another example is even more striking. Suppose there were no Social Security system at all. Then Carlo would receive $40,000 a year for 45 years but nothing at all in his retirement years. His lifetime resources would equal $lifetime\ income = 40,000 \times 45 = 1,800,000,$ which is again the same as before. To enjoy lifetime consumption of$30,000 a year, Carlo would save $10,000 in every working year and dissave$30,000 in every retirement year.
These numerical examples suggest an extraordinary conclusion: Social Security seems to be completely irrelevant for Carlo. No matter what the scheme looks like, Carlo has the same lifetime resources and same lifetime consumption. This is an amazing and perhaps even shocking finding. We have used some economics to analyze one of the most important government programs, one that is a source of constant scrutiny and debate (and, not incidentally, requires substantial resources for its administration). Not only have we found no reason to expect a crisis in Social Security, we have found that it is irrelevant.
Should we now pack up and go home, saying that “economists have analyzed Social Security and it is actually a nonissue”? We hope it is obvious that the answer is no. After all, all we have done so far is present a numerical example. The example suggests that Social Security might be irrelevant under certain circumstances, but it certainly does not prove that it is irrelevant in general.
This is how economists very often work. A simple numerical example can help us understand the operation of a complicated system like Social Security and can lead to some suggestive conclusions. Our next task is to determine whether the conclusion from our example holds more generally. We will first see that the result does not depend only on the particular numbers that we chose. We will then try to understand exactly where the conclusion comes from.
Key Takeaways
1. Households respond to variations in income over their lifetime through adjustments in saving to smooth consumption.
2. In a pay-as-you-go system, the government’s payments to Social Security recipients exactly matches the revenues received from workers.
3. The integration of the government and household budget constraints implies that in a pay-as-you-go system, Social Security influences household saving but leaves lifetime consumption and income unchanged.
Exercises
1. What uncertainties did Carlo face over his lifetime?
2. In what parts of the discussion did we use the assumption that the real interest rate was zero? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/28%3A_Social_Security/28.02%3A_Individual_and_Government_Perspectives_on_Social_Security.txt |
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