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Learning Objectives
By the end of this section, you will be able to:
• Explain antitrust law and its significance
• Calculate concentration ratios
• Calculate the Herfindahl-Hirschman Index (HHI)
• Evaluate methods of antitrust regulation
A corporate merger occurs when two formerly separate firms combine to become a single firm. When one firm purchases another, it is called an acquisition. An acquisition may not look just like a merger, since the newly purchased firm may continue to operate under its former company name. Mergers can also be lateral, where two firms of similar sizes combine to become one. However, both mergers and acquisitions lead to two formerly separate firms operating under common ownership, and so they are commonly grouped together.
Regulations for Approving Mergers
Since a merger combines two firms into one, it can reduce the extent of competition between firms. Therefore, when two U.S. firms announce a merger or acquisition where at least one of the firms is above a minimum size of sales (a threshold that moves up gradually over time, and was at \$101 million in 2022), or certain other conditions are met, they are required under law to notify the U.S. Federal Trade Commission (FTC). The left-hand panel of Figure 11.2 (a) shows the number of mergers submitted for review to the FTC each year from 1999 to 2012. Mergers follow the business cycle, falling after the 2001 recession, peaking in 2007 as the Great Recession struck, and then rising since 2009. The right-hand panel of Figure 11.2 (b) shows the distribution of those mergers submitted for review in 2015 as measured by the size of the transaction. It is important to remember that this total leaves out many small mergers under \$50 million, which companies only need to report in certain limited circumstances. In 2012, 26 percent of all reported merger and acquisition transactions exceeded \$500 million, while 11 percent exceeded \$1 billion.
Figure 11.2 Number and Size of Mergers (a) The number of mergers grew from 2003 to 2007, then fell dramatically during the 2008-2009 Great Recession, before recovering since. (b) In 2012, the greatest number of mergers submitted for review by the Federal Trade Commission was for transactions between \$100–\$150 million.
The laws that give government the power to block certain mergers, and even in some cases to break up large firms into smaller ones, are called antitrust laws. Before a large merger happens, the antitrust regulators at the FTC and the U.S. Department of Justice can allow the merger, prohibit it, or allow it if certain conditions are met. One common condition is that the merger will be allowed if the firm agrees to sell off certain parts. For example, in 2006, Johnson & Johnson bought the Pfizer’s “consumer health” division, which included well-known brands like Listerine mouthwash and Sudafed cold medicine. As a condition of allowing the merger, Johnson & Johnson was required to sell off six brands to other firms, including Zantac® heartburn relief medication, Cortizone anti-itch cream, and Balmex diaper rash medication, to preserve a greater degree of competition in these markets.
The U.S. government approves most proposed mergers. In a market-oriented economy, firms have the freedom to make their own choices. Private firms generally have the freedom to:
• expand or reduce production
• set the price they choose
• open new factories or sales facilities or close them
• hire workers or to lay them off
• start selling new products or stop selling existing ones
If the owners want to acquire a firm or be acquired, or to merge with another firm, this decision is just one of many that firms are free to make. In these conditions, the managers of private firms will sometimes make mistakes. They may close down a factory which, it later turns out, would have been profitable. They may start selling a product that ends up losing money. A merger between two companies can sometimes lead to a clash of corporate personalities that makes both firms worse off. However, the fundamental belief behind a market-oriented economy is that firms, not governments, are in the best position to know if their actions will lead to attracting more customers or producing more efficiently.
Government regulators agree that most mergers are beneficial to consumers. As the Federal Trade Commission has noted on its website (as of November, 2013): “Most mergers actually benefit competition and consumers by allowing firms to operate more efficiently.” At the same time, the FTC recognizes, “Some [mergers] are likely to lessen competition. That, in turn, can lead to higher prices, reduced availability of goods or services, lower quality of products, and less innovation. Some mergers create a concentrated market, while others enable a single firm to raise prices.” The challenge for the antitrust regulators at the FTC and the U.S. Department of Justice is to figure out when a merger may hinder competition. This decision involves both numerical tools and some judgments that are difficult to quantify. The following Clear It Up explains the origins of U.S. antitrust law.
Clear It Up
What is U.S. antitrust law?
In the closing decades of the 1800s, many industries in the U.S. economy were dominated by a single firm that had most of the sales for the entire country. Supporters of these large firms argued that they could take advantage of economies of scale and careful planning to provide consumers with products at low prices. However, critics pointed out that when competition was reduced, these firms were free to charge more and make permanently higher profits, and that without the goading of competition, it was not clear that they were as efficient or innovative as they could be.
In many cases, these large firms were organized in the legal form of a “trust,” in which a group of formerly independent firms were consolidated by mergers and purchases, and a group of “trustees” then ran the companies as if they were a single firm. Thus, when the U.S. government sought to limit the power of these trusts, it passed the Sherman Antitrust Act in 1890 - the nation's first antitrust law. In an early demonstration of the law’s power, the U.S. Supreme Court in 1911 upheld the government’s right to break up Standard Oil, which had controlled about 90% of the country’s oil refining, into 34 independent firms, including Exxon, Mobil, Amoco, and Chevron. In 1914, the Clayton Antitrust Act outlawed mergers and acquisitions (where the outcome would be to “substantially lessen competition” in an industry), price discrimination (where different customers are charged different prices for the same product), and tied sales (where purchase of one product commits the buyer to purchase some other product). Also in 1914, the Federal Trade Commission (FTC) was created to define more specifically what competition was unfair. In 1950, the Celler-Kefauver Act extended the Clayton Act by restricting vertical and conglomerate mergers. A vertical merger occurs when two or more firms, operating at different levels within an industry's supply chain, merge operations. A conglomerate merger is a merger between firms that are involved in totally unrelated business activities. In the twenty-first century, the FTC and the U.S. Department of Justice continue to enforce antitrust laws.
The Four-Firm Concentration Ratio
Regulators have struggled for decades to measure the degree of monopoly power in an industry. An early tool was the concentration ratio, which measures the combined market share (or percent of total industry sales) which is accounted for by the largest firms (typically the top four to eight). For an explanation of how high market concentrations can create inefficiencies in an economy, refer to Monopoly.
Say that the market for replacing broken automobile windshields in a certain city has 18 firms with the market shares in Table 11.1, where the market share is each firm’s proportion of total sales in that market. We calculate the four-firm concentration ratio by adding the market shares of the four largest firms: in this case, 16 + 10 + 8 + 6 = 40. We do not consider this concentration ratio especially high, because the largest four firms have less than half the market.
If the market shares for replacing automobile windshields are:
Smooth as Glass Repair Company 16% of the market
The Auto Glass Doctor Company 10% of the market
Your Car Shield Company 8% of the market
Seven firms that each have 6% of the market 42% of the market, combined
Eight firms that each have 3% of the market 24% of the market, combined
Then the four-firm concentration ratio is 16 + 10 + 8 + 6 = 40.
Table 11.1 Calculating Concentration Ratios from Market Shares
The concentration ratio approach can help to clarify some of the fuzziness over deciding when a merger might affect competition. For instance, if two of the smallest firms in the hypothetical market for repairing automobile windshields merged, the four-firm concentration ratio would not change—which implies that there is not much worry that the degree of competition in the market has notably diminished. However, if the top two firms merged, then the four-firm concentration ratio would become 46 (that is, 26 + 8 + 6 + 6). While this concentration ratio is modestly higher, the four-firm concentration ratio would still be less than half, so such a proposed merger might barely raise an eyebrow among antitrust regulators.
Link It Up
Visit this website to read an article about Google’s run-in with the FTC.
The Herfindahl-Hirschman Index
A four-firm concentration ratio is a simple tool, which may reveal only part of the story. For example, consider two industries that both have a four-firm concentration ratio of 80. However, in one industry five firms each control 20% of the market, while in the other industry, the top firm holds 77% of the market and all the other firms have 1% each. Although the four-firm concentration ratios are identical, it would be reasonable to worry more about the extent of competition in the second case—where the largest firm is nearly a monopoly—than in the first.
Another approach to measuring industry concentration that can distinguish between these two cases is called the Herfindahl-Hirschman Index (HHI). We calculate HHI by summing the squares of the market share of each firm in the industry, as the following Work It Out shows.
Work It Out
Calculating HHI
Step 1. Calculate the HHI for a monopoly with a market share of 100%. Because there is only one firm, it has 100% market share. The HHI is 1002 = 10,000.
Step 2. For an extremely competitive industry, with dozens or hundreds of extremely small competitors, the HHI value might drop as low as 100 or even less. Calculate the HHI for an industry with 100 firms that each have 1% of the market. In this case, the HHI is 100(12) = 100.
Step 3. Calculate the HHI for the industry in Table 11.1. In this case, the HHI is 162 + 102 + 82 + 7(62) + 8(32) = 744.
Step 4. Note that the HHI gives greater weight to large firms.
Step 5. Consider the earlier example, comparing one industry where five firms each have 20% of the market with an industry where one firm has 77% and the other 23 firms have 1% each. The two industries have the same four-firm concentration ratio of 80. However, the HHI for the first industry is 5(202) = 2,000, while the HHI for the second industry is much higher at 772 + 23(12) = 5,952.
Step 6. Note that the near-monopolist in the second industry drives up the HHI measure of industrial concentration.
Step 7. Review Table 11.2 which gives some examples of the four-firm concentration ratio and the HHI in various U.S. industries in 2016. (You can find market share data from multiple industry sources. Data in the table are from: Statista.com (for wireless), The Wall Street Journal (for automobiles), Gartner.com (for computers) and the U.S. Bureau of Transportation Statistics (for airlines).)
U.S. Industry Four-Firm Ratio HHI
Wireless 98 2,736
Largest five: Verizon, AT&T, Sprint, T-Mobile, US Cellular
Personal Computers 76 1,234
Largest five: HP, Lenovo, Dell, Asus, Apple, Acer
Airlines 69 1,382
Largest five: American, Southwest, Delta, United, JetBlue
Automobiles 58 1,099
Largest five: Ford, GM, Toyota, Chrysler, Nissan
Table 11.2 Examples of Concentration Ratios and HHIs in the U.S. Economy, 2016
In the 1980s, the FTC followed these guidelines: If a merger would result in an HHI of less than 1,000, the FTC would probably approve it. If a merger would result in an HHI of more than 1,800, the FTC would probably challenge it. If a merger would result in an HHI between 1,000 and 1,800, then the FTC would scrutinize the plan and make a case-by-case decision. However, in the last several decades, the antitrust enforcement authorities have moved away from relying as heavily on measures of concentration ratios and HHIs to determine whether they will allow a merger, and instead they carry out more case-by-case analysis on the extent of competition in different industries.
New Directions for Antitrust
Both the four-firm concentration ratio and the Herfindahl-Hirschman index share some weaknesses. First, they begin from the assumption that the “market” under discussion is well-defined, and the only question is measuring how sales are divided in that market. Second, they are based on an implicit assumption that competitive conditions across industries are similar enough that a broad measure of concentration in the market is enough to make a decision about the effects of a merger. These assumptions, however, are not always correct. In response to these two problems, the antitrust regulators have been changing their approach in the last decade or two.
Defining a market is often controversial. For example, Microsoft in the early 2000s had a dominant share of the software for computer operating systems. However, in the total market for all computer software and services, including everything from games to scientific programs, the Microsoft share was only about 14% in 2014. A narrowly defined market will tend to make concentration appear higher, while a broadly defined market will tend to make it appear smaller.
In recent decades, there have been two especially important shifts affecting how we define markets: one centers on technology and the other centers on globalization. In addition, these two shifts are interconnected. With the vast improvement in communications technologies, including the development of the internet, a consumer can order books or pet supplies from all over the country or the world. As a result, the degree of competition many local retail businesses face has increased. The same effect may operate even more strongly in markets for business supplies, where so-called “business-to-business” websites can allow buyers and suppliers from anywhere in the world to find each other.
Globalization has changed the market boundaries. As recently as the 1970s, it was common for measurements of concentration ratios and HHIs to stop at national borders. Now, many industries find that their competition comes from the global market. A few decades ago, three companies, General Motors, Ford, and Chrysler, dominated the U.S. auto market. By 2014, however, production of these three firms accounted for less than half of U.S. auto sales, although by 2021, with the emergence of COVID-19, the three firms accounted for essentially half of U.S. auto sales. The three firms face competition from well-known car manufacturers such as Toyota, Honda, Nissan, Volkswagen, Mitsubishi, and Mazda. When analysts calculate HHIs with a global perspective, concentration in most major industries—including cars—is lower than in a purely domestic context.
Because attempting to define a particular market can be difficult and controversial, the Federal Trade Commission has begun to look less at market share and more at the data on actual competition between businesses. For example, in February 2007, Whole Foods Market and Wild Oats Market announced that they wished to merge. These were the two largest companies in the market that the government defined as “premium natural and organic supermarket chains.” However, one could also argue that they were two relatively small companies in the broader market for all stores that sell groceries or specialty food products.
Rather than relying on a market definition, the government antitrust regulators looked at detailed evidence on profits and prices for specific stores in different cities, both before and after other competitive stores entered or exited. Based on that evidence, the Federal Trade Commission decided to block the merger. After two years of legal battles, the FTC eventually allowed the merger in 2009 under the conditions that Whole Foods sell off the Wild Oats brand name and a number of individual stores, to preserve competition in certain local markets. For more on the difficulties of defining markets, refer to Monopoly.
This new approach to antitrust regulation involves detailed analysis of specific markets and companies, instead of defining a market and counting up total sales. A common starting point is for antitrust regulators to use statistical tools and real-world evidence to estimate the demand curves and supply curves the firms proposing a merger face. A second step is to specify how competition occurs in this specific industry. Some possibilities include competing to cut prices, to raise output, to build a brand name through advertising, and to build a reputation for good service or high quality. With these pieces of the puzzle in place, it is then possible to build a statistical model that estimates the likely outcome for consumers if the two firms are allowed to merge. These models do require some degree of subjective judgment, and so they can become the subject of legal disputes between the antitrust authorities and the companies that wish to merge. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/11%3A_Monopoly_and_Antitrust_Policy/11.02%3A_Corporate_Mergers.txt |
Learning Objectives
By the end of this section, you will be able to:
• Analyze restrictive practices
• Explain tying sales, bundling, and predatory pricing
• Evaluate a real-world situation of possible anticompetitive and restrictive practices
The U.S. antitrust laws reach beyond blocking mergers that would reduce competition to include a wide array of anticompetitive practices. For example, it is illegal for competitors to form a cartel to collude to make pricing and output decisions, as if they were a monopoly firm. The Federal Trade Commission and the U.S. Department of Justice prohibit firms from agreeing to fix prices or output, rigging bids, or sharing or dividing markets by allocating customers, suppliers, territories, or lines of commerce.
In the late 1990s, for example, the antitrust regulators prosecuted an international cartel of vitamin manufacturers, including the Swiss firm Hoffman-La Roche, the German firm BASF, and the French firm Rhone-Poulenc. These firms reached agreements on how much to produce, how much to charge, and which firm would sell to which customers. Firms like General Mills, Kellogg, Purina Mills, and Proctor and Gamble bought the high-priced vitamins, which pushed up the prices more. Hoffman-La Roche pleaded guilty in May 1999 and agreed both to pay a fine of \$500 million and to have at least one top executive be incarcerated for four months.
Under U.S. antitrust laws, monopoly itself is not illegal. If a firm has a monopoly because of a newly patented invention, for example, the law explicitly allows a firm to earn higher-than-normal profits for a time as a reward for innovation. If a firm achieves a large share of the market by producing a better product at a lower price, such behavior is not prohibited by antitrust law.
Restrictive Practices
Antitrust law includes rules against restrictive practices—practices that do not involve outright agreements to raise price or to reduce the quantity produced, but that might have the effect of reducing competition. Antitrust cases involving restrictive practices are often controversial, because they delve into specific contracts or agreements between firms that are allowed in some cases but not in others.
For example, an exclusive dealing agreement between a manufacturer and a dealer can be legal or illegal. It is legal if the purpose of the contract is to encourage competition between dealers. For example, it is legal for the Ford Motor Company to sell its cars to only Ford dealers, and for General Motors to sell to only GM dealers, and so on. However, exclusive deals may also limit competition. If one large retailer obtained the exclusive rights to be the sole distributor of televisions, computers, and audio equipment made by a number of companies, then this exclusive contract would have an anticompetitive effect on other retailers.
Tying sales happen when a customer is allowed to buy one product only if the customer also buys a second product. Tying sales are controversial because they force consumers to purchase a product that they may not actually want or need. Further, the additional, required products are not necessarily advantageous to the customer. Suppose that to purchase a popular DVD, the store required that you also purchase a certain portable TV model. These products are only loosely related, thus there is no reason to make the purchase of one contingent on the other. Even if a customer were interested in a portable TV, the tying to a particular model prevents the customer from having the option of selecting one from the numerous types available in the market.
A related, but not identical, concept is bundling, where a firm sells two or more products as one. Bundling typically offers an advantage for consumers by allowing them to acquire multiple products or services for a better price. For example, several cable companies allow customers to buy products like cable, internet, and a phone line through a special price available through bundling. Customers are also welcome to purchase these products separately, but the price of bundling is usually more appealing.
In some cases, we can view tying sales and bundling as anticompetitive. However, in other cases they may be legal and even common. It is common for people to purchase season tickets to a sports team or a set of concerts so as to guarantee tickets to the few contests or shows that are most popular and likely to sell out. Computer software manufacturers may often bundle a number of different programs, even when the buyer wants only a few. Think about the software that is included in a new computer purchase, for example.
Recall from the chapter on Monopoly that predatory pricing occurs when the existing firm (or firms) reacts to a new firm by dropping prices very low, until the new firm is driven out of the market, at which point the existing firm raises prices again. This pattern of pricing is aimed at deterring new firms from entering the market. However, in practice, it can be hard to figure out when pricing is predatory. Say that American Airlines is flying between two cities, and a new airline starts flying between the same two cities, at a lower price. If American Airlines cuts its price to match the new entrant, is this predatory pricing or is it just market competition at work? A commonly proposed rule is that if a firm is selling for less than its average variable cost—that is, at a price where it should be shutting down—then there is evidence for predatory pricing. However, calculating in the real world what costs are variable and what costs are fixed is often not obvious, either.
The Microsoft antitrust case embodies many of these gray areas in restrictive practices, as the next Clear It Up shows.
Clear It Up
Did Microsoft® engage in anticompetitive and restrictive practices?
The most famous restrictive practices case of recent years was a series of lawsuits by the U.S. government against Microsoft—lawsuits that some of Microsoft’s competitors encouraged. All sides admitted that Microsoft’s Windows program had a near-monopoly position in the market for the software used in general computer operating systems. All sides agreed that the software had many satisfied customers and that the computer software capabilities were compatible with Windows. Software that Microsoft and other companies produced had expanded dramatically in the 1990s. Having a monopoly or a near-monopoly is not necessarily illegal in and of itself, but in cases where one company controls a great deal of the market, antitrust regulators look at any allegations of restrictive practices with special care.
The antitrust regulators argued that Microsoft had gone beyond profiting from its software innovations and its dominant position in the software market for operating systems, and had tried to use its market power in operating systems software to take over other parts of the software industry. For example, the government argued that Microsoft had engaged in an anticompetitive form of exclusive dealing by threatening computer makers that, if they did not leave another firm’s software off their machines (specifically, Netscape’s Internet browser), then Microsoft would not sell them its operating system software. Government antitrust regulators accused Microsoft of tying together its Windows operating system software, where it had a monopoly, with its Internet Explorer browser software, where it did not have a monopoly, and thus using this bundling as an anticompetitive tool. The government also accused Microsoft of a form of predatory pricing; namely, giving away certain additional software products for free as part of Windows, as a way of driving out the competition from other software makers.
In April 2000, a federal court held that Microsoft’s behavior had crossed the line into unfair competition, and recommended that the company be split into two competing firms. However, the court overturned that penalty on appeal, and in November 2002 Microsoft reached a settlement with the government that it would end its restrictive practices.
The concept of restrictive practices is continually evolving, as firms seek new ways to earn profits and government regulators define what is permissible. A situation where the law is evolving and changing is always somewhat troublesome, since laws are most useful and fair when firms know what they are in advance. In addition, since the law is open to interpretation, competitors who are losing out in the market can accuse successful firms of anticompetitive restrictive practices, and try to win through government regulation what they have failed to accomplish in the market. Officials at the Federal Trade Commission and the Department of Justice are, of course, aware of these issues, but there is no easy way to resolve them. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/11%3A_Monopoly_and_Antitrust_Policy/11.03%3A_Regulating_Anticompetitive_Behavior.txt |
Learning Objectives
By the end of this section, you will be able to:
• Evaluate the appropriate competition policy for a natural monopoly
• Interpret a graph of regulatory choices
• Contrast cost-plus and price cap regulation
Most true monopolies today in the U.S. are regulated, natural monopolies. A natural monopoly poses a difficult challenge for competition policy, because the structure of costs and demand makes competition unlikely or costly. A natural monopoly arises when average costs are declining over the range of production that satisfies market demand. This typically happens when fixed costs are large relative to variable costs. As a result, one firm is able to supply the total quantity demanded in the market at lower cost than two or more firms—so splitting up the natural monopoly would raise the average cost of production and force customers to pay more.
Public utilities, the companies that have traditionally provided water and electrical service across much of the United States, are leading examples of natural monopoly. It would make little sense to argue that a local water company should be divided into several competing companies, each with its own separate set of pipes and water supplies. Installing four or five identical sets of pipes under a city, one for each water company, so that each household could choose its own water provider, would be terribly costly. The same argument applies to the idea of having many competing companies for delivering electricity to homes, each with its own set of wires. Before the advent of wireless phones, the argument also applied to the idea of many different phone companies, each with its own set of phone wires running through the neighborhood.
The Choices in Regulating a Natural Monopoly
What then is the appropriate competition policy for a natural monopoly? Figure 11.3 illustrates the case of natural monopoly, with a market demand curve that cuts through the downward-sloping portion of the average cost curve. Points A, B, C, and F illustrate four of the main choices for regulation. Table 11.3 outlines the regulatory choices for dealing with a natural monopoly.
Figure 11.3 Regulatory Choices in Dealing with Natural Monopoly A natural monopoly will maximize profits by producing at the quantity where marginal revenue (MR) equals marginal costs (MC) and by then looking to the market demand curve to see what price to charge for this quantity. This monopoly will produce at point A, with a quantity of 4 and a price of 9.3. If antitrust regulators split this company exactly in half, then each half would produce at point B, with average costs of 9.75 and output of 2. The regulators might require the firm to produce where marginal cost crosses the market demand curve at point C. However, if the firm is required to produce at a quantity of 8 and sell at a price of 3.5, the firm will incur losses. The most likely choice is point F, where the firm is required to produce a quantity of 6 and charge a price of 6.5.
Quantity Price Total Revenue* Marginal Revenue Total Cost Marginal Cost Average Cost
1 14.7 14.7 14.7 11.0 - 11.00
2 12.4 24.7 10.0 19.5 8.5 9.75
3 10.6 31.7 7.0 25.5 6.0 8.50
4 9.3 37.2 5.5 31.0 5.5 7.75
5 8.0 40.0 2.8 35.0 4.0 7.00
6 6.5 39.0 –1.0 39.0 4.0 6.50
7 5.0 35.0 –4.0 42.0 3.0 6.00
8 3.5 28.0 –7.0 45.5 3.5 5.70
9 2.0 18.0 –10.0 49.5 4.0 5.5
Table 11.3 Regulatory Choices in Dealing with Natural Monopoly (*We obtain total revenue by multiplying price and quantity. However, we have rounded some of the price values in this table for ease of presentation.)
The first possibility is to leave the natural monopoly alone. In this case, the monopoly will follow its normal approach to maximizing profits. It determines the quantity where MR = MC, which happens at point P at a quantity of 4. The firm then looks to point A on the demand curve to find that it can charge a price of 9.3 for that profit-maximizing quantity. Since the price is above the average cost curve, the natural monopoly would earn economic profits.
A second outcome arises if antitrust authorities decide to divide the company, so that the new firms can compete. As a simple example, imagine that the company is cut in half. Thus, instead of one large firm producing a quantity of 4, two half-size firms each produce a quantity of 2. Because of the declining average cost curve (AC), the average cost of production for each of the half-size companies producing 2, as point B shows, would be 9.75, while the average cost of production for a larger firm producing 4 would only be 7.75. Thus, the economy would become less productively efficient, since the good is produced at a higher average cost. In a situation with a downward-sloping average cost curve, two smaller firms will always have higher average costs of production than one larger firm for any quantity of total output. In addition, the antitrust authorities must worry that splitting the natural monopoly into pieces may be only the start of their problems. If one of the two firms grows larger than the other, it will have lower average costs and may be able to drive its competitor out of the market. Alternatively, two firms in a market may discover subtle ways of coordinating their behavior and keeping prices high. Either way, the result will not be the greater competition that was desired.
A third alternative is that regulators may decide to set prices and quantities produced for this industry. The regulators will try to choose a point along the market demand curve that benefits both consumers and the broader social interest. Point C illustrates one tempting choice: the regulator requires that the firm produce the quantity of output where marginal cost crosses the demand curve at an output of 8, and charge the price of 3.5, which is equal to marginal cost at that point. This rule is appealing because it requires price to be set equal to marginal cost, which is what would occur in a perfectly competitive market, and it would assure consumers a higher quantity and lower price than at the monopoly choice A. In fact, efficient allocation of resources would occur at point C, since the value to the consumers of the last unit bought and sold in this market is equal to the marginal cost of producing it.
Attempting to bring about point C through force of regulation, however, runs into a severe difficulty. At point C, with an output of 8, a price of 3.5 is below the average cost of production, which is 5.7, so if the firm charges a price of 3.5, it will be suffering losses. Unless the regulators or the government offer the firm an ongoing public subsidy (and there are numerous political problems with that option), the firm will lose money and go out of business.
Perhaps the most plausible option for the regulator is point F; that is, to set the price where AC crosses the demand curve at an output of 6 and a price of 6.5. This plan makes some sense at an intuitive level: let the natural monopoly charge enough to cover its average costs and earn a normal rate of profit, so that it can continue operating, but prevent the firm from raising prices and earning abnormally high monopoly profits, as it would at the monopoly choice A. Determining this level of output and price with the political pressures, time constraints, and limited information of the real world is much harder than identifying the point on a graph. For more on the problems that can arise from a centrally determined price, see the discussion of price floors and price ceilings in Demand and Supply.
Cost-Plus versus Price Cap Regulation
Regulators of public utilities for many decades followed the general approach of attempting to choose a point like F in Figure 11.3. They calculated the average cost of production for the water or electricity companies, added in an amount for the normal rate of profit the firm should expect to earn, and set the price for consumers accordingly. This method was known as cost-plus regulation.
Cost-plus regulation raises difficulties of its own. If producers receive reimbursement for their costs, plus a bit more, then at a minimum, producers have less reason to be concerned with high costs—because they can just pass them along in higher prices. Worse, firms under cost-plus regulation even have an incentive to generate high costs by building huge factories or employing many staff, because what they can charge is linked to the costs they incur.
Thus, in the 1980s and 1990s, some public utility regulators began to use price cap regulation, where the regulator sets a price that the firm can charge over the next few years. A common pattern was to require a price that declined slightly over time. If the firm can find ways of reducing its costs more quickly than the price caps, it can make a high level of profits. However, if the firm cannot keep up with the price caps or suffers bad luck in the market, it may suffer losses. A few years down the road, the regulators will then set a new series of price caps based on the firm’s performance.
Price cap regulation requires delicacy. It will not work if the price regulators set the price cap unrealistically low. It may not work if the market changes dramatically so that the firm is doomed to incurring losses no matter what it does—say, if energy prices rise dramatically on world markets, then the company selling natural gas or heating oil to homes may not be able to meet price caps that seemed reasonable a year or two ago. However, if the regulators compare the prices with producers of the same good in other areas, they can, in effect, pressure a natural monopoly in one area to compete with the prices charged in other areas. Moreover, the possibility of earning greater profits or experiencing losses—instead of having an average rate of profit locked in every year by cost-plus regulation—can provide the natural monopoly with incentives for efficiency and innovation.
With natural monopoly, market competition is unlikely to take root, so if consumers are not to suffer the high prices and restricted output of an unrestricted monopoly, government regulation will need to play a role. In attempting to design a system of price cap regulation with flexibility and incentive, government regulators do not have an easy task. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/11%3A_Monopoly_and_Antitrust_Policy/11.04%3A_Regulating_Natural_Monopolies.txt |
Learning Objectives
By the end of this section, you will be able to:
• Evaluate the effectiveness of price regulation and antitrust policy
• Explain regulatory capture and its significance
Governments at all levels across the United States have regulated prices in a wide range of industries. In some cases, like water and electricity that have natural monopoly characteristics, there is some room in economic theory for such regulation. However, once politicians are given a basis to intervene in markets and to choose prices and quantities, it is hard to know where to stop.
Doubts about Regulation of Prices and Quantities
Beginning in the 1970s, it became clear to policymakers of all political leanings that the existing price regulation was not working well. The United States carried out a great policy experiment—the deregulation that we discussed in Monopoly—removing government controls over prices and quantities produced in airlines, railroads, trucking, intercity bus travel, natural gas, and bank interest rates. The Clear It Up discusses the outcome of deregulation in one industry in particular—airlines.
Clear It Up
What are the results of airline deregulation?
Why did the pendulum swing in favor of deregulation? Consider the airline industry. In the early days of air travel, no airline could make a profit just by flying passengers. Airlines needed something else to carry and the Postal Service provided that something with airmail. Thus, the first U.S. government regulation of the airline industry happened through the Postal Service, when in 1926 the Postmaster General began giving airlines permission to fly certain routes based on mail delivery needs—and the airlines took some passengers along for the ride. In 1934, the antitrust authorities charged the Postmaster General with colluding with the major airlines of that day to monopolize the nation’s airways. In 1938, the U.S. government created the Civil Aeronautics Board (CAB) to regulate airfares and routes instead. For 40 years, from 1938 to 1978, the CAB approved all fares, controlled all entry and exit, and specified which airlines could fly which routes. There was zero entry of new airlines on the main routes across the country for 40 years, because the CAB did not think it was necessary.
In 1978, the Airline Deregulation Act took the government out of the business of determining airfares and schedules. The new law shook up the industry. Famous old airlines like Pan American, Eastern, and Braniff went bankrupt and disappeared. Some new airlines like People Express were created—and then vanished.
The greater competition from deregulation reduced airfares by about one-third over the next two decades, saving consumers billions of dollars a year. The average flight used to take off with just half its seats full; now it is two-thirds full, which is far more efficient. Airlines have also developed hub-and-spoke systems, where planes all fly into a central hub city at a certain time and then depart. As a result, one can fly between any of the spoke cities with just one connection—and there is greater service to more cities than before deregulation. With lower fares and more service, the number of air passengers doubled from the late 1970s to the start of the 2000s—an increase that, in turn, doubled the number of jobs in the airline industry. Meanwhile, with the watchful oversight of government safety inspectors, commercial air travel has continued to get safer over time.
The U.S. airline industry is far from perfect. For example, a string of mergers in recent years has raised concerns over how competition might be compromised.
One difficulty with government price regulation is what economists call regulatory capture, in which the firms that are supposedly regulated end up playing a large role in setting the regulations that they will follow. When the airline industry was regulated, for example, it suggested appointees to the regulatory board, sent lobbyists to argue with the board, provided most of the information on which the board made decisions, and offered well-paid jobs to at least some of the people leaving the board. In this situation, it is easy for regulators to poorly represent consumers. The result of regulatory capture is that government price regulation can often become a way for existing competitors to work together to reduce output, keep prices high, and limit competition.
The Effects of Deregulation
Deregulation, both of airlines and of other industries, has its negatives. The greater pressure of competition led to entry and exit. When firms went bankrupt or contracted substantially in size, they laid off workers who had to find other jobs. Market competition is, after all, a full-contact sport.
A number of major accounting scandals involving prominent corporations such as Enron, Tyco International, and WorldCom led to the Sarbanes-Oxley Act in 2002. The government designed Sarbanes-Oxley to increase confidence in financial information provided by public corporations to protect investors from accounting fraud.
The Great Recession, which began in late 2007, was caused at least in part by a global financial crisis, which began in the United States. The key component of the crisis was the creation and subsequent failure of several types of unregulated financial assets, such as collateralized mortgage obligations (CMOs, a type of mortgage-backed security), and credit default swaps (CDSs, insurance contracts on assets like CMOs that provided a payoff even if the holder of the CDS did not own the CMO). Private credit rating agencies such as Standard & Poors, Moody’s, and Fitch rated many of these assets very safe.
The collapse of the markets for these assets precipitated the financial crisis and led to the failure of Lehman Brothers, a major investment bank, numerous large commercial banks, such as Wachovia, and even the Federal National Mortgage Corporation (Fannie Mae), which had to be nationalized—that is, taken over by the federal government. One response to the financial crisis was the Dodd-Frank Act, which majorly attempted to reform the financial system. The legislation’s purpose, as noted on dodd-frank.com is:
To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail,” to protect the American taxpayer by ending bailouts, [and] to protect consumers from abusive financial services practices. . .
All market-based economies operate against a background of laws and regulations, including laws about enforcing contracts, collecting taxes, and protecting health and the environment. The government policies that we discussed in this chapter—like blocking certain anticompetitive mergers, ending restrictive practices, imposing price cap regulation on natural monopolies, and deregulation—demonstrate the role of government to strengthen the incentives that come with a greater degree of competition.
Bring It Home
More than Cooking, Heating, and Cooling
What did the Federal Trade Commission (FTC) decide on the Kinder Morgan / El Paso Corporation merger? After careful examination, federal officials decided there was only one area of significant overlap that might provide the merged firm with strong market power. The FTC approved the merger, provided Kinder Morgan divest itself of the overlap area. Tallgrass purchased Kinder Morgan Interstate Gas Transmission, Trailblazer Pipeline Co. LLC, two processing facilities in Wyoming, and Kinder Morgan’s 50 percent interest in the Rockies Express Pipeline to meet the FTC requirements. The FTC was attempting to strike a balance between potential cost reductions resulting from economies of scale and concentration of market power.
Did the price of natural gas decrease? Yes, rather significantly. In 2010, the wellhead price of natural gas was \$4.48 per thousand cubic foot. In 2012 the price had fallen to just \$2.66. Was the merger responsible for the large drop in price? The answer is uncertain. The larger contributor to the sharp drop in price was the overall increase in the supply of natural gas. Increasingly, more natural gas was able to be recovered by fracturing shale deposits, a process called fracking. Fracking, which is controversial for environmental reasons, enabled the recovery of known reserves of natural gas that previously were not economically feasible to tap. Kinder Morgan’s control of 80,000-plus miles of pipeline likely made moving the gas from wellheads to end users smoother and allowed for an even greater benefit from the increased supply. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/11%3A_Monopoly_and_Antitrust_Policy/11.05%3A_The_Great_Deregulation_Experiment.txt |
acquisition
when one firm purchases another
antitrust laws
laws that give government the power to block certain mergers, and even in some cases to break up large firms into smaller ones
bundling
a situation in which multiple products are sold as one
concentration ratio
an early tool to measure the degree of monopoly power in an industry; measures what share of the total sales in the industry are accounted for by the largest firms, typically the top four to eight firms
cost-plus regulation
when regulators permit a regulated firm to cover its costs and to make a normal level of profit
exclusive dealing
an agreement that a dealer will sell only products from one manufacturer
four-firm concentration ratio
the percentage of the total sales in the industry that are accounted for by the largest four firms
Herfindahl-Hirschman Index (HHI)
approach to measuring market concentration by adding the square of the market share of each firm in the industry
market share
the percentage of total sales in the market
merger
when two formerly separate firms combine to become a single firm
minimum resale price maintenance agreement
an agreement that requires a dealer who buys from a manufacturer to sell for at least a certain minimum price
price cap regulation
when the regulator sets a price that a firm cannot exceed over the next few years
regulatory capture
when the supposedly regulated firms end up playing a large role in setting the regulations that they will follow and as a result, they “capture” the people usually through the promise of a job in that “regulated” industry once their term in government has ended
restrictive practices
practices that reduce competition but that do not involve outright agreements between firms to raise prices or to reduce the quantity produced
tying sales
a situation where a customer is allowed to buy one product only if the customer also buys another product
11.07: Key Concepts and Summary
11.1 Corporate Mergers
A corporate merger involves two private firms joining together. An acquisition refers to one firm buying another firm. In either case, two formerly independent firms become one firm. Antitrust laws seek to ensure active competition in markets, sometimes by preventing large firms from forming through mergers and acquisitions, sometimes by regulating business practices that might restrict competition, and sometimes by breaking up large firms into smaller competitors.
A four-firm concentration ratio is one way of measuring the extent of competition in a market. We calculate it by adding the market shares—that is, the percentage of total sales—of the four largest firms in the market. A Herfindahl-Hirschman Index (HHI) is another way of measuring the extent of competition in a market. We calculate it by taking the market shares of all firms in the market, squaring them, and then summing the total.
The forces of globalization and new communications and information technology have increased the level of competition that many firms face by increasing the amount of competition from other regions and countries.
11.2 Regulating Anticompetitive Behavior
Antitrust firms block authorities from openly colluding to form a cartel that will reduce output and raise prices. Companies sometimes attempt to find other ways around these restrictions and, consequently, many antitrust cases involve restrictive practices that can reduce competition in certain circumstances, like tie-in sales, bundling, and predatory pricing.
11.3 Regulating Natural Monopolies
In the case of a natural monopoly, market competition will not work well and so, rather than allowing an unregulated monopoly to raise price and reduce output, the government may wish to regulate price and/or output. Common examples of regulation are public utilities, the regulated firms that often provide electricity and water service.
Cost-plus regulation refers to government regulating a firm which sets the price that a firm can charge over a period of time by looking at the firm’s accounting costs and then adding a normal rate of profit. Price cap regulation refers to government regulation of a firm where the government sets a price level several years in advance. In this case, the firm can either earn high profits if it manages to produce at lower costs or sell a higher quantity than expected or suffer low profits or losses if costs are high or it sells less than expected.
11.4 The Great Deregulation Experiment
The U.S. economy experienced a wave of deregulation in the late 1970s and early 1980s, when the government eliminated a number of regulations that had set prices and quantities produced in a number of industries. Major accounting scandals in the early 2000s and, more recently, the Great Recession have spurred new regulation to prevent similar occurrences in the future. Regulatory capture occurs when the regulated industries end up having a strong influence over what regulations exist. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/11%3A_Monopoly_and_Antitrust_Policy/11.06%3A_Key_Terms.txt |
1.
Is it true that a merger between two firms that are not already in the top four by size can affect both the four-firm concentration ratio and the Herfindahl-Hirschman Index? Explain briefly.
2.
Is it true that the four-firm concentration ratio puts more emphasis on one or two very large firms, while the Herfindahl-Hirschman Index puts more emphasis on all the firms in the entire market? Explain briefly.
3.
Some years ago, two intercity bus companies, Greyhound Lines, Inc. and Trailways Transportation System, wanted to merge. One possible definition of the market in this case was “the market for intercity bus service.” Another possible definition was “the market for intercity transportation, including personal cars, car rentals, passenger trains, and commuter air flights.” Which definition do you think the bus companies preferred, and why?
4.
As a result of globalization and new information and communications technology, would you expect that the definitions of markets that antitrust authorities use will become broader or narrower?
5.
Why would a firm choose to use one or more of the anticompetitive practices described in Regulating Anticompetitive Behavior?
6.
Urban transit systems, especially those with rail systems, typically experience significant economies of scale in operation. Consider the transit system data in Table 11.4. Note that the quantity is in millions of riders.
Demand: Quantity 1 2 3 4 5 6 7 8 9 10
Price 10 9 8 7 6 5 4 3 2 1
Marginal Revenue 10 8 6 4 2 0 –2 –4 –6 –8
Costs: Marginal Cost 9 6 5 3 2 3 4 5 7 10
Average Cost 9 7.5 6.7 5.8 5 4.7 4.6 4.6 4.9 5.4
Table 11.4
Draw the demand, marginal revenue, marginal cost, and average cost curves. Do they have the normal shapes?
7.
From the graph you drew to answer Exercise 11.6, would you say this transit system is a natural monopoly? Justify.
Use the following information to answer the next three questions. In the years before wireless phones, when telephone technology required having a wire running to every home, it seemed plausible that telephone service had diminishing average costs and might require regulation like a natural monopoly. For most of the twentieth century, the national U.S. phone company was AT&T, and the company functioned as a regulated monopoly. Think about the deregulation of the U.S. telecommunications industry that has occurred over the last few decades. (This is not a research assignment, but a thought assignment based on what you have learned in this chapter.)
8.
What real-world changes made the deregulation possible?
9.
What are some of the benefits of the deregulation?
10.
What might some of the negatives of deregulation be?
11.09: Review Questions
11.
What is a corporate merger? What is an acquisition?
12.
What is the goal of antitrust policies?
13.
How do we measure a four-firm concentration ratio? What does a high measure mean about the extent of competition?
14.
How do we measure a Herfindahl-Hirschman Index? What does a low measure mean about the extent of competition?
15.
Why can it be difficult to decide what a “market” is for purposes of measuring competition?
16.
What is a minimum resale price maintenance agreement? How might it reduce competition and when might it be acceptable?
17.
What is exclusive dealing? How might it reduce competition and when might it be acceptable?
18.
What is a tie-in sale? How might it reduce competition and when might it be acceptable?
19.
What is predatory pricing? How might it reduce competition, and why might it be difficult to tell when it should be illegal?
20.
If public utilities are a natural monopoly, what would be the danger in deregulating them?
21.
If public utilities are a natural monopoly, what would be the danger in splitting them into a number of separate competing firms?
22.
What is cost-plus regulation?
23.
What is price cap regulation?
24.
What is deregulation? Name some industries that have been deregulated in the United States.
25.
What is regulatory capture?
26.
Why does regulatory capture reduce the persuasiveness of the case for regulating industries for the benefit of consumers?
11.10: Critical Thinking Questions
27.
Does either the four-firm concentration ratio or the HHI directly measure the amount of competition in an industry? Why or why not?
28.
What would be evidence of serious competition between firms in an industry? Can you identify two highly competitive industries?
29.
Can you think of any examples of successful predatory pricing in the real world?
30.
If you were developing a product (like a web browser) for a market with significant barriers to entry, how would you try to get your product into the market successfully?
31.
In the middle of the twentieth century, major U.S. cities had multiple competing city bus companies. Today, there is usually only one and it runs as a subsidized, regulated monopoly. What do you suppose caused the change?
32.
Why are urban areas willing to subsidize urban transit systems? Does the argument for subsidies make sense to you?
33.
Deregulation, like all changes in government policy, always has pluses and minuses. What do you think some of the minuses might be for airline deregulation?
34.
Do you think it is possible for government to outlaw everything that businesses could do wrong? If so, why does government not do that? If not, how can regulation stay ahead of rogue businesses that push the limits of the system until it breaks?
11.11: Problems
35.
Use Table 11.5 to calculate the four-firm concentration ratio for the U.S. auto market. Does this indicate a concentrated market or not?
GM 19%
Ford 17%
Toyota 14%
Chrysler 11%
Table 11.5 Global Auto Manufacturers with Top Four U.S. Market Share, June 2013
36.
Use Table 11.5 and Table 11.6 to calculate the Herfindahl-Hirschman Index for the U.S. auto market. Would the FTC approve a merger between GM and Ford?
Honda 10%
Nissan 7%
Hyundai 5%
Kia 4%
Subaru 3%
Volkswagen 3%
Table 11.6 Global Auto Manufacturers with additional U.S. Market Share, June 2013
Use Table 11.4 to answer the following questions.
37.
If the transit system were allowed to operate as an unregulated monopoly, what output would it supply and what price would it charge?
38.
If the transit system were regulated to operate with no subsidy (i.e., at zero economic profit), what approximate output would it supply and what approximate price would it charge?
39.
If the transit system were regulated to provide the most allocatively efficient quantity of output, what output would it supply and what price would it charge? What subsidy would be necessary to ensure this efficient provision of transit services? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/11%3A_Monopoly_and_Antitrust_Policy/11.08%3A_Self-Check_Questions.txt |
Figure 12.1 Environmental Debate Across the country, countless people have protested, even risking arrest, against the Keystone XL Pipeline. (Credit: modification of "People Risk Arrest at State Department Office in Boston Protesting Keystone XL Pipeline" by NoKXL/Flickr, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• The Economics of Pollution
• Command-and-Control Regulation
• Market-Oriented Environmental Tools
• The Benefits and Costs of U.S. Environmental Laws
• International Environmental Issues
• The Tradeoff between Economic Output and Environmental Protection
Bring It Home
Keystone XL
You might have heard about Keystone XL in the news. It was a pipeline system designed to bring oil from Canada to the refineries near the Gulf of Mexico, as well as to boost crude oil production in the United States. While a private company, TransCanada, planned to build and own the pipeline, U.S. government approval was required because of its size and location. There were four phases in plans to build the pipeline, and the first two of these had been in operation.
Sounds like a great idea, right? A pipeline that would move much needed crude oil to the Gulf refineries would increase oil production for manufacturing needs, reduce price pressure at the gas pump, and increase overall economic growth. Supporters argued that the pipeline would be one of the safest pipelines built yet, and would reduce America’s dependence on politically vulnerable Middle Eastern oil imports.
Not so fast, said its critics. The Keystone XL would be constructed over an enormous aquifer (one of the largest in the world) in the Midwest, and through an environmentally fragile area in Nebraska, causing great concern among environmentalists about possible destruction to the natural surroundings. They argued that leaks could taint valuable water sources and pipeline construction could disrupt and even harm indigenous species. Environmentalist groups fought government approval of the proposed pipeline construction, and in November 2015, the Obama administration refused to grant the cross-border permit necessary to build the Keystone XL pipeline. In 2017, the Trump administration sought to grant the necessary cross-border permit, and legal challenges emerged. In 2021, President Biden, on his first day in office, canceled the cross-border permit, effectively ending (for now) the Keystone XL pipeline.
Environmental concerns matter when discussing issues related to economic growth. However, how much should economists factor in these issues when deciding policy? In the case of the pipeline, how do we know how much damage it would cause when we do not know how to put a value on the environment? Would the pipeline's benefits outweigh the opportunity cost? The issue of how to balance economic progress with unintended effects on our planet is the subject of this chapter.
In 1969, the Cuyahoga River in Ohio was so polluted that it spontaneously burst into flame. Air pollution was so bad at that time that Chattanooga, Tennessee was a city where, as an article from Sports Illustrated put it: “the death rate from tuberculosis was double that of the rest of Tennessee and triple that of the rest of the United States, a city in which the filth in the air was so bad it melted nylon stockings off women’s legs, in which executives kept supplies of clean white shirts in their offices so they could change when a shirt became too gray to be presentable, in which headlights were turned on at high noon because the sun was eclipsed by the gunk in the sky.”
The problem of pollution arises for every economy in the world, whether high-income or low-income, and whether market-oriented or command-oriented. Every country needs to strike some balance between production and environmental quality. This chapter begins by discussing how firms may fail to take certain social costs, like pollution, into their planning if they do not need to pay these costs. Traditionally, policies for environmental protection have focused on governmental limits on how much of each pollutant could be emitted. While this approach has had some success, economists have suggested a range of more flexible, market-oriented policies that reduce pollution at a lower cost. We will consider both approaches, but first let’s see how economists frame and analyze these issues. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/12%3A_Environmental_Protection_and_Negative_Externalities/12.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain and give examples of positive and negative externalities
• Identify equilibrium price and quantity
• Evaluate how firms can contribute to market failure
From 1970 to 2020, the U.S. population increased by 63 percent, and the size of the U.S. economy increased by more than 3.8-fold. Since the 1970s, however, the United States, using a variety of anti-pollution policies, has made genuine progress against a number of pollutants. Table 12.1 lists the change in carbon dioxide emissions by energy users (from residential to industrial) according to the U.S. Energy Information Administration (EIA). The table shows that emissions of certain key air pollutants declined substantially from 2007 to 2012. They dropped 740 million metric tons (MMT) a year—a 12% reduction. This seems to indicate that there has been progress made in the United States in reducing overall carbon dioxide emissions, which contribute to the greenhouse effect.
Year Coal Natural Gas Petroleum Total
1973 1,221 1,175 2,325 4,721
2007 2,171 1,245 2,587 6,016
2020 875 1,648 2,042 4,576
Table 12.1 Carbon Dioxide Emissions from Energy Consumption, by Source (Source: EIA Monthly Energy Review)
Despite the gradual reduction in emissions from fossil fuels, many important environmental issues remain. Along with the still high levels of air and water pollution, other issues include hazardous waste disposal, destruction of wetlands and other wildlife habitats, and the impact on human health from pollution.
Externalities
Private markets, such as the cell phone industry, offer an efficient way to put buyers and sellers together and determine what goods they produce, how they produce them and who gets them. The principle that voluntary exchange benefits both buyers and sellers is a fundamental building block of the economic way of thinking. However, what happens when a voluntary exchange affects a third party who is neither the buyer nor the seller?
As an example, consider a concert producer who wants to build an outdoor arena that will host country music concerts a half-mile from your neighborhood. You will be able to hear these outdoor concerts while sitting on your back porch—or perhaps even in your dining room. In this case, the sellers and buyers of concert tickets may both be quite satisfied with their voluntary exchange, but you have no voice in their market transaction. The effect of a market exchange on a third party who is outside or “external” to the exchange is called an externality. Because externalities that occur in market transactions affect other parties beyond those involved, they are sometimes called spillovers.
Externalities can be negative or positive. If you hate country music, then having it waft into your house every night would be a negative externality. If you love country music, then what amounts to a series of free concerts would be a positive externality.
Pollution as a Negative Externality
Pollution is a negative externality. Economists illustrate the social costs of production with a demand and supply diagram. The social costs include the private costs of production that a company incurs and the external costs of pollution that pass on to society. Figure 12.2 shows the demand and supply for manufacturing refrigerators. The demand curve (D) shows the quantity demanded at each price. The supply curve (Sprivate) shows the quantity of refrigerators that all firms in the industry supply at each price assuming they are taking only their private costs into account and they are allowed to emit pollution at zero cost. The market equilibrium (E0), where quantity supplied equals quantity demanded, is at a price of \$650 per refrigerator and a quantity of 45,000 refrigerators. Table 12.2 reflects this information in the first three columns.
Figure 12.2 Taking Social Costs into Account: A Supply Shift If the firm takes only its own costs of production into account, then its supply curve will be Sprivate, and the market equilibrium will occur at E0. Accounting for additional external costs of \$100 for every unit produced, the firm’s supply curve will be Ssocial. The new equilibrium will occur at E1.
Price Quantity Demanded Quantity Supplied before Considering Pollution Cost Quantity Supplied after Considering Pollution Cost
\$600 50,000 40,000 30,000
\$650 45,000 45,000 35,000
\$700 40,000 50,000 40,000
\$750 35,000 55,000 45,000
\$800 30,000 60,000 50,000
\$850 25,000 65,000 55,000
\$900 20,000 70,000 60,000
Table 12.2 A Supply Shift Caused by Pollution Costs
However, as a by-product of the metals, plastics, chemicals and energy that refrigerator manufacturers use, some pollution is created. Let’s say that, if these pollutants were emitted into the air and water, they would create costs of \$100 per refrigerator produced. These costs might occur because of adverse effects on human health, property values, or wildlife habitat, reduction of recreation possibilities, or because of other negative impacts. In a market with no anti-pollution restrictions, firms can dispose of certain wastes absolutely free. Now imagine that firms which produce refrigerators must factor in these external costs of pollution—that is, the firms have to consider not only labor and material costs, but also the broader costs to society of harm to health and other costs caused by pollution. If the firm is required to pay \$100 for the additional external costs of pollution each time it produces a refrigerator, production becomes more costly and the entire supply curve shifts up by \$100.
As Table 12.2 and Figure 12.2 illustrate, the firm will need to receive a price of \$700 per refrigerator and produce a quantity of 40,000—and the firm’s new supply curve will be Ssocial. The new equilibrium will occur at E1. In short, taking the additional external costs of pollution into account results in a higher price, a lower quantity of production, and a lower quantity of pollution. The following Work It Out feature will walk you through an example, this time with musical accompaniment.
Work It Out
Identifying the Equilibrium Price and Quantity
Table 12.3 shows the supply and demand conditions for a firm that will play trumpets on the streets when requested. We measure output as the number of songs played.
Price Quantity Demanded Quantity Supplied without paying the costs of the externality Quantity Supplied after paying the costs of the externality
\$20 0 10 8
\$18 1 9 7
\$15 2.5 7.5 5.5
\$12 4 6 4
\$10 5 5 3
\$5 7.5 2.5 0.5
Table 12.3 Supply and Demand Conditions for a Trumpet-Playing Firm
Step 1. Determine the negative externality in this situation. To do this, you must think about the situation and consider all parties that might be impacted. A negative externality might be the increase in noise pollution in the area where the firm is playing.
Step 2. Identify the initial equilibrium price and quantity only taking private costs into account. Next, identify the new equilibrium taking into account social costs as well as private costs. Remember that equilibrium is where the quantity demanded is equal to the quantity supplied.
Step 3. Look down the columns to where the quantity demanded (the second column) is equal to the “quantity supplied without paying the costs of the externality” (the third column). Then refer to the first column of that row to determine the equilibrium price. In this case, the equilibrium price and quantity would be at a price of \$10 and a quantity of five when we only take into account private costs.
Step 4. Identify the equilibrium price and quantity when we take into account the additional external costs. Look down the columns of quantity demanded (the second column) and the “quantity supplied after paying the costs of the externality” (the fourth column) then refer to the first column of that row to determine the equilibrium price. In this case, the equilibrium will be at a price of \$12 and a quantity of four.
Step 5. Consider how taking into account the externality affects the equilibrium price and quantity. Do this by comparing the two equilibrium situations. If the firm is forced to pay its additional external costs, then production of trumpet songs becomes more costly, and the supply curve will shift up.
Remember that the supply curve is based on choices about production that firms make while looking at their marginal costs, while the demand curve is based on the benefits that individuals perceive while maximizing utility. If no externalities existed, private costs would be the same as the costs to society as a whole, and private benefits would be the same as the benefits to society as a whole. Thus, if no externalities existed, the interaction of demand and supply will coordinate social costs and benefits.
However, when the externality of pollution exists, the supply curve no longer represents all social costs. Because externalities represent a case where markets no longer consider all social costs, but only some of them, economists commonly refer to externalities as an example of market failure. When there is market failure, the private market fails to achieve efficient output, because either firms do not account for all costs incurred in the production of output and/or consumers do not account for all benefits obtained (a positive externality). In the case of pollution, at the market output, social costs of production exceed social benefits to consumers, and the market produces too much of the product.
We can see a general lesson here. If firms were required to pay the social costs of pollution, they would create less pollution but produce less of the product and charge a higher price. In the next module, we will explore how governments require firms to account for the social costs of pollution.
12.03: Command-and-Control Regulation
Learning Objectives
By the end of this section, you will be able to:
• Explain command-and-control regulation
• Evaluate the effectiveness of command-and-control regulation
When the United States started passing comprehensive environmental laws in the late 1960s and early 1970s, a typical law specified to companies how much pollution their smokestacks or drainpipes could emit and imposed penalties if companies exceeded the limit. Other laws required that companies install certain equipment—for example, on automobile tailpipes or on smokestacks—to reduce pollution. These types of laws, which specify allowable quantities of pollution and which also may detail which pollution-control technologies companies must use, fall under the category of command-and-control regulation. In effect, command-and-control regulation requires that firms increase their costs by installing anti-pollution equipment. Thus, firms are required to account for the social costs of pollution in deciding how much output to produce.
Command-and-control regulation has been highly successful in protecting and cleaning up the U.S. environment. In 1970, the Federal government created the Environmental Protection Agency (EPA) to oversee all environmental laws. In the same year, Congress enacted the Clean Air Act to address air pollution. Just two years later, in 1972, Congress passed and the president signed the far-reaching Clean Water Act. These command-and-control environmental laws, and their amendments and updates, have been largely responsible for America’s cleaner air and water in recent decades. However, economists have pointed out three difficulties with command-and-control environmental regulation.
First, command-and-control regulation offers no incentive to improve the quality of the environment beyond the standard set by a particular law. Once firms meet the standard, polluters have zero incentive to do better.
Second, command-and-control regulation is inflexible. It usually requires the same standard for all polluters, and often the same pollution-control technology as well. This means that command-and-control regulation draws no distinctions between firms that would find it easy and inexpensive to meet the pollution standard—or to reduce pollution even further—and firms that might find it difficult and costly to meet the standard. Firms have no reason to rethink their production methods in fundamental ways that might reduce pollution even more and at lower cost.
Third, legislators and EPA analysts write the command-and-control regulations, and so they are subject to compromises in the political process. Existing firms often argue (and lobby) that stricter environmental standards should not apply to them, only to new firms that wish to start production. Consequently, real-world environmental laws are full of fine print, loopholes, and exceptions.
Although critics accept the goal of reducing pollution, they question whether command-and-control regulation is the best way to design policy tools for accomplishing that goal. A different approach is the use of market-oriented tools, which we discussed in the next section. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/12%3A_Environmental_Protection_and_Negative_Externalities/12.02%3A_The_Economics_of_Pollution.txt |
Learning Objectives
By the end of this section, you will be able to:
• Show how pollution charges impact firm decisions
• Suggest other laws and regulations that could fall under pollution charges
• Explain the significance of marketable permits and property rights
• Evaluate which policies are most appropriate for various situations
Market-oriented environmental policies create incentives to allow firms some flexibility in reducing pollution. The three main categories of market-oriented approaches to pollution control are pollution charges, marketable permits, and better-defined property rights. All of these policy tools which we discuss, below, address the shortcomings of command-and-control regulation—albeit in different ways.
Pollution Charges
A pollution charge is a tax imposed on the quantity of pollution that a firm emits. A pollution charge gives a profit-maximizing firm an incentive to determine ways to reduce its emissions—as long as the marginal cost of reducing the emissions is less than the tax.
For example, consider a small firm that emits 50 pounds per year of small particles, such as soot, into the air. This particulate matter causes respiratory illnesses and also imposes costs on firms and individuals.
Figure 12.3 illustrates the marginal costs that a firm faces in reducing pollution. The marginal cost of pollution reduction, like most marginal cost curves, increases with output, at least in the short run. Reducing the first 10 pounds of particulate emissions costs the firm \$300. Reducing the second 10 pounds would cost \$500; reducing the third ten pounds would cost \$900; reducing the fourth 10 pounds would cost \$1,500; and the fifth 10 pounds would cost \$2,500. This pattern for the costs of reducing pollution is common, because the firm can use the cheapest and easiest method to make initial reductions in pollution, but additional reductions in pollution become more expensive.
Figure 12.3 A Pollution Charge If a pollution charge is set equal to \$1,000, then the firm will have an incentive to reduce pollution by 30 pounds because the \$900 cost of these reductions would be less than the cost of paying the pollution charge.
Imagine the firm now faces a pollution tax of \$1,000 for every 10 pounds of particulates it emits. The firm has the choice of either polluting and paying the tax, or reducing the amount of particulates it emits and paying the cost of abatement as the figure shows. How much will the firm pollute and how much will the firm abate? The first 10 pounds would cost the firm \$300 to abate. This is substantially less than the \$1,000 tax, so the firm will choose to abate. The second 10 pounds would cost \$500 to abate, which is still less than the tax, so it will choose to abate. The third 10 pounds would cost \$900 to abate, which is slightly less than the \$1,000 tax. The fourth 10 pounds would cost \$1,500, which is much more costly than paying the tax. As a result, the firm will decide to reduce pollutants by 30 pounds, because the marginal cost of reducing pollution by this amount is less than the pollution tax. With a tax of \$1,000, the firm has no incentive to reduce pollution more than 30 pounds.
A firm that has to pay a pollution tax will have an incentive to figure out the least expensive technologies for reducing pollution. Firms that can reduce pollution cheaply and easily will do so to minimize their pollution taxes; whereas firms that will incur high costs for reducing pollution will end up paying the pollution tax instead. If the pollution tax applies to every source of pollution, then there are no special favoritism or loopholes for politically well-connected producers.
For an example of a pollution charge at the household level, consider two ways of charging for garbage collection. One method is to have a flat fee per household, no matter how much garbage a household produces. An alternative approach is to have several levels of fees, depending on how much garbage the household produces—and to offer lower or free charges for recyclable materials. As of 2006 (latest statistics available), the EPA had recorded over 7,000 communities that have implemented “pay as you throw” programs. When people have a financial incentive to put out less garbage and to increase recycling, they find ways to make it happen.
A number of environmental policies are really pollution charges, although they often do not travel under that name. For example, the federal government and many state governments impose taxes on gasoline. We can view this tax as a charge on the air pollution that cars generate as well as a source of funding for maintaining roads. Gasoline taxes are far higher in most other countries than in the United States.
Similarly, the refundable charge of five or 10 cents that only 10 states have for returning recyclable cans and bottles works like a pollution tax that provides an incentive to avoid littering or throwing bottles in the trash. Compared with command-and-control regulation, a pollution tax reduces pollution in a more flexible and cost-effective way.
Link It Up
Visit this website to see the current U.S. states with bottle bills and the states that have active campaigns for new bottle bills. You can also view current and proposed bills in Canada and other countries around the world.
Marketable Permits
When a city or state government sets up a marketable permit program (e.g., cap-and-trade), it must start by determining the overall quantity of pollution it will allow as it tries to meet national pollution standards. Then, it divides a number of permits allowing only this quantity of pollution among the firms that emit that pollutant. The government can sell or provide these permits to pollute free to firms.
Now, add two more conditions. Imagine that these permits are designed to reduce total emissions over time. For example, a permit may allow emission of 10 units of pollution one year, but only nine units the next year, then eight units the year after that, and so on down to some lower level. In addition, imagine that these are marketable permits, meaning that firms can buy and sell them.
To see how marketable permits can work to reduce pollution, consider the four firms in Table 12.4. The table shows current emissions of lead from each firm. At the start of the marketable permit program, each firm receives permits to allow this level of pollution. However, these permits are shrinkable, and next year the permits allow the firms to emit only half as much pollution. Let’s say that in a year, Firm Gamma finds it easy and cheap to reduce emissions from 600 tons of lead to 200 tons, which means that it has permits that it is not using that allow emitting 100 tons of lead. Firm Beta reduces its lead pollution from 400 tons to 200 tons, so it does not need to buy any permits, and it does not have any extra permits to sell. However, although Firm Alpha can easily reduce pollution from 200 tons to 150 tons, it finds that it is cheaper to purchase permits from Gamma rather than to reduce its own emissions to 100. Meanwhile, Firm Delta did not even exist in the first period, so the only way it can start production is to purchase permits to emit 50 tons of lead.
The total quantity of pollution will decline. However, buying and selling the marketable permits will determine exactly which firms reduce pollution and by how much. With a system of marketable permits, the firms that find it least expensive to do so will reduce pollution the most.
Firm Alpha Firm Beta Firm Gamma Firm Delta
Current emissions—permits distributed free for this amount 200 tons 400 tons 600 tons 0 tons
How much pollution will these permits allow in one year? 100 tons 200 tons 300 tons 0 tons
Actual emissions one year in the future 150 tons 200 tons 200 tons 50 tons
Buyer or seller of marketable permit? Buys permits for 50 tons Doesn’t buy or sell permits Sells permits for 100 tons Buys permits for 50 tons
Table 12.4 How Marketable Permits Work
Another application of marketable permits occurred when the U.S. government amended the Clean Air Act in 1990. The revised law sought to reduce sulfur dioxide emissions from electric power plants to half of the 1980 levels out of concern that sulfur dioxide was causing acid rain, which harms forests as well as buildings. In this case, the marketable permits the federal government issued were free of charge (no pun intended) to electricity-generating plants across the country, especially those that were burning coal (which produces sulfur dioxide). These permits were of the “shrinkable” type; that is, the amount of pollution allowed by a given permit declined with time.
Better-Defined Property Rights
A clarified and strengthened idea of property rights can also strike a balance between economic activity and pollution. Ronald Coase (1910–2013), who won the 1991 Nobel Prize in economics, offered a vivid illustration of an externality: a railroad track running beside a farmer’s field where the railroad locomotive sometimes emits sparks and sets the field ablaze. Coase asked whose responsibility it was to address this spillover. Should the farmer be required to build a tall fence alongside the field to block the sparks, or should the railroad be required to place a gadget on the locomotive’s smokestack to reduce the number of sparks?
Coase pointed out that one cannot resolve this issue until one clearly defines property rights—that is, the legal rights of ownership on which others are not allowed to infringe without paying compensation. Does the farmer have a property right not to have a field burned? Does the railroad have a property right to run its own trains on its own tracks? If neither party has a property right, then the two sides may squabble endlessly, doing nothing, and sparks will continue to set the field aflame. However, if either the farmer or the railroad has a well-defined legal responsibility, then that party will seek out and pay for the least costly method of reducing the risk that sparks will hit the field. The property right determines whether the farmer or the railroad pays the bills.
The property rights approach is highly relevant in cases involving endangered species. The U.S. government’s endangered species list includes about 1,000 plants and animals, and about 90% of these species live on privately owned land. The protection of these endangered species requires careful thinking about incentives and property rights. The discovery of an endangered species on private land has often triggered an automatic reaction from the government to prohibit the landowner from using that land for any purpose that might disturb the imperiled creatures. Consider the incentives of that policy: If you admit to the government that you have an endangered species, the government effectively prohibits you from using your land. As a result, rumors abounded of landowners who followed a policy of “shoot, shovel, and shut up” when they found an endangered animal on their land. Other landowners have deliberately cut trees or managed land in a way that they knew would discourage endangered animals from locating there.
Clear It Up
How effective are market-oriented environmental policy tools?
Environmentalists sometimes fear that market-oriented environmental tools are an excuse to weaken or eliminate strict limits on pollution emissions and instead to allow more pollution. It is true that if pollution charges are set very low or if marketable permits do not reduce pollution by very much then market-oriented tools will not work well. However, command-and-control environmental laws can also be full of loopholes or have exemptions that do not reduce pollution by much, either. The advantage of market-oriented environmental tools is not that they reduce pollution by more or less, but because of their incentives and flexibility, they can achieve any desired reduction in pollution at a lower cost to society.
A more productive policy would consider how to provide private landowners with an incentive to protect the endangered species that they find and to provide a habitat for additional endangered species. For example, the government might pay landowners who provide and maintain suitable habitats for endangered species or who restrict the use of their land to protect an endangered species. Again, an environmental law built on incentives and flexibility offers greater promise than a command-and-control approach when trying to oversee millions of acres of privately owned land.
Applying Market-Oriented Environmental Tools
Market-oriented environmental policies are a tool kit. Specific policy tools will work better in some situations than in others. For example, marketable permits work best when a few dozen or a few hundred parties are highly interested in trading, as in the cases of oil refineries that trade lead permits or electrical utilities that trade sulfur dioxide permits. However, for cases in which millions of users emit small amounts of pollution—such as emissions from car engines or unrecycled soda cans—and have no strong interest in trading, pollution charges will typically offer a better choice. We can also combine market-oriented environmental tools. We can view marketable permits as a form of improved property rights. Alternatively, the government could combine marketable permits with a pollution tax on any emissions not covered by a permit. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/12%3A_Environmental_Protection_and_Negative_Externalities/12.04%3A_Market-Oriented_Environmental_Tools.txt |
Learning Objectives
By the end of this section, you will be able to:
• Evaluate the benefits and costs of environmental protection
• Explain the effects of ecotourism
• Apply marginal analysis to illustrate the marginal costs and marginal benefits of reducing pollution
Government economists have estimated that U.S. firms may pay more than \$200 billion per year to comply with federal environmental laws. That is a sizable amount of money. Is the money well spent?
Benefits and Costs of Clean Air and Clean Water
We can divide the benefits of a cleaner environment into four areas: (1) people may stay healthier and live longer; (2) certain industries that rely on clean air and water, such as farming, fishing, and tourism, may benefit; (3) property values may be higher; and (4) people may simply enjoy a cleaner environment in a way that does not need to involve a market transaction. Some of these benefits, such as gains to tourism or farming, are relatively easy to value in economic terms. It is harder to assign a monetary value to others, such as the value of clean air for someone with asthma. It seems difficult to put a clear-cut monetary value on still others, such as the satisfaction you might feel from knowing that the air is clear over the Grand Canyon, even if you have never visited the Grand Canyon, but advanced techniques in economics allow one to generate estimates.
Although estimates of environmental benefits are not precise, they can still be revealing. For example, a study by the Environmental Protection Agency looked at the costs and benefits of the Clean Air Act from 1970 to 1990. It found that total costs over that time period were roughly \$500 billion—a huge amount. However, it also found that a middle-range estimate of the health and other benefits from cleaner air was \$22 trillion—about 44 times higher than the costs. A more recent EPA study estimated that the environmental benefits to Americans from the Clean Air Act will exceed their costs by a margin of four to one. The EPA estimated that “in 2010 the benefits of Clean Air Act programs will total about \$110 billion. This estimate represents the value of avoiding increases in illness and premature death which would have prevailed.” Saying that overall benefits of environmental regulation have exceeded costs in the past, however, is very different from saying that every environmental regulation makes sense. For example, studies suggest that when breaking down emission reductions by type of contaminants, the benefits of air pollution control outweigh the costs primarily for particulates and lead, but when looking at other air pollutants, the costs of reducing them may be comparable to or greater than the benefits. Just because some environmental regulations have had benefits much higher than costs does not prove that every individual regulation is a sensible idea.
Ecotourism: Making Environmentalism Pay
The definition of ecotourism is a little vague. Does it mean sleeping on the ground, eating roots, and getting close to wild animals? Does it mean flying in a helicopter to shoot anesthetic darts at African wildlife, or a little of both? The definition may be fuzzy, but tourists who hope to appreciate the ecology of their destination—“eco tourists”—are the impetus to a big and growing business. The International Ecotourism Society estimates that international tourists interested in seeing nature or wildlife would take 1.56 billion trips by 2020. While COVID-19 prevented this from happening in 2020, it is clear that there is a strong demand for ecotourism.
Link It Up
Visit The International Ecotourism Society’s website to learn more about The International Ecotourism Society, its programs, and tourism’s role in sustainable community development.
Realizing the attraction of ecotourism, the residents of low-income countries may come to see that preserving wildlife habitats is more lucrative than, say, cutting down forests or grazing livestock. In South Africa, Namibia, and Zimbabwe, for example, ecotourism has given local communities an economic interest in protecting elephant and rhinoceros populations. Some of the leading ecotourism destinations include Costa Rica and Panama in Central America; the Caribbean; Malaysia, and other South Pacific destinations; New Zealand; the Serengeti in Tanzania; the Amazon rain forests; and the Galapagos Islands. In many of these countries and regions, governments have enacted policies whereby they share revenues from ecotourism with local communities, to give people in those local communities a kind of property right that encourages them to conserve their local environment.
Ecotourism needs careful management, so that the combination of eager tourists and local entrepreneurs does not destroy what the visitors are coming to see. And recent research indicates that wild animals that are continually exposed to tourists and vehicles exhibit stress and atypical behaviors. In general, however, well-managed ecotourism is viewed as a net positive, which provides an alternative to damaging the local environment.
Marginal Benefits and Marginal Costs
We can use the tools of marginal analysis to illustrate the marginal costs and the marginal benefits of reducing pollution. Figure 12.4 illustrates a theoretical model of this situation. When the quantity of environmental protection is low so that pollution is extensive—for example, at quantity Qa—there are usually numerous relatively cheap and easy ways to reduce pollution, and the marginal benefits of doing so are quite high. At Qa, it makes sense to allocate more resources to fight pollution. However, as the extent of environmental protection increases, the cheap and easy ways of reducing pollution begin to decrease, and one must use more costly methods. The marginal cost curve rises. Also, as environmental protection increases, one achieves the largest marginal benefits first, followed by reduced marginal benefits. As the quantity of environmental protection increases to, say, Qb, the gap between marginal benefits and marginal costs narrows. At point Qc the marginal costs will exceed the marginal benefits. At this level of environmental protection, society is not allocating resources efficiently, because it is forfeiting too many resources to reduce pollution.
Figure 12.4 Marginal Costs and Marginal Benefits of Environmental Protection Reducing pollution is costly—one must sacrifice resources. The marginal costs of reducing pollution are generally increasing, because one can first make the least expensive and easiest reductions, leaving the more expensive methods for later. The marginal benefits of reducing pollution are generally declining, because one can take the steps that provide the greatest benefit first, and steps that provide less benefit can wait until later.
As society draws closer to Qb, some might argue that it becomes more important to use market-oriented environmental tools to hold down the costs of reducing pollution. Their objective would be to avoid environmental rules that would provide the quantity of environmental protection at Qc, where marginal costs exceed marginal benefits. The following Clear It Up feature delves into how the EPA measures its policies – and the monetary value of our lives.
Clear It Up
What's a life worth?
The U.S. Environmental Protection Agency (EPA) must estimate the value of saving lives by reducing pollution against the additional costs. In measuring the benefits of government environmental policies, the EPA’s National Center for Environmental Economics (NCEE) values a statistical human life at \$7.4 million (in 2006 U.S. dollars, which corresponds to a little more than \$10.5 million in February 2022.)
Economists value a human life on the basis of studies of the value that people actually place on human lives in their own decisions. For example, some jobs have a higher probability of death than others, and these jobs typically pay more to compensate for the risk. Examples are ocean fishery as opposed to fish farming, and ice trucking in Alaska as opposed to truck driving in the “lower forty-eight” states.
Government regulators use estimates such as these when deciding what proposed regulations are “reasonable,” which means deciding which proposals have high enough benefits to justify their cost. For example, when the U.S. Department of Transportation makes decisions about what safety systems should be required in cars or airplanes, it will approve rules only where the estimated cost per life saved is \$3 million or less.
Resources that we spend on life-saving regulations create a tradeoff. A study by W. Kip Viscusi of Vanderbilt University estimated that when a regulation costs \$50 million, it diverts enough spending in the rest of the economy from health care and safety expenditures that it costs a life. This finding suggests that any regulation that costs more than \$50 million per life saved actually costs lives, rather than saving them. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/12%3A_Environmental_Protection_and_Negative_Externalities/12.05%3A_The_Benefits_and_Costs_of_U.S._Environmental_Laws.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain biodiversity
• Analyze the partnership of high-income and low-income countries in efforts to address international externalities
Many countries around the world have become more aware of the benefits of environmental protection. Yet even if most nations individually took steps to address their environmental issues, no nation acting alone can solve certain environmental problems which spill over national borders. No nation by itself can reduce emissions of carbon dioxide and other gases by enough to solve the problem of global warming—not without the cooperation of other nations. Another issue is the challenge of preserving biodiversity, which includes the full spectrum of animal and plant genetic material. Although a nation can protect biodiversity within its own borders, no nation acting alone can protect biodiversity around the world. Global warming and biodiversity are examples of international externalities.
Bringing the nations of the world together to address environmental issues requires a difficult set of negotiations between countries with different income levels and different sets of priorities. If nations such as China, India, Brazil, Mexico, and others are developing their economies by burning vast amounts of fossil fuels or by stripping their forest and wildlife habitats, then the world’s high-income countries acting alone will not be able to reduce greenhouse gases. However, low-income countries, with some understandable exasperation, point out that high-income countries do not have much moral standing to lecture them on the necessities of putting environmental protection ahead of economic growth. After all, high-income countries have historically been the primary contributors to greenhouse warming by burning fossil fuels—and still are today. It is hard to tell people who are living in a low-income country, where adequate diet, health care, and education are lacking, that they should sacrifice an improved quality of life for a cleaner environment.
Can rich and poor countries come together to address global environmental spillovers? At the initiative of the European Union and the most vulnerable developing nations, the Durban climate conference in December 2011 launched negotiations to develop a new international climate change agreement that covers all countries. The outcome of these negotiations was the Paris Climate Agreement, passed in 2015. The Paris Agreement committed participating countries to significant limits on CO2 emissions. To date, 196 entities have signed on, including the two biggest emitters of greenhouse gases—China and the United States. The U.S. contribution to the agreement was the Clean Power Plan, which planned to reduce power plant CO2 emissions across the U.S. by 17% to pre-2005 levels by 2020, and to further reduce emissions by a cumulative 32% by 2030. In early 2017, the Trump Administration announced plans to back out of the Paris Climate Agreement. Trump opposed the Clean Power plan, opting instead to shift focus to the use of natural gas. This represented a significant blow to the success of the Paris Agreement. However, on his first day in office, President Biden, on behalf of the United States, rejoined the Paris Climate Agreement.
Link It Up
Visit this website to learn more about the European Commission.
If high-income countries want low-income countries to reduce their emission of greenhouse gases, then the high-income countries may need to pay some of the costs. Perhaps some of these payments will happen through private markets. For example, some tourists from rich countries will pay handsomely to vacation near the natural treasures of low-income countries. Perhaps some of the transfer of resources can happen through making modern pollution-control technology available to poorer countries.
The practical details of what such an international system might look like and how it would operate across international borders are forbiddingly complex. However, it seems highly unlikely that some form of world government will impose a detailed system of environmental command-and-control regulation around the world. As a result, a decentralized and market-oriented approach may be the only practical way to address international issues such as global warming and biodiversity. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/12%3A_Environmental_Protection_and_Negative_Externalities/12.06%3A_International_Environmental_Issues.txt |
Learning Objectives
By the end of this section, you will be able to:
• Apply the production possibility frontier to evaluate the tradeoff between economic output and the environment
• Interpret a graphic representation of the tradeoff between economic output and environmental protection
We can analyze the tradeoff between economic output and the environment with a production possibility frontier (PPF) such as the one in Figure 12.5. At one extreme, at a choice like P, a country would be selecting a high level of economic output but very little environmental protection. At the other extreme, at a choice like T, a country would be selecting a high level of environmental protection but little economic output. According to the graph, an increase in environmental protection involves an opportunity cost of less economic output. No matter what their preferences, all societies should wish to avoid choices like M, which are productively inefficient. Efficiency requires that the choice should be on the production possibility frontier.
Figure 12.5 The Tradeoff between Economic Output and Environmental Protection Each society will have to weigh its own values and decide whether it prefers a choice like P with more economic output and less environmental protection, or a choice like T with more environmental protection and less economic output.
Economists do not have a great deal to say about the choice between P, Q, R, S and T in Figure 12.5, all of which lie along the production possibility frontier. Countries with low per capita gross domestic product (GDP), such as India, place a greater emphasis on economic output—which in turn helps to produce nutrition, shelter, health, education, and desirable consumer goods. Countries with higher income levels, where a greater share of people have access to the basic necessities of life, may be willing to place a relatively greater emphasis on environmental protection.
However, economists are united in their belief that an inefficient choice such as M is undesirable. Rather than choosing M, a nation could achieve either greater economic output with the same environmental protection, as at point Q, or greater environmental protection with the same level of output, as at point S. The problem with command-and-control environmental laws is that they sometimes involve a choice like M. Market-oriented environmental tools offer a mechanism for providing either the same environmental protection at lower cost, or providing a greater degree of environmental protection for the same cost.
Bring It Home
Keystone XL
How would an economist respond to claims of environmental damage caused by the Keystone XL project? Clearly, we can consider the environmental cost of oil spills a negative externality, but how large would these external costs be? Furthermore, are these costs “too high” when we measure them against any potential for economic benefit?
As this chapter indicates, in deciding whether pipeline construction is a good idea, an economist would want to know not only about the marginal benefits resulting from the additional pipeline construction, but also the potential marginal costs—and especially the pipeline's marginal external costs. Typically these come in the form of environmental impact statements, which are usually required for such projects. For example, an impact statement, released in March 2013 by the Nebraska Department of State, considered the possibility of fewer pipeline miles going over the aquifer system and avoiding completely environmentally fragile areas. It indicated that pipeline construction would not harm "most resources".
As noted at the outset of this chapter, the Obama Administration declined to approve construction of the Keystone XL project. However, the Trump administration announced its willingness to do so, but as noted earlier, the Biden administration effectively ended the project. While we may fairly easily quantify the economic benefits of additional oil in the United States, the social costs are more challenging to measure. Consequently, different observers may reach different conclusions about the balance between estimates of economic benefits and estimates of the social costs of the pipeline project. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/12%3A_Environmental_Protection_and_Negative_Externalities/12.07%3A_The_Tradeoff_between_Economic_Output_and_Environmental_Protection.txt |
additional external cost
additional costs incurred by third parties outside the production process when a unit of output is produced
biodiversity
the full spectrum of animal and plant genetic material
command-and-control regulation
laws that specify allowable quantities of pollution and that also may detail which pollution-control technologies one must use
externality
a market exchange that affects a third party who is outside or “external” to the exchange; sometimes called a “spillover”
international externalities
externalities that cross national borders and that a single nation acting alone cannot resolve
market failure
When the market on its own does not allocate resources efficiently in a way that balances social costs and benefits; externalities are one example of a market failure
marketable permit program
a permit that allows a firm to emit a certain amount of pollution; firms with more permits than pollution can sell the remaining permits to other firms
negative externality
a situation where a third party, outside the transaction, suffers from a market transaction by others
pollution charge
a tax imposed on the quantity of pollution that a firm emits; also called a pollution tax
positive externality
a situation where a third party, outside the transaction, benefits from a market transaction by others
property rights
the legal rights of ownership on which others are not allowed to infringe without paying compensation
social costs
costs that include both the private costs incurred by firms and also additional costs incurred by third parties outside the production process, like costs of pollution
spillover
see externality
12.09: Key Concepts and Summary
12.1 The Economics of Pollution
Economic production can cause environmental damage. This tradeoff arises for all countries, whether high-income or low-income, and whether their economies are market-oriented or command-oriented.
An externality occurs when an exchange between a buyer and seller has an impact on a third party who is not part of the exchange. An externality, which is sometimes also called a spillover, can have a negative or a positive impact on the third party. If those parties imposing a negative externality on others had to account for the broader social cost of their behavior, they would have an incentive to reduce the production of whatever is causing the negative externality. In the case of a positive externality, the third party obtains benefits from the exchange between a buyer and a seller, but they are not paying for these benefits. If this is the case, then markets would tend to under produce output because suppliers are not aware of the additional demand from others. If the parties generating benefits to others would somehow receive compensation for these external benefits, they would have an incentive to increase production of whatever is causing the positive externality.
12.2 Command-and-Control Regulation
Command-and-control regulation sets specific limits for pollution emissions and/or specific pollution-control technologies that firms must use. Although such regulations have helped to protect the environment, they have three shortcomings: they provide no incentive for going beyond the limits they set; they offer limited flexibility on where and how to reduce pollution; and they often have politically-motivated loopholes.
12.3 Market-Oriented Environmental Tools
Examples of market-oriented environmental policies, also called cap and trade programs, include pollution charges, marketable permits, and better-defined property rights. Market-oriented environmental policies include taxes, markets, and property rights so that those who impose negative externalities must face the social cost.
12.4 The Benefits and Costs of U.S. Environmental Laws
We can make a strong case, taken as a whole, that the benefits of U.S. environmental regulation have outweighed the costs. As the extent of environment regulation increases, additional expenditures on environmental protection will probably have increasing marginal costs and decreasing marginal benefits. This pattern suggests that the flexibility and cost savings of market-oriented environmental policies will become more important.
12.5 International Environmental Issues
Certain global environmental issues, such as global warming and biodiversity, spill over national borders and require addressing with some form of international agreement.
12.6 The Tradeoff between Economic Output and Environmental Protection
Depending on their different income levels and political preferences, countries are likely to make different choices about allocative efficiency—that is, the choice between economic output and environmental protection along the production possibility frontier. However, all countries should prefer to make a choice that shows productive efficiency—that is, the choice is somewhere on the production possibility frontier rather than inside it. Revisit Choice in a World of Scarcity for more on these terms. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/12%3A_Environmental_Protection_and_Negative_Externalities/12.08%3A_Key_Terms.txt |
1.
Identify the following situations as an example of a negative or a positive externality:
1. You are a birder (bird watcher), and your neighbor has put up several birdhouses in the yard as well as planting trees and flowers that attract birds.
2. Your neighbor paints his house a hideous color.
3. Investments in private education raise your country’s standard of living.
4. Trash dumped upstream flows downstream right past your home.
5. Your roommate is a smoker, but you are a nonsmoker.
2.
Identify whether the market supply curve will shift right or left or will stay the same for the following:
1. Firms in an industry are required to pay a fine for their carbon dioxide emissions.
2. Companies are sued for polluting the water in a river.
3. Power plants in a specific city are not required to address the impact of their air quality emissions.
4. Companies that use fracking to remove oil and gas from rock are required to clean up the damage.
3.
For each of your answers to Exercise 12.2, will equilibrium price rise or fall or stay the same?
4.
Table 12.5 provides the supply and demand conditions for a manufacturing firm. The third column represents a supply curve without accounting for the social cost of pollution. The fourth column represents the supply curve when the firm is required to account for the social cost of pollution. Identify the equilibrium before the social cost of production is included and after the social cost of production is included.
Price Quantity Demanded Quantity Supplied without paying the cost of the pollution Quantity Supplied after paying the cost of the pollution
\$10 450 400 250
\$15 440 440 290
\$20 430 480 330
\$25 420 520 370
\$30 410 560 410
Table 12.5
5.
Consider two approaches to reducing emissions of CO2 into the environment from manufacturing industries in the United States. In the first approach, the U.S. government makes it a policy to use only predetermined technologies. In the second approach, the U.S. government determines which technologies are cleaner and subsidizes their use. Of the two approaches, which is the command-and-control policy?
6.
Classify the following pollution-control policies as command-and-control or market incentive based.
1. A state emissions tax on the quantity of carbon emitted by each firm.
2. The federal government requires domestic auto companies to improve car emissions by 2020.
3. The EPA sets national standards for water quality.
4. A city sells permits to firms that allow them to emit a specified quantity of pollution.
5. The federal government pays fishermen to preserve salmon.
7.
An emissions tax on a quantity of emissions from a firm is not a command-and-control approach to reducing pollution. Why?
8.
Four firms called Elm, Maple, Oak, and Cherry, produce wooden chairs. However, they also produce a great deal of garbage (a mixture of glue, varnish, sandpaper, and wood scraps). The first row of Table 12.6 shows the total amount of garbage (in tons) that each firm currently produces. The other rows of the table show the cost of reducing garbage produced by the first five tons, the second five tons, and so on. First, calculate the cost of requiring each firm to reduce the weight of its garbage by one-fourth. Now, imagine that the government issues marketable permits for the current level of garbage, but the permits will shrink the weight of allowable garbage for each firm by one-fourth. What will be the result of this alternative approach to reducing pollution?
Elm Maple Oak Cherry
Current production of garbage (in tons) 20 40 60 80
Cost of reducing garbage by first five tons \$5,500 \$6,300 \$7,200 \$3,000
Cost of reducing garbage by second five tons \$6,000 \$7,200 \$7,500 \$4,000
Cost of reducing garbage by third five tons \$6,500 \$8,100 \$7,800 \$5,000
Cost of reducing garbage by fourth five tons \$7,000 \$9,000 \$8,100 \$6,000
Cost of reducing garbage by fifth five tons \$0 \$9,900 \$8,400 \$7,000
Table 12.6
9.
The rows in Table 12.7 show three market-oriented tools for reducing pollution. The columns of the table show three complaints about command-and-control regulation. Fill in the table by stating briefly how each market-oriented tool addresses each of the three concerns.
Incentives to Go Beyond Flexibility about Where and How Pollution Will Be Reduced Political Process Creates Loopholes and Exceptions
Pollution Charges
Marketable Permits
Property Rights
Table 12.7
10.
Suppose a city releases 16 million gallons of raw sewage into a nearby lake. Table 12.8 shows the total costs of cleaning up the sewage to different levels, together with the total benefits of doing so. (Benefits include environmental, recreational, health, and industrial benefits.)
Total Cost (in thousands of dollars) Total Benefits (in thousands of dollars)
16 million gallons Current situation Current situation
12 million gallons 50 800
8 million gallons 150 1300
4 million gallons 500 1650
0 gallons 1200 1900
Table 12.8
1. Using the information in Table 12.8, calculate the marginal costs and marginal benefits of reducing sewage emissions for this city. See Production, Costs and Industry Structure if you need a refresher on how to calculate marginal costs.
2. What is the optimal level of sewage for this city?
3. Why not just pass a law that firms can emit zero sewage? After all, the total benefits of zero emissions exceed the total costs.
11.
The state of Colorado requires oil and gas companies who use fracking techniques to return the land to its original condition after the oil and gas extractions. Table 12.9 shows the total cost and total benefits (in dollars) of this policy.
Land Restored (in acres) Total Cost Total Benefit
0 \$0 \$0
100 \$20 \$140
200 \$80 \$240
300 \$160 \$320
400 \$280 \$380
Table 12.9
1. Calculate the marginal cost and the marginal benefit at each quantity (acre) of land restored. See Production, Costs and Industry Structure if you need a refresher on how to calculate marginal costs and benefits.
2. If we apply marginal analysis, what is the optimal amount of land to be restored?
12.
Consider the case of global environmental problems that spill across international borders as a prisoner’s dilemma of the sort studied in Monopolistic Competition and Oligopoly. Say that there are two countries, A and B. Each country can choose whether to protect the environment, at a cost of 10, or not to protect it, at a cost of zero. If one country decides to protect the environment, there is a benefit of 16, but the benefit is divided equally between the two countries. If both countries decide to protect the environment, there is a benefit of 32, which is divided equally between the two countries.
1. In Table 12.10, fill in the costs, benefits, and total payoffs to the countries of the following decisions. Explain why, without some international agreement, they are likely to end up with neither country acting to protect the environment.
Country B
Protect Not Protect
Country A Protect
Not Protect
Table 12.10
13.
A country called Sherwood is very heavily covered with a forest of 50,000 trees. There are proposals to clear some of Sherwood’s forest and grow corn, but obtaining this additional economic output will have an environmental cost from reducing the number of trees. Table 12.11 shows possible combinations of economic output and environmental protection.
Combos Corn Bushels (thousands) Number of Trees (thousands)
P 9 5
Q 2 30
R 7 20
S 2 40
T 6 10
Table 12.11
1. Sketch a graph of a production possibility frontier with environmental quality on the horizontal axis, measured by the number of trees, and the quantity of economic output, measured in corn, on the vertical axis.
2. Which choices display productive efficiency? How can you tell?
3. Which choices show allocative efficiency? How can you tell?
4. In the choice between T and R, decide which one is better. Why?
5. In the choice between T and S, can you say which one is better, and why?
6. If you had to guess, which choice would you think is more likely to represent a command-and-control environmental policy and which choice is more likely to represent a market-oriented environmental policy, choice Q or S? Why? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/12%3A_Environmental_Protection_and_Negative_Externalities/12.10%3A_Self-Check_Questions.txt |
14.
What is an externality?
15.
Give an example of a positive externality and an example of a negative externality.
16.
What is the difference between private costs and social costs?
17.
In a market without environmental regulations, will the supply curve for a firm account for private costs, external costs, both, or neither? Explain.
18.
What is command-and-control environmental regulation?
19.
What are the three problems that economists have noted with regard to command-and-control regulation?
20.
What is a pollution charge and what incentive does it provide for a firm to take external costs into account?
21.
What is a marketable permit and what incentive does it provide for a firm to account for external costs?
22.
What are better-defined property rights and what incentive do they provide to account for external costs?
23.
As the extent of environmental protection expands, would you expect marginal costs of environmental protection to rise or fall? Why or why not?
24.
As the extent of environmental protection expands, would you expect the marginal benefits of environmental protection to rise or fall? Why or why not?
25.
What are the economic tradeoffs between low-income and high-income countries in international conferences on global environmental damage?
26.
What arguments do low-income countries make in international discussions of global environmental clean-up?
27.
In the tradeoff between economic output and environmental protection, what do the combinations on the protection possibility curve represent?
28.
What does a point inside the production possibility frontier represent?
12.12: Critical Thinking Questions
29.
Suppose you want to put a dollar value on the external costs of carbon emissions from a power plant. What information or data would you obtain to measure the external [not social] cost?
30.
Would environmentalists favor command-and-control policies as a way to reduce pollution? Why or why not?
31.
Consider two ways of protecting elephants from poachers in African countries. In one approach, the government sets up enormous national parks that have sufficient habitat for elephants to thrive and forbids all local people to enter the parks or to injure either the elephants or their habitat in any way. In a second approach, the government sets up national parks and designates 10 villages around the edges of the park as official tourist centers that become places where tourists can stay and bases for guided tours inside the national park. Consider the different incentives of local villagers—who often are living in poverty—in each of these plans. Which plan seems more likely to help the elephant population?
32.
Will a system of marketable permits work with thousands of firms? Why or why not?
33.
Is zero pollution possible under a marketable permits system? Why or why not?
34.
Is zero pollution an optimal goal? Why or why not?
35.
From an economic perspective, is it sound policy to pursue a goal of zero pollution? Why or why not?
36.
Recycling is a relatively inexpensive solution to much of the environmental contamination from plastics, glass, and other waste materials. Is it a sound policy to make it mandatory for everybody to recycle?
37.
Can extreme levels of pollution hurt the economic development of a high-income country? Why or why not?
38.
How can high-income countries benefit from covering much of the cost of reducing pollution created by low-income countries?
39.
Technological innovations shift the production possibility curve. Look at graph you sketched for Exercise 12.13. Which types of technologies should a country promote? Should “clean” technologies be promoted over other technologies? Why or why not? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/12%3A_Environmental_Protection_and_Negative_Externalities/12.11%3A_Review_Questions.txt |
40.
Show the market for cigarettes in equilibrium, assuming that there are no laws banning smoking in public. Label the equilibrium private market price and quantity as Pm and Qm. Add whatever is needed to the model to show the impact of the negative externality from second-hand smoking. (Hint: In this case it is the consumers, not the sellers, who are creating the negative externality.) Label the socially optimal output and price as Pe and Qe. On the graph, shade in the deadweight loss at the market output.
41.
Refer to Table 12.2. The externality created by the refrigerator production was \$100. However, once we accounted for both the private and additional external costs, the market price increased by only \$50. If the external costs were \$100 why did the price only increase by \$50 when we accounted for all costs?
42.
Table 12.12 shows the supply and demand conditions for a firm that will play trumpets on the streets when requested. Qs1 is the quantity supplied without social costs. Qs2 is the quantity supplied with social costs. What is the negative externality in this situation? Identify the equilibrium price and quantity when we account only for private costs, and then when we account for social costs. How does accounting for the externality affect the equilibrium price and quantity?
P Qd Qs1 Qs2
\$20 0 10 8
\$18 1 9 7
\$15 2.5 7.5 5.5
\$12 4 6 4
\$10 5 5 3
\$5 7.5 2.5 0.5
Table 12.12
43.
A city currently emits 16 million gallons (MG) of raw sewage into a lake that is beside the city. Table 12.13 shows the total costs (TC) in thousands of dollars of cleaning up the sewage to different levels, together with the total benefits (TB) of doing so. Benefits include environmental, recreational, health, and industrial benefits.
TC TB
16 MG Current Current
12 MG 50 800
8 MG 150 1300
4 MG 500 1850
0 MG 1200 2000
Table 12.13
1. Using the information in Table 12.13, calculate the marginal costs and marginal benefits of reducing sewage emissions for this city.
2. What is the optimal level of sewage for this city? How can you tell?
44.
In the Land of Purity, there is only one form of pollution, called “gunk.” Table 12.14 shows possible combinations of economic output and reduction of gunk, depending on what kinds of environmental regulations you choose.
Combos Eco Output Gunk Cleaned Up
J 800 10%
K 500 30%
L 600 40%
M 400 40%
N 100 90%
Table 12.14
1. Sketch a graph of a production possibility frontier with environmental quality on the horizontal axis, measured by the percentage reduction of gunk, and with the quantity of economic output on the vertical axis.
2. Which choices display productive efficiency? How can you tell?
3. Which choices show allocative efficiency? How can you tell?
4. In the choice between K and L, can you say which one is better and why?
5. In the choice between K and N, can you say which one is better, and why?
6. If you had to guess, which choice would you think is more likely to represent a command-and-control environmental policy and which choice is more likely to represent a market-oriented environmental policy, choice L or M? Why? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/12%3A_Environmental_Protection_and_Negative_Externalities/12.13%3A_Problems.txt |
Figure 13.1 View from Voyager I Launched by NASA on September 5, 1977, Voyager I’s primary mission was to provide detailed images of Jupiter, Saturn, and their moons. It took this photograph of Jupiter on its journey. In August of 2012, Voyager I entered interstellar space—the first human-made object to do so—and it is expected to send data and images back to earth until 2025. Such a technological feat entails many economic principles. (Credit: modification of "Voyager's View of Jupiter's Great Red Spot" by NASA/JPL, Public Domain)
Chapter Objectives
In this chapter, you will learn about:
• Why the Private Sector Underinvests in Technologies
• How Governments Can Encourage Innovation
• Public Goods
Bring It Home
The Benefits of Voyager I Endure
The rapid growth of technology has increased our ability to access and process data, to navigate through a busy city, and to communicate with friends on the other side of the globe. The research and development efforts of citizens, scientists, firms, universities, and governments have truly revolutionized the modern economy. To get a sense of how far we have come in a short period of time, let’s compare one of humankind’s greatest achievements to the smartphone.
In 1977 the United States launched Voyager I, a spacecraft originally intended to reach Jupiter and Saturn, to send back photographs and other cosmic measurements. Voyager I, however, kept going, and going—past Jupiter and Saturn—right out of our solar system. At the time of its launch, Voyager had some of the most sophisticated computing processing power NASA could engineer (8,000 instructions per second), but today, we Earthlings use handheld devices that can process 14 billion instructions per second.
Still, the technology of today is a spillover product of the incredible feats NASA accomplished over forty years ago. NASA research, for instance, is responsible for the kidney dialysis and mammogram machines that we use today. Research in new technologies not only produces private benefits to the investing firm, or in this case to NASA, but it also creates benefits for the broader society. In this way, new knowledge often becomes what economists refer to as a public good. This leads us to the topic of this chapter—technology, positive externalities, public goods, and the role of government in encouraging innovation and the social benefits that it provides.
As economist Mariana Mazzucato explores in her well-known work The Entrepreneurial State, what makes a smartphone smart? What allows its apps to help you navigate new towns while getting updates about your home, all while your hands are on the steering wheel and your children are in the back seat watching their shows? For starters, the internet, cell tower networks, GPS, and voice activation. Each of these, and many other technologies we rely on, were developed with intensive government support. For example, GPS, which enables many cell phone functions beyond the frequently used mapping and ride-sharing applications, was developed by the U.S. Department of Defense over several generations of satellite tracking and complex computer algorithm development. The U.S. government still provides GPS for many of the world’s users.
We do not often think of the government when we consider our leading products and entrepreneurs. We think of Apple, Google, Lyft, Tesla, Fitbit, and so on—creative innovators who built on the tools provided by these government efforts, using them in transformative ways. We may not think of the estimated \$19 billion per year that the U.S. spends to maintain the GPS system, but we would certainly think of it if it suddenly went away. (Beyond the impact on our daily lives, economists estimate U.S. businesses alone would lose about \$1 billion per day without GPS.)
Mazzucato is one of several prominent economists advocating for an embrace of continued government-sponsored innovations in order to build economic prosperity, reduce inequality, and manage ongoing challenges such as drought, coastal changes, and extreme weather. She argues that competitive, private sector markets are often resistant to the risks involved with large-scale innovation, because failed experiments and lack of uptake lead to massive corporate and personal losses. Governments can take on riskier research and development projects. Because government spending is fueled by taxpayers, and all innovation leads to some level of employment change, these proposals are certainly complex and challenging to implement.
This chapter deals with some of these issues: Will private companies be willing to invest in new technology? In what ways does new technology have positive externalities? What motivates inventors? What role should government play in encouraging research and technology? Are there certain types of goods that markets fail to provide efficiently, and that only government can produce? What happens when consumption or production of a product creates positive externalities? Why is it unsurprising when we overuse a common resource, like marine fisheries? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/13%3A_Positive_Externalities_and_Public_Goods/13.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify the positive externalities of new technology.
• Explain the difference between private benefits and social benefits and give examples of each.
• Calculate and analyze rates of return
Market competition can provide an incentive for discovering new technology because a firm can earn higher profits by finding a way to produce products more cheaply or to create products with characteristics consumers want. As Gregory Lee, CEO of Samsung said, “Relentless pursuit of new innovation is the key principle of our business and enables consumers to discover a world of possibilities with technology.” An innovative firm knows that it will usually have a temporary edge over its competitors and thus an ability to earn above-normal profits before competitors can catch up.
In certain cases, however, competition can discourage new technology, especially when other firms can quickly copy a new idea. Consider a pharmaceutical firm deciding to develop a new drug. On average, it can cost \$800 million and take more than a decade to discover a new drug, perform the necessary safety tests, and bring the drug to market. If the research and development (R&D) effort fails—and every R&D project has some chance of failure—then the firm will suffer losses and could even be driven out of business. If the project succeeds, then the firm’s competitors may figure out ways of adapting and copying the underlying idea, but without having to pay the costs themselves. As a result, the innovative company will bear the much higher costs of the R&D and will enjoy at best only a small, temporary advantage over the competition.
Many inventors over the years have discovered that their inventions brought them less profit than they might have reasonably expected.
• Eli Whitney (1765–1825) invented the cotton gin, but then southern cotton planters built their own seed-separating devices with a few minor changes in Whitney’s design. When Whitney sued, he found that the courts in southern states would not uphold his patent rights.
• Thomas Edison (1847–1931) still holds the record for most patents granted to an individual. His first invention was an automatic vote counter, and despite the social benefits, he could not find a government that wanted to buy it.
• Gordon Gould came up with the idea behind the laser in 1957. He put off applying for a patent and, by the time he did apply, other scientists had laser inventions of their own. A lengthy legal battle resulted, in which Gould spent \$100,000 on lawyers, before he eventually received a patent for the laser in 1977. Compared to the enormous social benefits of the laser, Gould received relatively little financial reward.
• In 1936, Alan Turing delivered a paper titled, "On Computable Numbers, with an Application to the Entscheidungsproblem," in which he presented the notion of a universal machine (later called the “Universal Turing Machine," and then the "Turing machine") capable of computing anything that is computable. The central concept of the modern computer was based on Turing’s paper. Today scholars widely consider Turing as the father of theoretical computer science and artificial intelligence; however, the UK government prosecuted Turing in 1952 for engaging in same-sex sexual acts and gave him the choice of chemical castration or prison. Turing chose castration and died in 1954 from cyanide poisoning.
A variety of studies by economists have found that the original inventor receives one-third to one-half of the total economic benefits from innovations, while other businesses and new product users receive the rest.
The Positive Externalities of New Technology
Will private firms in a market economy underinvest in research and technology? If a firm builds a factory or buys a piece of equipment, the firm receives all the economic benefits that result from the investments. However, when a firm invests in new technology, the private benefits, or profits, that the firm receives are only a portion of the overall social benefits. The social benefits of an innovation account for the value of all the positive externalities of the new idea or product, whether enjoyed by other companies or society as a whole, as well as the private benefits the firm that developed the new technology receives. As you learned in Environmental Protection and Negative Externalities, positive externalities are beneficial spillovers to a third party, or parties.
Consider the example of the Big Drug Company, which is planning its R&D budget for the next year. Economists and scientists working for Big Drug have compiled a list of potential research and development projects and estimated rates of return. (The rate of return is the estimated payoff from the project.) Figure 13.2 shows how the calculations work. The downward-sloping DPrivate curve represents the firm’s demand for financial capital and reflects the company’s willingness to borrow to finance research and development projects at various interest rates. Suppose that this firm’s investment in research and development creates a spillover benefit to other firms and households. After all, new innovations often spark other creative endeavors that society also values. If we add the spillover benefits society enjoys to the firm’s private demand for financial capital, we can draw DSocial that lies above DPrivate.
If there were a way for the firm to fully monopolize those social benefits by somehow making them unavailable to the rest of us, the firm’s private demand curve would be the same as society’s demand curve. According to Figure 13.2 and Table 13.1, if the going rate of interest on borrowing is 8%, and the company can receive the private benefits of innovation only, then the company would finance \$30 million. Society, at the same rate of 8%, would find it optimal to have \$52 million of borrowing. Unless there is a way for the company to fully enjoy the total benefits, then it will borrow less than the socially optimal level of \$52 million.
Figure 13.2 Positive Externalities and Technology Big Drug faces a cost of borrowing of 8%. If the firm receives only the private benefits of investing in R&D, then we show its demand curve for financial capital by DPrivate, and the equilibrium will occur at \$30 million. Because there are spillover benefits, society would find it optimal to have \$52 million of investment. If the firm could keep the social benefits of its investment for itself, its demand curve for financial capital would be DSocial and it would be willing to borrow \$52 million.
Rate of Return DPrivate (in millions) DSocial (in millions)
2% \$72 \$84
4% \$52 \$72
6% \$38 \$62
8% \$30 \$52
10% \$26 \$44
Table 13.1 Return and Demand for Capital
Big Drug’s original demand for financial capital (DPrivate) is based on the profits the firm receives. However, other pharmaceutical firms and health care companies may learn new lessons about how to treat certain medical conditions and are then able to create their own competing products. The social benefit of the drug takes into account the value of all the drug's positive externalities. If Big Drug were able to gain this social return instead of other companies, its demand for financial capital would shift to the demand curve DSocial, and it would be willing to borrow and invest \$52 million. However, if Big Drug is receiving only 50 cents of each dollar of social benefits, the firm will not spend as much on creating new products. The amount it would be willing to spend would fall somewhere in between DPrivate and DSocial.
Why Invest in Human Capital?
The investment in anything, whether it is the construction of a new power plant or research in a new cancer treatment, usually requires a certain upfront cost with an uncertain future benefit. The investment in education, or human capital, is no different. Over the span of many years, a student and her family invest significant amounts of time and money into that student’s education. The idea is that higher levels of educational attainment will eventually serve to increase the student’s future productivity and subsequent ability to earn. Once the student crunches the numbers, does this investment pay off for her?
Almost universally, economists have found that the answer to this question is a clear “Yes.” For example, several studies of the return to education in the United States estimate that the rate of return to a college education is approximately 10-15%. Data in Table 13.2, from the U.S. Bureau of Labor Statistics’ Usual Weekly Earnings of Wage and Salary Workers, Fourth Quarter 2021, demonstrate that median weekly earnings are higher for workers who have completed more education. While these rates of return will beat equivalent investments in Treasury bonds or savings accounts, the estimated returns to education go primarily to the individual worker, so these returns are private rates of return to education.
Less than a High School Degree High School Degree, No College Bachelor's Degree or Higher
Median Weekly Earnings (full-time workers over the age of 25) \$651 \$831 \$1,467
Table 13.2 Usual Weekly Earnings of Wage and Salary Workers, Fourth Quarter 2021 (Source: www.bls.gov/news.release/pdf/wkyeng.pdf)
What does society gain from investing in the education of another student? After all, if the government is spending taxpayer dollars to subsidize public education, society should expect some kind of return on that spending. Economists like George Psacharopoulos have found that, across a variety of nations, the social rate of return on schooling is also positive. After all, positive externalities exist from investment in education. While not always easy to measure, according to Walter McMahon, the positive externalities to education typically include better health outcomes for the population, lower levels of crime, a cleaner environment and a more stable, democratic government. For these reasons, many nations have chosen to use taxpayer dollars to subsidize primary, secondary, and higher education. Education clearly benefits the person who receives it, but a society where most people have a good level of education provides positive externalities for all.
Other Examples of Positive Externalities
Although technology may be the most prominent example of a positive externality, it is not the only one. For example, vaccinations against disease are not only a protection for the individual, but they have the positive spillover of protecting others who may become infected. When a number of homes in a neighborhood are modernized, updated, and restored, not only does it increase the homes' value, but other property values in the neighborhood may increase as well.
The appropriate public policy response to a positive externality, like a new technology, is to help the party creating the positive externality receive a greater share of the social benefits. In the case of vaccines, like flu shots, an effective policy might be to provide a subsidy to those who choose to get vaccinated.
Figure 13.3 shows the market for flu shots. The market demand curve DMarket for flu shots reflects only the marginal private benefits (MPB) that the vaccinated individuals receive from the shots. Assuming that there are no spillover costs in the production of flu shots, the market supply curve is given by the marginal private cost (MPC) of producing the vaccinations.
The equilibrium quantity of flu shots produced in the market, where MPB is equal to MPC, is QMarket and the price of flu shots is PMarket. However, spillover benefits exist in this market because others, those who chose not to purchase a flu shot, receive a positive externality in the form of a reduced chance of contracting the flu. When we add the spillover benefits to the marginal private benefit of flu shots, the marginal social benefit (MSB) of flu shots is given by DSocial. Because the MSB is greater than MPB, we see that the socially optimal level of flu shots is greater than the market quantity (QSocial exceeds QMarket) and the corresponding price of flu shots, if the market were to produce QSocial, would be at PSocial. Unfortunately, the marketplace does not recognize the positive externality and flu shots will go under-produced and under-consumed.
How can government try to move the market level of output closer to the socially desirable level of output? One policy would be to provide a subsidy, like a voucher, to any citizen who wishes to get vaccinated. This voucher would act as “income” that one could use to purchase only a flu shot and, if the voucher were exactly equal to the per-unit spillover benefits, would increase market equilibrium to a quantity of QSocial and a price of PSocial where MSB equals MSC (which equals MPC given the assumption that there are no spillover costs in producing the vaccine). Suppliers of the flu shots would receive payment of PSocial per vaccination, while consumers of flu shots would redeem the voucher and only pay a price of PSubsidy. When the government uses a subsidy in this way, it produces the socially optimal quantity of vaccinations.
Figure 13.3 The Market for Flu Shots with Spillover Benefits (A Positive Externality) The market demand curve does not reflect the positive externality of flu vaccinations, so only QMarket will be exchanged. This outcome is inefficient because the marginal social benefit exceeds the marginal social cost. If the government provides a subsidy to consumers of flu shots, equal to the marginal social benefit minus the marginal private benefit, the level of vaccinations can increase to the socially optimal quantity of QSocial.
Societal Change as an Innovation Outcome
Economist Carlota Perez draws on the lessons of past innovations to understand the current state of our economy. She demonstrates that prior technological turning points, such as the proliferation of railroads and the emergence of mass production, created initial periods of employment and wealth shifting but eventually led to greater well-being and economic growth. After difficult transition periods and sometimes economic meltdowns during the “installment” phase of widespread new technologies, many economies and the people within them have benefited from prolonged periods of economic and lifestyle improvement, including lower unemployment and better quality of life.
Most prior innovation periods, such as the Industrial Revolution, had one significant downside: negative impacts on the environment, such as pollution and habitat destruction. Perez notes that our current revolution—in information and communications technology (ICT)—has the potential for significant positive externalities related to the environment. ICT is shifting many areas of society (and therefore industry) to digital experiences and services that do not require fossil fuels or similar natural resources. Vehicle sharing, product rental-reuse networks, and new manufacturing methods offer the promise of far less consumable consumption. And even though the appearance of delivery trucks and shipping boxes gives the impression of environmental damage, most studies indicate that online shopping is better for the environment than individuals shopping in person. (This is partly attributed to greater efficiency in a few trucks driving to a neighborhood rather than everyone in the neighborhood driving to several stores.) Consumers and governments can spur on those environmental benefits by choosing or partnering with companies that focus on furthering their environmental impact, such as by using solar power to fuel their computer servers or by using electrically powered delivery trucks.
Like other innovations, ICT has created some employment and economic opportunities while it has reduced others. Increased globalization and efficiencies have shuttered businesses and reduced wages in some areas. Perez’s research indicates that those types of employment shifts can be managed through proper regulation and investment (especially in human capital), particularly as firms in the relevant industries become mature and profitable. The prospects aren’t simple: ICT has created megafirms like Amazon and Apple, which despite pleasing their consumers can wield significant power over governments and employees. But on the environmental and societal front at least, ICT has offered a wealth of opportunities and externalities. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/13%3A_Positive_Externalities_and_Public_Goods/13.02%3A_Investments_in_Innovation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the effects of intellectual property rights on social and private rates of return.
• Identify three U.S. Government policies and explain how they encourage innovation
A number of different government policies can increase the incentives to innovate, including: guaranteeing intellectual property rights, government assistance with the costs of research and development, and cooperative research ventures between universities and companies.
Intellectual Property Rights
One way to increase new technology is to guarantee the innovator an exclusive right to that new product or process. Intellectual property rights include patents, which give the inventor the exclusive legal right to make, use, or sell the invention for a limited time, and copyright laws, which give the author an exclusive legal right over works of literature, music, film/video, and pictures. For example, if a pharmaceutical firm has a patent on a new drug, then no other firm can manufacture or sell that drug for 20 years, unless the firm with the patent grants permission. Without a patent, the pharmaceutical firm would have to face competition for any successful products, and could earn no more than a normal rate of profit. With a patent, a firm is able to earn monopoly profits on its product for a period of time—which offers an incentive for research and development. In general, how long can “a period of time” be? The Clear It Up discusses patent and copyright protection timeframes for some works you might know.
Clear It Up
How long is Mickey Mouse protected from being copied?
All patents and copyrights are scheduled to end someday. In 2003, copyright protection for Mickey Mouse was scheduled to run out. Once the copyright had expired, anyone would be able to copy Mickey Mouse cartoons or draw and sell new ones. In 1998, however, Congress passed the Sonny Bono Copyright Term Extension Act. For copyrights owned by companies or other entities, it increased or extended the copyright from 75 years to 95 years after publication. For copyrights owned by individuals, it increased or extended the copyright coverage from 50 years to 70 years after death. Along with protecting Mickey for another 20 years, the copyright extension affected about 400,000 books, movies, and songs.
Figure 13.4 illustrates how the total number of patent applications filed with the U.S. Patent and Trademark Office, as well as the total number of patents granted, surged in the mid-1990s with the invention of the internet, and is still going strong today.
Figure 13.4 Patents Filed and Granted, 1981–2012 The number of applications filed for patents increased substantially beginning in the 1990s, due in part to the invention of the internet, which has led to many other inventions and to the 1998 Copyright Term Extension Act. (Source: http://www.uspto.gov/web/offices/ac/...af/us_stat.htm)
While patents provide an incentive to innovate by protecting the innovator, they are not perfect. For example:
• In countries that already have patents, economic studies show that inventors receive only one-third to one-half of the total economic value of their inventions.
• In a fast-moving high-technology industry like biotechnology or semiconductor design, patents may be almost irrelevant because technology is advancing so quickly.
• Not every new idea can be protected with a patent or a copyright—for example, a new way of organizing a factory or a new way of training employees.
• Patents may sometimes cover too much or be granted too easily. In the early 1970s, Xerox had received over 1,700 patents on various elements of the photocopy machine. Every time Xerox improved the photocopier, it received a patent on the improvement.
• The 20-year time period for a patent is somewhat arbitrary. Ideally, a patent should cover a long enough period of time for the inventor to earn a good return, but not so long that it allows the inventor to charge a monopoly price permanently.
Because patents are imperfect and do not apply well to all situations, alternative methods of improving the rate of return for inventors of new technology are desirable. The following sections describe some of these possible alternative policies.
Policy #1: Government Spending on Research and Development
If the private sector does not have sufficient incentive to carry out research and development, one possibility is for the government to fund such work directly. Government spending can provide direct financial support for research and development (R&D) conducted at colleges and universities, nonprofit research entities, and sometimes by private firms, as well as at government-run laboratories. While government spending on research and development produces technology that is broadly available for firms to use, it costs taxpayers money and can sometimes be directed more for political than for scientific or economic reasons.
Link It Up
Visit the NASA website and the USDA website to read about government research that would not take place were it left to firms, due to the externalities.
The first column of Table 13.3 shows the sources of total U.S. spending on research and development. The second column shows the total dollars of R&D funding by each source. The third column shows that, relative to the total amount of funding, 22.7% comes from the federal government, about 69% of R&D is done by industry, and less than 4% is done by universities and colleges. (The percentages below do not add up to exactly 100% due to rounding.)
Sources of R&D Funding Amount (\$ billions) Percent of the Total
Federal government \$129.6 21.4%
Industry \$426.0 70.3%
Universities and colleges \$20.7 3.4%
Nonprofits \$25.0 4.1%
Nonfederal government \$4.8 0.8%
Total \$606.1
Table 13.3 U.S. Research and Development Expenditures, 2018 (Source: https://ncses.nsf.gov/pubs/nsf21324)
In the 1960s the federal government paid for about two-thirds of the nation’s R&D. Over time, the U.S. economy has come to rely much more heavily on industry-funded R&D. The federal government has tried to focus its direct R&D spending on areas where private firms are not as active. One difficulty with direct government support of R&D is that it inevitably involves political decisions about which projects are worthy. The scientific question of whether research is worthwhile can easily become entangled with considerations like the location of the congressional district in which the research funding is spent.
Policy #2: Tax Breaks for Research and Development
A complementary approach to supporting R&D that does not involve the government’s close scrutiny of specific projects is to give firms a reduction in taxes depending on how much research and development they do. The federal government refers to this policy as the research and experimentation (R&E) tax credit. According to the Treasury Department: “. . . the R&E Credit is also a cost-effective policy for stimulating additional private sector investment. Most recent studies find that each dollar of foregone tax revenue through the R&E Tax Credit causes firms to invest at least a dollar in R&D, with some studies finding a benefit to cost ratio of 2 or 2.96.”
Link It Up
Visit this website for more information on how the R&E Tax Credit encourages investment.
Policy #3 Cooperative Research
State and federal governments support research in a variety of ways. For example, United for Medical Research, a coalition of groups that seek funding for the National Institutes of Health, (which is supported by federal grants), states: “NIH-supported research added \$69 billion to our GDP and supported seven million jobs in 2011 alone.” The United States remains the leading sponsor of medical-related research, spending \$117 billion in 2011. Other institutions, such as the National Academy of Sciences and the National Academy of Engineering, receive federal grants for innovative projects. The Agriculture and Food Research Initiative (AFRI) at the United States Department of Agriculture awards federal grants to projects that apply the best science to the most important agricultural problems, from food safety to childhood obesity. Cooperation between government-funded universities, academies, and the private sector can spur product innovation and create whole new industries. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/13%3A_Positive_Externalities_and_Public_Goods/13.03%3A_How_Governments_Can_Encourage_Innovation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify a public good using nonexcludable and non-rival as criteria
• Explain the free rider problem
• Identify several sources of public goods
Even though new technology creates positive externalities so that perhaps one-half or two-thirds of the social benefit of new inventions spills over to others, the inventor still receives some private return. What about a situation where the positive externalities are so extensive that private firms could not expect to receive any of the social benefit? We call this kind of good a public good. Spending on national defense is a good example of a public good. Let’s begin by defining the characteristics of a public good and discussing why these characteristics make it difficult for private firms to supply public goods. Then we will see how government may step in to address the issue.
The Definition of a Public Good
Economists have a strict definition of a public good, and it does not necessarily include all goods financed through taxes. To understand the defining characteristics of a public good, first consider an ordinary private good, like a piece of pizza. We can buy and sell a piece of pizza fairly easily because it is a separate and identifiable item. However, public goods are not separate and identifiable in this way.
Instead, public goods have two defining characteristics: they are nonexcludable and non-rival. The first characteristic, that a public good is nonexcludable, means that it is costly or impossible to exclude someone from using the good. If Larry buys a private good like a piece of pizza, then he can exclude others, like Lorna, from eating that pizza. However, if national defense is provided, then it includes everyone. Even if you strongly disagree with America’s defense policies or with the level of defense spending, the national defense still protects you. You cannot choose to be unprotected, and national defense cannot protect everyone else and exclude you.
The second main characteristic of a public good, that it is non-rival, means that when one person uses the public good, another can also use it. With a private good like pizza, if Max is eating the pizza then Michelle cannot also eat it; that is, the two people are rivals in consumption. With a public good like national defense, Max’s consumption of national defense does not reduce the amount left for Michelle, so they are non-rival in this area.
A number of government services are examples of public goods. For instance, it would not be easy to provide fire and police service so that some people in a neighborhood would be protected from the burning and burglary of their property, while others would not be protected at all. Protecting some necessarily means protecting others, too.
Positive externalities and public goods are closely related concepts. Public goods have positive externalities, like police protection or public health funding. Not all goods and services with positive externalities, however, are public goods. Investments in education have huge positive spillovers but can be provided by a private company. Private companies can invest in new inventions such as the Apple iPad and reap profits that may not capture all of the social benefits. We can also describe patents as an attempt to make new inventions into private goods, which are excludable and rivalrous, so that no one but the inventor can use them during the length of the patent.
The Free Rider Problem of Public Goods
Private companies find it difficult to produce public goods. If a good or service is nonexcludable, like national defense, so that it is impossible or very costly to exclude people from using this good or service, then how can a firm charge people for it?
Link It Up
Visit this website to read about a connection between free riders and “bad music.”
When individuals make decisions about buying a public good, a free rider problem can arise, in which people have an incentive to let others pay for the public good and then to “free ride” on the purchases of others. We can express the free rider problem in terms of the prisoner’s dilemma game, which we discussed as a representation of oligopoly in Monopolistic Competition and Oligopoly.
There is a dilemma with the Prisoner’s Dilemma, though. See the Work It Out feature.
Work It Out
The Problem with the Prisoner’s Dilemma
Suppose two people, Rachel and Samuel, are considering purchasing a public good. The difficulty with the prisoner’s dilemma arises as each person thinks through their strategic choices.
Step 1. Rachel reasons in this way: If Samuel does not contribute, then I would be a fool to contribute. However, if Samuel does contribute, then I can come out ahead by not contributing.
Step 2. Either way, I should choose not to contribute, and instead hope that I can be a free rider who uses the public good paid for by Samuel.
Step 3. Samuel reasons the same way about Rachel.
Step 4. When both people reason in that way, the public good never gets built, and there is no movement to the option where everyone cooperates—which is actually best for all parties.
The Role of Government in Paying for Public Goods
The key insight in paying for public goods is to find a way of assuring that everyone will make a contribution and to prevent free riders. For example, if people come together through the political process and agree to pay taxes and make group decisions about the quantity of public goods, they can defeat the free rider problem by requiring, through the law, that everyone contributes.
However, government spending and taxes are not the only way to provide public goods. In some cases, markets can produce public goods. For example, think about radio. It is nonexcludable, since once the radio signal is broadcast, it would be very difficult to stop someone from receiving it. It is non-rival, since one person listening to the signal does not prevent others from listening as well. Because of these features, it is practically impossible to charge listeners directly for listening to conventional radio broadcasts.
Radio has found a way to collect revenue by selling advertising, which is an indirect way of “charging” listeners by taking up some of their time. Ultimately, consumers who purchase the goods advertised are also paying for the radio service, since the station builds in the cost of advertising into the product cost. In a more recent development, satellite radio companies, such as SiriusXM, charge a regular subscription fee for streaming music without commercials. In this case, however, the product is excludable—only those who pay for the subscription will receive the broadcast.
Some public goods will also have a mixture of public provision at no charge along with fees for some purposes, like a public city park that is free to use, but the government charges a fee for parking your car, for reserving certain picnic grounds, and for food sold at a refreshment stand.
Link It Up
Read this article to find out what economists say the government should pay for.
In other cases, we can use social pressures and personal appeals, rather than the force of law, to reduce the number of free riders and to collect resources for the public good. For example, neighbors sometimes form an association to carry out beautification projects or to patrol their area after dark to discourage crime. In low-income countries, where social pressure strongly encourages all farmers to participate, farmers in a region may come together to work on a large irrigation project that will benefit all. We can view many fundraising efforts, including raising money for local charities and for the endowments of colleges and universities, as an attempt to use social pressure to discourage free riding and to generate the outcome that will produce a public benefit.
Common Resources and the “Tragedy of the Commons”
There are some goods that do not fall neatly into the categories of private good or public good. While it is easy to classify a pizza as a private good and a city park as a public good, what about an item that is nonexcludable and rivalrous, such as the queen conch?
In the Caribbean, the queen conch is a large marine mollusk that lives in shallow waters of sea grass. These waters are so shallow, and so clear, that a single diver may harvest many conch in a single day. Not only is conch meat a local delicacy and an important part of the local diet, but artists use the large ornate shells and craftsmen transform them. Because almost anyone with a small boat, snorkel, and mask, can participate in the conch harvest, it is essentially nonexcludable. At the same time, fishing for conch is rivalrous. Once a diver catches one conch another diver cannot catch it.
We call goods that are nonexcludable and rivalrous common resources. Because the waters of the Caribbean are open to all conch fishermen, and because any conch that you catch is a conch that I cannot catch, fishermen tend to overharvest common resources like the conch.
The problem of overharvesting common resources is not a new one, but ecologist Garret Hardin put the tag “tragedy of the commons” to the problem in a 1968 article in the magazine Science. Economists view this as a problem of property rights. Since nobody owns the ocean, or the conch that crawl on the sand beneath it, no one individual has an incentive to protect that resource and responsibly harvest it. To address the issue of overharvesting conch and other marine fisheries, economists have advocated simple devices like fishing licenses, harvest limits, and shorter fishing seasons. One approach that has been turned to more recently is the implementation of catch shares, whereby regulators establish a total allowable catch, and then fishermen are allocated a portion of that total allowable catch. Catch shares appear to slow the race to fish. When the population of a species drops to critically low numbers, governments have even banned the harvest until biologists determine that the population has returned to sustainable levels. In fact, such is the case with the conch, the harvesting of which the government has effectively banned in the United States since 1986.
The tragedy of the commons is a frequent economic and social framework for discussions about a range of common resources, even extending into digital resources such as open media repositories and online libraries. Prominent economist Elinor Ostrom, the first woman to receive the Nobel Prize in Economics, proposed an alternate version, sometimes referred to as the "non-tragedy of the commons." After extensive fieldwork in areas as diverse as Indonesia, Kenya, Maine (U.S.), and Nepal, she challenged the notion that people would only avoid depletion of common resources if they were forced to by regulatory laws and property rights. She noted that farmers working shared land could communicate and cooperate in order to maximize and preserve the fields over time. She argued that when those who benefit most from a resource are in close proximity to it (like a farm field that directly serves a town), the resource is better managed without external influence.
Link It Up
Visit this website for more on the queen conch industry.
Positive Externalities in Public Health Programs
One of the most remarkable changes in the standard of living in the last several centuries is that people are living longer. Scientists believe that, thousands of years ago, human life expectancy ranged between 20 to 30 years. By 1900, average life expectancy in the United States was 47 years. By 2015, life expectancy was 79 years; due to COVID-19, life expectancy declined slightly to 77 years in 2020. Most of the gains in life expectancy in the history of the human race happened in the twentieth century.
The rise in life expectancy seems to stem from three primary factors. First, systems for providing clean water and disposing of human waste helped to prevent the transmission of many diseases. Second, changes in public behavior have advanced health. Early in the twentieth century, for example, people learned the importance of boiling bottles before using them for food storage and baby’s milk, washing their hands, and protecting food from flies. More recent behavioral changes include reducing the number of people who smoke tobacco and precautions to limit sexually transmitted diseases. Third, medicine has played a large role. Scientists developed immunizations for diphtheria, cholera, pertussis, tuberculosis, tetanus, and yellow fever between 1890 and 1930. Penicillin, discovered in 1941, led to a series of other antibiotic drugs for bringing infectious diseases under control. In recent decades, drugs that reduce the risks of high blood pressure have had a dramatic effect in extending lives.
These advances in public health have all been closely linked to positive externalities and public goods. Public health officials taught hygienic practices to mothers in the early 1900s and encouraged less smoking in the late 1900s. Government funded many public sanitation systems and storm sewers because they have the key traits of public goods. In the twentieth century, many medical discoveries emerged from government or university-funded research. Patents and intellectual property rights provided an additional incentive for private inventors. The reason for requiring immunizations, phrased in economic terms, is that it prevents spillovers of illness to others—as well as helping the person immunized.
Bring It Home
The Benefits of Voyager I Endure
While we applaud the technology spillovers of NASA’s space projects, we should also acknowledge that those benefits are not shared equally. Economists like Tyler Cowen, a professor at George Mason University, are seeing increasing evidence of a widening gap between those who have access to rapidly improving technology, and those who do not. According to Cowen, author of the 2013 book, Average Is Over: Powering America Beyond the Age of the Great Stagnation, this inequality in access to technology and information is going to deepen the inequality in skills, and ultimately, in wages and global standards of living. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/13%3A_Positive_Externalities_and_Public_Goods/13.04%3A_Public_Goods.txt |
external benefits (or positive externalities)
beneficial spillovers to a third party of parties, who did not purchase the good or service that provided the externalities
free rider
those who want others to pay for the public good and then plan to use the good themselves; if many people act as free riders, the public good may never be provided
intellectual property
the body of law including patents, trademarks, copyrights, and trade secret law that protect the right of inventors to produce and sell their inventions
nonexcludable
when it is costly or impossible to exclude someone from using the good, and thus hard to charge for it
nonrivalrous
even when one person uses the good, others can also use it
positive externalities
beneficial spillovers to a third party or parties
private benefits
the benefits a person who consumes a good or service receives, or a new product's benefits or process that a company invents that the company captures
private rates of return
when the estimated rates of return go primarily to an individual; for example, earning interest on a savings account
public good
good that is nonexcludable and non-rival, and thus is difficult for market producers to sell to individual consumers
social benefits
the sum of private benefits and external benefits
social rate of return
when the estimated rates of return go primarily to society; for example, providing free education
13.06: Key Concepts and Summary
13.1 Investments in Innovation
Competition creates pressure to innovate. However, if one can easily copy new inventions, then the original inventor loses the incentive to invest further in research and development. New technology often has positive externalities; that is, there are often spillovers from the invention of new technology that benefit firms other than the innovator. The social benefit of an invention, once the firm accounts for these spillovers, typically exceeds the private benefit to the inventor. If inventors could receive a greater share of the broader social benefits for their work, they would have a greater incentive to seek out new inventions.
13.2 How Governments Can Encourage Innovation
Public policy with regard to technology must often strike a balance. For example, patents provide an incentive for inventors, but they should be limited to genuinely new inventions and not extend forever.
Government has a variety of policy tools for increasing the rate of return for new technology and encouraging its development, including: direct government funding of R&D, tax incentives for R&D, protection of intellectual property, and forming cooperative relationships between universities and the private sector.
13.3 Public Goods
A public good has two key characteristics: it is nonexcludable and non-rival. Nonexcludable means that it is costly or impossible for one user to exclude others from using the good. Non-rival means that when one person uses the good, it does not prevent others from using it. Markets often have a difficult time producing public goods because free riders will attempt to use the public good without paying for it. One can overcome the free rider problem through measures to assure that users of the public good pay for it. Such measures include government actions, social pressures, and specific situations where markets have discovered a way to collect payments. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/13%3A_Positive_Externalities_and_Public_Goods/13.05%3A_Key_Terms.txt |
1.
Do market demand curves reflect positive externalities? Why or why not?
2.
Suppose that Sony's R&D investment in digital devices has increased profits by 20%. Is this a private or social benefit?
3.
The Gizmo Company is planning to develop new household gadgets. Table 13.4 shows the company’s demand for financial capital for research and development of these gadgets, based on expected rates of return from sales. Now, say that every investment would have an additional 5% social benefit—that is, an investment that pays at least a 6% return to the Gizmo Company will pay at least an 11% return for society as a whole; an investment that pays at least 7% for the Gizmo Company will pay at least 12% for society as a whole, and so on. Answer the questions that follow based on this information.
Estimated Rate of Return Private profits of the firm from an R&D project (in \$ millions)
10% \$100
9% \$102
8% \$108
7% \$118
6% \$133
5% \$153
4% \$183
3% \$223
Table 13.4
1. If the going interest rate is 9%, how much will Gizmo invest in R&D if it receives only the private benefits of this investment?
2. Assume that the interest rate is still 9%. How much will the firm invest if it also receives the social benefits of its investment? (Add an additional 5% return on all levels of investment.)
4.
The Junkbuyers Company travels from home to home, looking for opportunities to buy items that would otherwise end up with the garbage, but which the company can resell or recycle. Which will be larger, the private or the social benefits?
5.
When residents in a neighborhood tidy it and keep it neat, there are a number of positive spillovers: higher property values, less crime, happier residents. What types of government policies can encourage neighborhoods to clean up?
6.
Education provides both private benefits to those who receive it and broader social benefits for the economy as a whole. Think about the types of policies a government can follow to address the issue of positive spillovers in technology and then suggest a parallel set of policies that governments could follow for addressing positive externalities in education.
7.
Which of the following goods or services are nonexcludable?
1. police protection
2. streaming music from satellite transmission programs
3. roads
4. primary education
5. cell phone service
8.
Are the following goods non-rival in consumption?
1. slice of pizza
2. laptop computer
3. public radio
4. ice cream cone
13.08: Review Questions
9.
In what ways do company investments in research and development create positive externalities?
10.
Will the demand for borrowing and investing in R&D be higher or lower if there are no external benefits?
11.
Why might private markets tend to provide too few incentives for the development of new technology?
12.
What can government do to encourage the development of new technology?
13.
What are the two key characteristics of public goods?
14.
Name two public goods and explain why they are public goods.
15.
What is the free rider problem?
16.
Explain why the federal government funds national defense. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/13%3A_Positive_Externalities_and_Public_Goods/13.07%3A_Self-Check_Questions.txt |
17.
Can a company be guaranteed all of the social benefits of a new invention? Why or why not?
18.
Is it inevitable that government must become involved in supporting investments in new technology?
19.
How do public television stations, like PBS, try to overcome the free rider problem?
20.
Why is a football game on ESPN a quasi-public good but a game on the NBC, CBS, or ABC is a public good?
21.
Provide two examples of goods/services that are classified as private goods/services even though they are provided by a federal government.
22.
Radio stations, tornado sirens, light houses, and street lights are all public goods in that all are nonrivalrous and nonexclusionary. Therefore why does the government provide tornado sirens, street lights and light houses but not radio stations (other than PBS stations)?
13.10: Problems
23.
HighFlyer Airlines wants to build new airplanes with greatly increased cabin space. This will allow HighFlyer Airlines to give passengers more comfort and sell more tickets at a higher price. However, redesigning the cabin means rethinking many other elements of the airplane as well, like engine and luggage placement and the most efficient shape of the plane for moving through the air. HighFlyer Airlines has developed a list of possible methods to increase cabin space, along with estimates of how these approaches would affect the plane's operating costs and ticket sales. Based on these estimates, Table 13.5 shows the value of R&D projects that provide at least a certain private rate of return. Column 1 = Private Rate of Return. Column 2 = Value of R&D Projects that Return at Least the Private Rate of Return to HighFlyer Airlines. Use the data to answer the following questions.
Private Rate of Return Value of R&D
12% \$100
10% \$200
8% \$300
6% \$400
4% \$500
Table 13.5
1. If the opportunity cost of financial capital for HighFlyer Airlines is 6%, how much should the firm invest in R&D?
2. Assume that the social rate of return for R&D is an additional 2% on top of the private return; that is, an R&D investment that had a 7% private return to HighFlyer Airlines would have a 9% social return. How much investment is socially optimal at the 6% interest rate?
24.
Assume that the marginal private costs of a firm producing fuel-efficient cars is greater than the marginal social costs. Assume that the marginal private benefits of a firm producing fuel-efficient cars is the same as the marginal social benefits. Discuss one way that the government can try to increase production and sales of fuel efficient cars to the socially desirable amount. Hint: the government is trying to affect production through costs, not benefits.
25.
Becky and Sarah are sisters who share a room. Their room can easily get messy, and their parents are always telling them to tidy it. Here are the costs and benefits to both Becky and Sarah, of taking the time to clean their room: If both Becky and Sarah clean, they each spends two hours and get a clean room. If Becky decides not to clean and Sarah does all the cleaning, then Sarah spends 10 hours cleaning (Becky spends 0) but Sarah is exhausted. The same would occur for Becky if Sarah decided not to clean—Becky spends 10 hours and becomes exhausted. If both girls decide not to clean, they both have a dirty room.
1. What is the best outcome for Becky and Sarah? What is the worst outcome? (It would help you to construct a prisoner’s dilemma table.)
2. Unfortunately, we know that the optimal outcome will most likely not happen, and that the sisters probably will choose the worst one instead. Explain what it is about Becky’s and Sarah’s reasoning that will lead them both to choose the worst outcome. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/13%3A_Positive_Externalities_and_Public_Goods/13.09%3A_Critical_Thinking_Questions.txt |
Figure 14.1 What determines incomes? In the U.S., income is primarily based on one's value to an employer, which depends in part on education. (Credit: modification of work by AFL-CIO America's Unions/Flickr Creative Commons and COD Newsroom/Flickr Creative Commons)
Chapter Objectives
In this chapter, you will learn about:
• The theory of labor markets
• How wages are determined in an imperfectly competitive labor market
• How unions affect wages and employment
• How labor market outcomes are determined under Bilateral Monopoly
• Theories of Employment Discrimination, and
• How Immigration affects labor market outcomes
Bring It Home
The Increasing Value of a College Degree
Working your way through college used to be fairly common in the United States. According to a 2015 study by the Georgetown Center on Education and the Workforce, 40% of college students work 30 hours or more per week.
At the same time, the cost of college seems to rise every year. The data show that between the 2000–2001 academic year and the 2019–2020 academic year, the cost of tuition, fees, and room and board has slightly more than doubled for private four-year colleges, and has increased by a factor of almost 2.5 for public four-year colleges. Thus, even full time employment may not be enough to cover college expenses anymore. Working full time at minimum wage—40 hours per week, 52 weeks per year—earns \$15,080 before taxes, which is substantially less than the more than \$25,000 estimated as the average cost in 2022 for a year of college at a public university. The result of these costs is that student loan debt topped \$1.3 trillion this year.
Despite these disheartening figures, the value of a bachelor’s degree has never been higher. How do we explain this? This chapter will tell us.
In a market economy like the United States, income comes from ownership of the means of production: resources or assets. More precisely, one’s income is a function of two things: the quantity of each resource one owns, and the value society places on those resources. Recall from the chapter on Production, Costs, and Industry Structure, each factor of production has an associated factor payment. For the majority of us, the most important resource we own is our labor. Thus, most of our income is wages, salaries, commissions, tips and other types of labor income. Your labor income depends on how many hours you work and the wage rate an employer will pay you for those hours. At the same time, some people own real estate, which they can either use themselves or rent out to other users. Some people have financial assets like bank accounts, stocks and bonds, for which they earn interest, dividends or some other form of income.
Each of these factor payments, like wages for labor and interest for financial capital, is determined in their respective factor markets. For the rest of this chapter, we will focus on labor markets, but other factor markets operate similarly. Later in Chapter 17 we will describe how this works for financial capital.
14.02: The Theory of Labor Markets
Learning Objectives
By the end of this section, you will be able to:
• Describe the demand for labor in perfectly competitive output markets
• Describe the demand for labor in imperfectly competitive output markets
• Identify what determines the going market rate for labor
Clear It Up
What is the labor market?
The labor market is the term that economists use for all the different markets for labor. There is no single labor market. Rather, there is a different market for every different type of labor. Labor differs by type of work (e.g. retail sales vs. scientist), skill level (entry level or more experienced), and location (the market for administrative assistants is probably more local or regional than the market for university presidents). While each labor market is different, they all tend to operate in similar ways. For example, when wages go up in one labor market, they tend to go up in others too. When economists talk about the labor market, they are describing these similarities.
The labor market, like all markets, has a demand and a supply. Why do firms demand labor? Why is an employer willing to pay you for your labor? It’s not because the employer likes you or is socially conscious. Rather, it’s because your labor is worth something to the employer--your work brings in revenues to the firm. How much is an employer willing to pay? That depends on the skills and experience you bring to the firm.
If a firm wants to maximize profits, it will never pay more (in terms of wages and benefits) for a worker than the value of their marginal productivity to the firm. We call this the first rule of labor markets.
Suppose a worker can produce two widgets per hour and the firm can sell each widget for \$4 each. Then the worker is generating \$8 per hour in revenues to the firm, and a profit-maximizing employer will pay the worker up to, but no more than, \$8 per hour, because that is what the worker is worth to the firm.
Recall the definition of marginal product. Marginal product is the additional output a firm can produce by adding one more worker to the production process. Since employers often hire labor by the hour, we’ll define marginal product as the additional output the firm produces by adding one more worker hour to the production process. In this chapter, we assume that workers in a particular labor market are homogeneous—they have the same background, experience and skills and they put in the same amount of effort. Thus, marginal product depends on the capital and technology with which workers have to work.
A typist can type more pages per hour with an electric typewriter than a manual typewriter, and the typist can type even more pages per hour with a personal computer and word processing software. A ditch digger can dig more cubic feet of dirt in an hour with a backhoe than with a shovel.
Thus, we can define the demand for labor as the marginal product of labor times the value of that output to the firm.
# Workers (L) 1 2 3 4
MPL 4 3 2 1
Table 14.1 Marginal Product of Labor
Figure 14.2 Marginal Product of Labor Because of fixed capital, the marginal product of labor declines as the employer hires additional workers.
On what does the value of each worker’s marginal product depend? If we assume that the employer sells its output in a perfectly competitive market, the value of each worker’s output will be the market price of the product. Thus,
Demand for Labor = MPL x P = Value of the Marginal Product of Labor
We show this in Table 14.2, which is an expanded version of Table 14.1
# Workers (L) 1 2 3 4
MPL 4 3 2 1
Price of Output \$4 \$4 \$4 \$4
VMPL \$16 \$12 \$8 \$4
Table 14.2 Value of the Marginal Product of Labor
Note that the value of each additional worker is less than the value of the ones who came before.
Figure 14.3 Value of the Marginal Product of Labor For firms operating in a competitive output market, the value of additional output sold is the price the firms receive for the output. Since MPL declines with additional labor employed, while that marginal product is worth the market price, the value of the marginal product declines as employment increases.
Demand for Labor in Perfectly Competitive Output Markets
The question for any firm is how much labor to hire.
We can define a Perfectly Competitive Labor Market as one where firms can hire all the labor they want at the going market wage. Think about secretaries in a large city. Employers who need secretaries can probably hire as many as they need if they pay the going wage rate.
Graphically, this means that firms face a horizontal supply curve for labor, as Figure 14.3 shows.
Given the market wage, profit maximizing firms hire workers up to the point where: Wmkt = VMPL
Figure 14.4 Equilibrium Employment for Firms in a Competitive Labor Market In a perfectly competitive labor market, firms can hire all the labor they want at the going market wage. Therefore, they hire workers up to the point L1 where the going market wage equals the value of the marginal product of labor.
Clear It Up
Derived Demand
Economists describe the demand for inputs like labor as a derived demand. Since the demand for labor is MPL*P, it is dependent on the demand for the product the firm is producing. We show this by the P term in the demand for labor. An increase in demand for the firm’s product drives up the product’s price, which increases the firm’s demand for labor. Thus, we derive the demand for labor from the demand for the firm’s output.
Demand for Labor in Imperfectly Competitive Output Markets
If the employer does not sell its output in a perfectly competitive industry, they face a downward sloping demand curve for output, which means that in order to sell additional output the firm must lower its price. This is true if the firm is a monopoly, but it’s also true if the firm is an oligopoly or monopolistically competitive. In this situation, the value of a worker’s marginal product is the marginal revenue, not the price. Thus, the demand for labor is the marginal product times the marginal revenue.
The Demand for Labor = MPL x MR = Marginal Revenue Product
# Workers (L) 1 2 3 4
MPL 4 3 2 1
Marginal Revenue \$4 \$3 \$2 \$1
MRPL \$16 \$9 \$4 \$1
Table 14.3 Marginal Revenue Product
Figure 14.5 Marginal Revenue Product For firms with some market power in their output market, the value of additional output sold is the firm’s marginal revenue. Since MPL declines with additional labor employed and since MR declines with additional output sold, the firm’s marginal revenue declines as employment increases.
Everything else remains the same as we described above in the discussion of the labor demand in perfectly competitive labor markets. Given the market wage, profit-maximizing firms will hire workers up to the point where the market wage equals the marginal revenue product, as Figure 14.6 shows.
Figure 14.6 Equilibrium Level of Employment for Firms with Market Power For firms with market power in their output market, they choose the number of workers, L2, where the going market wage equals the firm’s marginal revenue product. Note that since marginal revenue is less than price, the demand for labor for a firm which has market power in its output market is less than the demand for labor (L1) for a perfectly competitive firm. As a result, employment will be lower in an imperfectly competitive industry than in a perfectly competitive industry.
Clear It Up
Do Profit Maximizing Employers Exploit Labor?
If you look back at Figure 14.4, you will see that the firm pays only the last worker it hires what they’re worth to the firm. Every other worker brings in more revenue than the firm pays them. This has sometimes led to the claim that employers exploit workers because they do not pay workers what they are worth. Let’s think about this claim. The first worker is worth \$x to the firm, and the second worker is worth \$y, but why are they worth that much? It is because of the capital and technology with which they work. The difference between workers’ worth and their compensation goes to pay for the capital and technology, without which the workers wouldn’t have a job. The difference also goes to the employer’s profit, without which the firm would close and workers wouldn’t have a job. The firm may be earning excessive profits, but that is a different topic of discussion.
What Determines the Going Market Wage Rate?
In the chapter on Labor and Financial Markets, we learned that the labor market has demand and supply curves like other markets. The demand for labor curve is a downward sloping function of the wage rate. The market demand for labor is the horizontal sum of all firms’ demands for labor. The supply of labor curve is an upward sloping function of the wage rate. This is because if wages for a particular type of labor increase in a particular labor market, people with appropriate skills may change jobs, and vacancies will attract people from outside the geographic area. The market supply of labor is the horizontal summation of all individuals’ supplies of labor.
Figure 14.7 The Market Wage Rate In a competitive labor market, the equilibrium wage and employment level are determined where the market demand for labor equals the market supply of labor.
Like all equilibrium prices, the market wage rate is determined through the interaction of supply and demand in the labor market. Thus, we can see in Figure 14.7 for competitive markets the wage rate and number of workers hired.
The FRED database has a great deal of data on labor markets, starting at the wage rate and number of workers hired.
The United States Census Bureau for the Bureau of Labor Statistics publishes The Current Population Survey, which is a monthly survey of households (you can find a link to it by going to the FRED database found in the previous link), which provides data on labor supply, including numerous measures of the labor force size (disaggregated by age, gender and educational attainment), labor force participation rates for different demographic groups, and employment. It also includes more than 3,500 measures of earnings by different demographic groups.
The Current Employment Statistics, which is a survey of businesses, offers alternative estimates of employment across all sectors of the economy.
The FRED database, found in the previous link, also has a link labeled "Productivity and Costs" has a wide range of data on productivity, labor costs, and profits across the business sector. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/14%3A_Labor_Markets_and_Income/14.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Define monopsony power
• Explain how imperfectly competitive labor markets determine wages and employment, where employers have market power
In the chapters on market structure, we observed that while economists use the theory of perfect competition as an ideal case of market structure, there are very few examples of perfectly competitive industries in the real world. What about labor markets? How many labor markets are perfectly competitive? There are probably more examples of perfectly competitive labor markets than perfectly competitive product markets, but that doesn’t mean that all labor markets are competitive.
When a job applicant is bargaining with an employer for a position, the applicant is often at a disadvantage—needing the job more than the employer needs that particular applicant. John Bates Clark (1847–1938), often named as the first great American economist, wrote in 1907: “In the making of the wages contract the individual laborer is always at a disadvantage. He has something which he is obliged to sell and which his employer is not obliged to take, since he [that is, the employer] can reject single men with impunity.”
To give workers more power, the U.S. government has passed, in response to years of labor protests, a number of laws to create a more equal balance of power between workers and employers. These laws include some of the following:
• Setting minimum hourly wages
• Setting maximum hours of work (at least before employers pay overtime rates)
• Prohibiting child labor
• Regulating health and safety conditions in the workplace
• Preventing discrimination on the basis of race, ethnicity, gender, sexual orientation, and age
• Requiring employers to provide family leave
• Requiring employers to give advance notice of layoffs
• Covering workers with unemployment insurance
• Setting a limit on the number of immigrant workers from other countries
Table 14.4 lists some prominent U.S. workplace protection laws. Many of the laws listed in the table were only the start of labor market regulations in these areas and have been followed, over time, by other related laws, regulations, and court rulings.
Law Protection
National Labor- Management Relations Act of 1935 (the “Wagner Act”) Establishes procedures for establishing a union that firms are obligated to follow; sets up the National Labor Relations Board for deciding disputes
Social Security Act of 1935 Under Title III, establishes a state-run system of unemployment insurance, in which workers pay into a state fund when they are employed and received benefits for a time when they are unemployed
Fair Labor Standards Act of 1938 Establishes the minimum wage, limits on child labor, and rules requiring payment of overtime pay for those in jobs that are paid by the hour and exceed 40 hours per week
Taft-Hartley Act of 1947 Allows states to decide whether all workers at a firm can be required to join a union as a condition of employment; in the case of a disruptive union strike, permits the president to declare a “cooling-off period” during which workers have to return to work
Civil Rights Act of 1964 Title VII of the Act prohibits discrimination in employment on the basis of race, gender, national origin, religion, or sexual orientation
Occupational Health and Safety Act of 1970 Creates the Occupational Safety and Health Administration (OSHA), which protects workers from physical harm in the workplace
Employee Retirement and Income Security Act of 1974 Regulates employee pension rules and benefits
Pregnancy Discrimination Act of 1978 Prohibits discrimination against women in the workplace who are planning to get pregnant or who are returning to work after pregnancy
Immigration Reform and Control Act of 1986 Prohibits hiring of illegal immigrants; requires employers to ask for proof of citizenship; protects rights of legal immigrants
Worker Adjustment and Retraining Notification Act of 1988 Requires employers with more than 100 employees to provide written notice 60 days before plant closings or large layoffs
Americans with Disabilities Act of 1990 Prohibits discrimination against those with disabilities and requires reasonable accommodations for them on the job
Family and Medical Leave Act of 1993 Allows employees to take up to 12 weeks of unpaid leave per year for family reasons, including birth or family illness
Pension Protection Act of 2006 Penalizes firms for underfunding their pension plans and gives employees more information about their pension accounts
Lilly Ledbetter Fair Pay Act of 2009 Restores protection for pay discrimination claims on the basis of sex, race, national origin, age, religion, or disability
Table 14.4 Prominent U.S. Workplace Protection Laws
There are two sources of imperfect competition in labor markets. These are demand side sources, that is, labor market power by employers, and supply side sources: labor market power by employees. In this section we will discuss the former. In the next section we will discuss the latter.
A competitive labor market is one where there are many potential employers for a given type of worker, say a secretary or an accountant. Suppose there is only one employer in a labor market. Because that employer has no direct competition in hiring, if they offer lower wages than would exist in a competitive market, employees will have few options. If they want a job, they must accept the offered wage rate. Since the employer is exploiting its market power, we call the firm a monopsony, a term introduced and widely discussed by Joan Robinson (though she credited scholar Bertrand Hallward with invention of the word). The classical example of monopsony is the sole coal company in a West Virginia town. If coal miners want to work, they must accept what the coal company is paying. This is not the only example of monopsony. Think about surgical nurses in a town with only one hospital. A situation in which employers have at least some market power over potential employees is not that unusual. After all, most firms have many employees while there is only one employer. Thus, even if there is some competition for workers, it may not feel that way to potential employees unless they do their research and find the opposite.
How does market power by an employer affect labor market outcomes? Intuitively, one might think that wages will be lower than in a competitive labor market. Let’s prove it. We will tell the story for a monopsonist, but the results will be qualitatively similar, although less extreme, for any firm with labor market power.
Think back to monopoly. The good news for the firm is that because the monopolist is the sole supplier in the market, it can charge any price it wishes. The bad news is that if it wants to sell a greater quantity of output, it must lower the price it charges. Monopsony is analogous. Because the monopsonist is the sole employer in a labor market, it can offer any wage that it wishes. However, because they face the market supply curve for labor, if they want to hire more workers, they must raise the wage they pay. This creates a quandary, which we can understand by introducing a new concept: the marginal cost of labor. The marginal cost of labor is the cost to the firm of hiring one more worker. However, here is the thing: we assume that the firm is determining how many workers to hire in total. They are not hiring sequentially. Let’s look how this plays out with the example in Table 14.5.
Supply of Labor 1 2 3 4 5
Wage Rate \$1 per hour \$2 per hour \$3 per hour \$4 per hour \$5 per hour
Total Cost of Labor \$1 \$4 \$9 \$16 \$25
Marginal Cost of Labor \$1 \$3 \$5 \$7 \$9
Table 14.5 The Marginal Cost of Labor
There are a couple of things to notice from the table. First, the marginal cost increases faster than the wage rate. In fact, for any number of workers more than one, the marginal cost of labor is greater than the wage. This is because to hire one more worker requires paying a higher wage rate, not just for the new worker but for all the previous hires also. We can see this graphically in Figure 14.7.
Figure 14.8 The Marginal Cost of Labor Since monopsonies are the sole demander for labor, they face the market supply curve for labor. In order to increase employment they must raise the wage they pay not just for new workers, but for all the existing workers they could have hired at the previous lower wage. As a result, the marginal cost of hiring additional labor is greater than the wage, and thus for any level of employment (above the first worker), MCL is above the Market Supply of Labor.
Figure 14.9 Labor Market Outcomes Under Monopsony A monopsony will hire workers up to the point Lm where its demand for labor equals the marginal cost of additional labor, paying the wage Wm given by the supply curve of labor necessary to obtain Lm workers.
If the firm wants to maximize profits, it will hire labor up to the point Lm where DL = VMP (or MRP) = MCL, as Figure 14.9 shows. Then, the supply curve for labor shows the wage the firm will have to pay to attract Lm workers. Graphically, we can draw a vertical line up from Lm to the Supply Curve for the label and then read the wage Wm off the vertical axis to the left.
How does this outcome compare to what would occur in a perfectly competitive market? A competitive market would operate where DL = SL, hiring Lc workers and paying Wc wage. In other words, under monopsony employers hire fewer workers and pay a lower wage. While pure monopsony may be rare, many employers have some degree of market power in labor markets. The outcomes for those employers will be qualitatively similar though not as extreme as monopsony.
Figure 14.10 Comparison of labor market outcomes: Monopsony vs. Perfect Competition A monopsony hires fewer workers (Lm) than would be hired in a competitive labor market (Lc). In exploiting its market power, the monopsony can also pay a lower wage (Wm) than workers would earn in a competitive labor market (Wc). | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/14%3A_Labor_Markets_and_Income/14.03%3A_Wages_and_Employment_in_an_Imperfectly_Competitive_Labor_Market.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the concept of labor unions, including membership levels and wages
• Evaluate arguments for and against labor unions
• Analyze reasons for the decline in U.S. union membership
A labor union is an organization of workers that negotiates with employers over wages and working conditions. A labor union seeks to change the balance of power between employers and workers by requiring employers to deal with workers collectively, rather than as individuals. As such, a labor union operates like a monopoly in a labor market. We sometimes call negotiations between unions and firms collective bargaining.
The subject of labor unions can be controversial. Supporters of labor unions view them as the workers’ primary line of defense against efforts by profit-seeking firms to hold down wages and benefits. Critics of labor unions view them as having a tendency to grab as much as they can in the short term, even if it means injuring workers in the long run by driving firms into bankruptcy or by blocking the new technologies and production methods that lead to economic growth. We will start with some facts about union membership in the United States.
Facts about Union Membership and Pay
According to the U.S. Bureau of Labor and Statistics, about 10.3% of all U.S. workers belong to unions. This represents nearly a 50% reduction since 1983 (the earliest year for which comparable data are available), when union members were 20.1% of all workers. Following are some facts about unions for 2021 (note that we are using the population categories and group names utilized in the data collection and publication):
• 10.6% of U.S. male workers belong to unions; 9.9% of female workers do
• 10.7% of White workers, 12.3% of Black workers, and 9.8 % of Hispanic workers belong to unions
• 11.8% of full-time workers and 5.7% of part-time workers are union members
• 4.4% of workers ages 16–24 belong to unions, as do 13.2% of workers ages 45-54
• Occupations in which relatively high percentages of workers belong to unions are the federal government (26.0% belong to a union), state government (29.9%), local government (41.7%); transportation and utilities (17.6%); natural resources, construction, and maintenance (15.9%); and production, transportation, and material moving (13.3%)
• Occupations that have relatively low percentages of unionized workers are agricultural workers (1.7%), financial services (1.9%), professional and business services (2.2%), leisure and hospitality (2.2%), and wholesale and retail trade (4.5%)
In summary, the percentage of workers belonging to a union is higher for men than women; higher for Black than for White or Hispanic people; higher for the 45–64 age range; and higher among workers in government and manufacturing than workers in agriculture or service-oriented jobs. Table 14.6 lists the largest U.S. labor unions and their membership.
Union Membership
National Education Association (NEA) 3.0 million
Service Employees International Union (SEIU) 2.0 million
American Federation of Teachers (AFT) 1.7 million
International Brotherhood of Teamsters (IBT) 1.4 million
The American Federation of State, County, and Municipal Workers (AFSCME) 1.6 million
United Food and Commercial Workers International Union 1.3 million
International Brotherhood of Electrical Workers (IBEW) 775,000
United Steelworkers 625,000
International Association of Machinists and Aerospace Workers 569,000
International Union, United Automobile, Aerospace and Agricultural Implement Workers of America (UAW) 408,000
Table 14.6 The Largest American Unions in 2021 (Source: U.S. Department of Labor and individual union websites)
In terms of pay, benefits, and hiring, U.S. unions offer a good news/bad news story. The good news for unions and their members is that their members earn about 20% more than nonunion workers, even after adjusting for factors such as years of work experience and education level. The bad news for unions is that the share of U.S. workers who belong to a labor union has been steadily declining for 50 years, as Figure 14.11 shows. About one-quarter of all U.S. workers belonged to a union in the mid-1950s, but only 10.3% of U.S. workers are union members today. If you leave out government workers (which includes teachers in public schools), only 6.1% of the workers employed by private firms now work for a union.
Figure 14.11 Percentage of Wage and Salary Workers Who Are Union Members The share of wage and salary workers who belong to unions rose sharply in the 1930s and 1940s, but has tailed off since then to 10.3% of all workers in 2021.
The following section analyzes the higher pay union workers receive compared the pay rates for nonunion workers. The section after that analyzes declining union membership levels. An overview of these two issues will allow us to discuss many aspects of how unions work.
Higher Wages for Union Workers
How does a union affect wages and employment? Because a union is the sole supplier of labor, it can act like a monopoly and ask for whatever wage rate it can obtain for its workers. If employers need workers, they have to meet the union’s wage demand.
What are the limits on how much higher pay union workers can receive? To analyze these questions, let’s consider a situation where all firms in an industry must negotiate with a single union, and no firm is allowed to hire nonunion labor. If no labor union existed in this market, then equilibrium (E) in the labor market would occur at the intersection of the demand for labor (D) and the supply of labor (S) as we see in Figure 14.12. This is the same result as we showed in Figure 14.6 above. The union can, however, threaten that, unless firms agree to the wages they demand, the workers will strike. As a result, the labor union manages to achieve, through negotiations with the firms, a union wage of Wu for its members, above what the equilibrium wage would otherwise have been.
Figure 14.12 Union Wage Negotiations Without a union, the equilibrium at E would have involved the wage We and the quantity of labor Qe. However, the union is able to use its bargaining power to raise the wage to Wu. The result is an excess supply of labor for union jobs. That is, a quantity of labor supplied, Qs is greater than firms’ quantity demanded for labor, Qd.
This labor market situation resembles what a monopoly firm does in selling a product, but in this case a union is a monopoly selling labor to firms. At the higher union wage Wu, the firms in this industry will hire less labor than they would have hired in equilibrium. Moreover, an excess supply of workers want union jobs, but firms will not be hiring for such jobs.
From the union point of view, workers who receive higher wages are better off. However, notice that the quantity of workers (Qd) hired at the union wage Wu is smaller than the quantity Qe that the firm would have hired at the original equilibrium wage. A sensible union must recognize that when it pushes up the wage, it also reduces the firms’ incentive to hire. This situation does not necessarily mean that union workers are fired. Instead, it may be that when union workers move on to other jobs or retire, they are not always replaced, or perhaps when a firm expands production, it expands employment somewhat less with a higher union wage than it would have done with the lower equilibrium wage. Other situations could be that a firm decides to purchase inputs from nonunion producers, rather than producing them with its own highly paid unionized workers, or perhaps the firm moves or opens a new facility in a state or country where unions are less powerful.
From the firm’s point of view, the key question is whether union workers’ higher wages are matched by higher productivity. If so, then the firm can afford to pay the higher union wages and, the demand curve for “unionized” labor could actually shift to the right. This could reduce the job losses as the equilibrium employment level shifts to the right and the difference between the equilibrium and the union wages will have been reduced. If worker unionization does not increase productivity, then the higher union wage will cause lower profits or losses for the firm.
Union workers might have higher productivity than nonunion workers for a number of reasons. First, higher wages may elicit higher productivity. Second, union workers tend to stay longer at a given job, a trend that reduces the employer’s costs for training and hiring and results in workers with more years of experience. Many unions also offer job training and apprenticeship programs.
In addition, firms that are confronted with union demands for higher wages may choose production methods that involve more physical capital and less labor, resulting in increased labor productivity. Table 14.7 provides an example. Assume that a firm can produce a home exercise cycle with three different combinations of labor and manufacturing equipment. Say that the firm pays labor \$16 an hour (including benefits) and the machines for manufacturing cost \$200 each. Under these circumstances, the total cost of producing a home exercise cycle will be lowest if the firm adopts the plan of 50 hours of labor and one machine, as the table shows. Now, suppose that a union negotiates a wage of \$20 an hour including benefits. In this case, it makes no difference to the firm whether it uses more hours of labor and fewer machines or less labor and more machines, although it might prefer to use more machines and to hire fewer union workers. (After all, machines never threaten to strike—but they do not buy the final product or service either.)
In the final column of the table, the wage has risen to \$24 an hour. In this case, the firm clearly has an incentive for using the plan that involves paying for fewer hours of labor and using three machines. If management responds to union demands for higher wages by investing more in machinery, then union workers can be more productive because they are working with more or better physical capital equipment than the typical nonunion worker. However, the firm will need to hire fewer workers.
Hours of Labor Number of Machines Cost of Labor + Cost of Machine \$16/hour Cost of Labor + Cost of Machine \$20/hour Cost of Labor + Cost of Machine \$24/hour
30 3 \$480 + \$600 = \$1,080 \$600 + \$600 = \$1,200 \$720 + \$600 = \$1,320
40 2 \$640 + \$400 = \$1,040 \$800 + \$400 = \$1,200 \$960 + \$400 = \$1,360
50 1 \$800 + \$200 = \$1,000 \$1,000 + \$200 = \$1,200 \$1,200 + \$200 = \$1,400
Table 14.7 Three Production Choices to Manufacture a Home Exercise Cycle
In some cases, unions have discouraged the use of labor-saving physical capital equipment—out of the reasonable fear that new machinery will reduce the number of union jobs. For example, in 2015, the union representing longshoremen who unload ships and the firms that operate shipping companies and port facilities staged a work stoppage that shut down the ports on the western coast of the United States. Two key issues in the dispute were the desire of the shipping companies and port operators to use handheld scanners for record-keeping and computer-operated cabs for loading and unloading ships—changes which the union opposed, along with overtime pay. President Obama threatened to use the Labor Management Relations Act of 1947—commonly known as the Taft-Hartley Act—where a court can impose an 80-day “cooling-off period” in order to allow time for negotiations to proceed without the threat of a work stoppage. Federal mediators were called in, and the two sides agreed to a deal in February 2015. The ultimate agreement allowed the new technologies, but also kept wages, health, and pension benefits high for workers. In the past, presidential use of the Taft-Hartley Act sometimes has made labor negotiations more bitter and argumentative but, in this case, it seems to have smoothed the road to an agreement.
In other instances, unions have proved quite willing to adopt new technologies. In one prominent example, during the 1950s and 1960s, the United Mineworkers union demanded that mining companies install labor-saving machinery in the mines. The mineworkers’ union realized that over time, the new machines would reduce the number of jobs in the mines, but the union leaders also knew that the mine owners would have to pay higher wages if the workers became more productive, and mechanization was a necessary step toward greater productivity.
In fact, in some cases union workers may be more willing to accept new technology than nonunion workers, because the union workers believe that the union will negotiate to protect their jobs and wages, whereas nonunion workers may be more concerned that the new technology will replace their jobs. In addition, union workers, who typically have higher job market experience and training, are likely to suffer less and benefit more than non-union workers from the introduction of new technology. Overall, it is hard to make a definitive case that union workers as a group are always either more or less welcoming to new technology than are nonunion workers
The Decline in U.S. Union Membership
The proportion of U.S. workers belonging to unions has declined dramatically since the early 1950s. Economists have offered a number of possible explanations:
• The shift from manufacturing to service industries
• The force of globalization and increased competition from foreign producers
• A reduced desire for unions because of the workplace protection laws now in place
• U.S. legal environment that makes it relatively more difficult for unions to organize workers and expand their membership
Let’s discuss each of these four explanations in more detail.
A first possible explanation for the decline in the share of U.S. workers belonging to unions involves the patterns of job growth in the manufacturing and service sectors of the economy as Figure 14.13 shows. The U.S. economy had about 15 million manufacturing jobs in 1960. This total rose to 19 million by the late 1970s and then declined to 17 million in 2013. Meanwhile, the number of jobs in service industries (including government employment) rose from 35 million in 1960 to over 118 million by 2013, according to the Bureau of Labor Statistics. Because over time unions were stronger in manufacturing than in service industries, the growth in jobs was not happening where the unions were. It is interesting to note that government workers comprise several of the biggest unions in the country, including the American Federation of State, County and Municipal Employees (AFSCME); the Service Employees International Union; and the National Education Association. Table 14.8 lists the membership of each of these unions. Outside of government employees, however, unions have not had great success in organizing the service sector.
Figure 14.13 The Growth of Service Jobs Jobs in services have increased dramatically for more than the past 50 years. Jobs in government have increased modestly until 1990 and then declined slightly since then. Jobs in manufacturing peaked in the late 1970s and have declined more than a third since then.
A second explanation for the decline in the share of unionized workers looks at import competition. Starting in the 1960s, U.S. carmakers and steelmakers faced increasing competition from Japanese and European manufacturers. As sales of imported cars and steel rose, the number of jobs in U.S. auto manufacturing fell. This industry is heavily unionized. Not surprisingly, membership in the United Auto Workers, which was 975,000 in 1985, had fallen to roughly 390,000 by 2015. Import competition not only decreases the employment in sectors where unions were once strong, but also decreases the bargaining power of unions in those sectors. However, as we have seen, unions that organize public-sector workers, who are not threatened by import competition, have continued to see growth.
A third possible reason for the decline in the number of union workers is that citizens often call on their elected representatives to pass laws concerning work conditions, overtime, parental leave, regulation of pensions, and other issues. Unions offered strong political support for these laws aimed at protecting workers but, in an ironic twist, the passage of those laws then made many workers feel less need for unions.
These first three possible reasons for the decline of unions are all somewhat plausible, but they have a common problem. Most other developed economies have experienced similar economic and political trends, such as the shift from manufacturing to services, globalization, and increasing government social benefits and regulation of the workplace. Clearly there are cultural differences between countries as to their acceptance of unions in the workplace. The share of the population belonging to unions in other countries is very high compared with the share in the United States. Table 14.8 shows the proportion of workers in a number of the world’s high-income economies who belong to unions. The United States is near the bottom, along with France and Spain. The last column shows union coverage, defined as including those workers whose wages are determined by a union negotiation even if the workers do not officially belong to the union. In the United States, union membership is almost identical to union coverage. However, in many countries, the wages of many workers who do not officially belong to a union are still determined by collective bargaining between unions and firms.
Country Union Density: Percentage of Workers Belonging to a Union Union Coverage: Percentage of Workers Whose Wages Are Determined by Union Bargaining
Austria 37% 99%
France 9% 95%
Germany 26% 63%
Japan 22% 23%
Netherlands 25% 82%
Spain 11.3% 81%
Sweden 82% 92%
United Kingdom 29% 35%
United States 11.1% 12.5%
Table 14.8 International Comparisons of Union Membership and Coverage in 2012 (Source, CIA World Factbook, retrieved from www.cia.gov)
These international differences in union membership suggest a fourth reason for the decline of union membership in the United States: perhaps U.S. laws are less friendly to the formation of unions than such laws in other countries. The close connection between union membership and a friendly legal environment is apparent in the history of U.S. unions. The great rise in union membership in the 1930s followed the passage of the National Labor Relations Act of 1935, which specified that workers had a right to organize unions and that management had to give them a fair chance to do so. The U.S. government strongly encouraged forming unions during the early 1940s in the belief that unions would help to coordinate the all-out production efforts needed during World War II. However, after World War II came the passage of the Taft-Hartley Act of 1947, which gave states the power to allow workers to opt out of the union in their workplace if they so desired. This law made the legal climate less encouraging to those seeking to form unions, and union membership levels soon started declining.
The procedures for forming a union differ substantially from country to country. For example, the procedures in the United States and those in Canada are strikingly different. When a group of workers wishes to form a union in the United States, they announce this fact and set an election date when the firm's employees will vote in a secret ballot on whether to form a union. Supporters of the union lobby for a “yes” vote, and the firm's management lobbies for a “no” vote—often even hiring outside consultants for assistance in swaying workers to vote “no.” In Canada, by contrast, a union is formed when a sufficient proportion of workers (usually about 60%) signs an official card saying that they want a union. There is no separate “election date.” The management of Canadian firms is limited by law in its ability to lobby against the union. In addition, although it is illegal to discriminate and fire workers based on their union activity in the United States, the penalties are slight, making this a not so costly way of deterring union activity. In short, forming unions is easier in Canada—and in many other countries—than in the United States.
In summary, union membership in the United States is lower than in many other high-income countries, a difference that may be due to different legal environments and cultural attitudes toward unions.
Link It Up
Visit this website to read more about recent protests regarding minimum wage for fast food employees.
14.05: Bilateral Monopoly
Learning Objectives
By the end of this section, you will be able to explain:
• How firms determine wages and employment when a specific labor market combines a union and a monopsony
What happens when there is market power on both sides of the labor market, in other words, when a union meets a monopsony? Economists call such a situation a bilateral monopoly.
Figure 14.14 Bilateral Monopoly Employment, L*, will be lower in a bilateral monopoly than in a competitive labor market, but the equilibrium wage is indeterminate, somewhere in the range between Wu, what the union would choose, and Wm, what the monopsony would choose.
Figure 14.14 is a combination of Figure 14.6 and Figure 14.11. A monopsony wants to reduce wages as well as employment, Wm and L* in the figure. A union wants to increase wages, but at the cost of lower employment, Wu and L* in the figure. Since both sides want to reduce employment, we can be sure that the outcome will be lower employment compared to a competitive labor market. What happens to the wage, though, is based on the monopsonist’s relative bargaining power compared to the bargaining power of the union. The actual outcome is indeterminate in the graph, but it will be closer to Wu if the union has more power and closer to Wm if the monopsonist has more power. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/14%3A_Labor_Markets_and_Income/14.04%3A_Market_Power_on_the_Supply_Side_of_Labor_Markets-_Unions.txt |
Learning Objectives
By the end of this section, you will be able to:
• Analyze earnings gaps based on race and gender
• Explain the impact of discrimination in a competitive market
• Identify U.S. public policies designed to reduce discrimination
Barriers to equitable participation in the labor market drive down economic growth. When certain populations are underrepresented, underpaid, or mistreated in a labor market or industry, the negative outcomes can effect the larger economy. For example, many science and technology fields were either unwelcoming or overtly unaccepting of women and people of color. Some major contributors to these fields overcame these challenges. Mexican-American scientist Lydia Villa-Komaroff, for example, faced overt discrimination when her college advisor told her not to pursue chemistry because women didn't "belong" in chemistry. She pursued biology instead; she developed the first instance of synthetic insulin (the chemical that people with diabetes need in order to survive) through a process that has saved million of lives and is credited with launching the entire industry of biotechnology—one of the most important in the U.S. economy. But for every Villa-Komaroff, there have been thousands of women who were prevented from making those contributions. Beyond the personal impact on those people, consider the impact on those scientific fields, our overall quality of life, and the economy itself. Economist Lisa D. Cook has quantified the costs of these innovation losses. She estimates that GDP could be as much as 4.4% higher if women and people from minority populations were fully able to participate in the science and technology innovation process.
Discrimination involves acting on the belief that members of a certain group are inferior or deserve less solely because of a factor such as race, gender, or religion. There are many types of discrimination but the focus here will be on discrimination in labor markets, which arises if workers with the same skill levels—as measured by education, experience, and expertise—receive different pay or have different job opportunities because of their race or gender. Much of the data collected and published on these topics are limited in terms of the diversity of people represented, and focus particularly on binary gender, single-race, and single-ethnicity identities. While these characterizations do not capture the diversity of Americans, the findings are important in order to understand discrimination and other practices, and to consider the impacts of policies and changes. Also, while sex and gender are different, many data sets, laws, court decisions, and media accounts use the terms interchangeably. For consistency, we will use the terminology found in the source material and government data.
Earnings Gaps by Race and Gender
A possible signal of labor market discrimination is when an employer pays one group less than another. Figure 14.15 shows the average wage of Black workers as a ratio of the average wage of White workers and the average wage of female workers as a ratio of the average wage of male workers. Research by the economists Francine Blau and Laurence Kahn shows that the gap between the earnings of women and men did not move much in the 1970s, but has declined since the 1980s. Detailed analysis by economists Kerwin Kofi Charles and Patrick Bayer show that the gap between the earnings of Black and White people diminished in the 1970s, but grew again so that current differences are as wide as they were nearly 70 years ago. In both gender and race, an earnings gap remains.
Figure 14.15 Wage Ratios by Sex and Race The ratio of wages for Black workers to White workers rose substantially in the late 1960s and through the 1970s. The 1990s saw a peak above 80% followed by a bumpy decline to the low 70s. The ratio of wages for female to male workers changed little through the 1970s. In both cases, a gap remains between the average wages of Black and White workers and between the average wages of female and male workers. Source: U.S. Department of Labor, Bureau of Labor Statistics.
An earnings gap between average wages, in and of itself, does not prove that discrimination is occurring in the labor market. We need to apply the same productivity characteristics to all parties (employees) involved. Gender discrimination in the labor market occurs when employers pay people of a specific gender less despite those people having comparable levels of education, experience, and expertise. (Read the Clear It Up about the sex-discrimination suit brought against Walmart.) Similarly, racial discrimination in the labor market exists when employers pay racially diverse employees less than their coworkers of the majority race despite having comparable levels of education, experience, and expertise. To bring a successful gender discrimination lawsuit, an employee must prove the employer is paying them less than an employee of a different gender who holds a similar job, with similar educational attainment, and with similar expertise. Likewise, someone who wants to sue on the grounds of racial discrimination must prove that the employer pays them less than an employee of another race who holds a similar job, with similar educational attainment, and with similar expertise.
The FRED database includes earnings data at earnings by age, gender and race/ethnicity.
As stated previously and as we will see below, not every instance of a wage gap or employment inequity is a product of overt discrimination on the part of individual employers. Significant overall issues in societies, such as inequitable education or housing segregation, can lead to earning gaps and limitations on economic mobility. However, these wider issues usually affect people from minority populations and/or those who have been historically underrepresented in positions of power. Economist William A. Darity Jr., whose work is discussed in more detail below, indicates that individualized employer racism still exists, but it is largely practiced in "covert and subtle forms."
Clear It Up
What was the sex-discrimination case against Walmart?
In one of the largest class-action sex-discrimination cases in U.S. history, 1.2 million female employees of Walmart claimed that the company engaged in wage and promotion discrimination. In 2011, the Supreme Court threw out the case on the grounds that the group was too large and too diverse to consider the case a class action suit. Lawyers for the women regrouped and were subsequently suing in smaller groups. Part of the difficulty for the female employees is that the court said that local managers made pay and promotion decisions that were not necessarily the company's policies as a whole. Consequently, female Walmart employees in Texas argued that their new suit would challenge the management of a “discrete group of regional district and store managers.” They claimed that these managers made biased pay and promotion decisions. However, in 2013, a federal district court rejected a smaller California class action suit against the company.
On other issues, Walmart made the news again in 2013 when the National Labor Relations Board found Walmart guilty of illegally penalizing and firing workers who took part in labor protests and strikes. Walmart paid \$11.7 million in back wages and compensation damages to women in Kentucky who were denied jobs due to their sex. And in 2020, a sex-based hiring discrimination lawsuit was filed by the U.S. Equal Employment Opportunity Commission (EEOC), in which the EEOC alleged that Walmart conducted a physical ability test (known as the PAT) as a requirement for applicants to be hired as order fillers at Walmart’s grocery distribution centers nationwide, and that the PAT disproportionately excluded female applicants from jobs as grocery order fillers. In September 2020, Walmart and the EEOC agreed to a consent decree, which requires Walmart to cease all physical ability testing that had been used for purposes of hiring grocery distribution center order fillers. The decree also required Walmart to pay \$20 million into a settlement fund to pay lost wages to women across the country who were denied grocery order filler positions because of the testing.
Investigating the Female/Male Earnings Gap
As a result of changes in law and culture, women began to enter the paid workforce in substantial numbers in the mid- to late-twentieth century. As of February 2022, 56.0% of women aged 20 and over held jobs, while 67.6% of men aged 20 and over did. Moreover, along with entering the workforce, women began to ratchet up their education levels. In 1971, 44% of undergraduate college degrees went to women. As of the 2018–19 academic year, women earned 57% of bachelor’s degrees. In 1970, women received 5.4% of the degrees from law schools and 8.4% of the degrees from medical schools. By 2017, women were receiving just over 50% of the law degrees, and by 2019, 48% of the medical degrees. There are now slightly more women than men in both law schools and medical schools. These gains in education and experience have reduced the female/male wage gap over time. However, concerns remain about the extent to which women have not yet assumed a substantial share of the positions at the top of the largest companies or in the U.S. Congress.
There are factors that can lower women’s average wages. Women are likely to bear a disproportionately large share of household responsibilities. A mother of young children is more likely to drop out of the labor force for several years or work on a reduced schedule than is the father. As a result, women in their 30s and 40s are likely, on average, to have less job experience than men. In the United States, childless women with the same education and experience levels as men are typically paid comparably. However, women with families and children are typically paid about 7% to 14% less than other women of similar education and work experience. Meanwhile, married men earn about 10% to 15% more than single men with comparable education and work experience. This circumstance or practice is often referred to as the "motherhood penalty" and the "fatherhood bonus."
Another aspect of the gender pay gap relates to work that isn’t actually paid, such as household chores, caring for children and other family members, and cooking. Studies have found that globally and within the United States, women undertake far more of this work than do men; even women who work full time and/or bring in the majority of family income take on more of this unpaid work than the men in their households.
Economists study many aspects of sex- and gender-based earnings gaps, often revealing unexpected causes and impacts. For example, economists Jessica Pan, Jonathan Guryan, and Kerwin Kofi Charles analyzed decades of sociological and employment data and uncovered that the amount of sexism in the U.S. state where a woman was born is an indicator of the woman's earnings throughout her life, even if she moves away from her home state. In other words, women born in states with more pronounced sexist attitudes earn less, no matter where they live later on. Other economists showed that from 1950–2000, as women's representation increased in the workforce, jobs that became occupied by women experienced wage reductions relative to jobs being done by men—an outcome often referred to as "devaluation." The value of this research and similar investigations comes from the deeper understanding of the origins of the earnings gap, so that workers, employers, and governments can take steps to address them.
Link It Up
Visit this website to read more about the persistently low numbers of women in executive roles in business and in the U.S. Congress.
Investigating the Earnings Gap Related to Race and Ethnicity
Black people experienced blatant labor market discrimination during much of the twentieth century. Until the passage of the Civil Rights Act of 1964, it was legal in many states to refuse to hire a Black worker, regardless of the credentials or experience of that worker. Moreover, Black people were often denied access to educational opportunities, which in turn meant that they had lower levels of qualifications for many jobs. At least one economic study has shown that the 1964 law is partially responsible for the narrowing of the gap in Black–White earnings in the late 1960s and into the 1970s. For example, the ratio of total earnings of Black male workers to White male workers rose from 62% in 1964 to 75.3% in 2013, according to the Bureau of Labor Statistics.
However, the earnings gap between Black and White workers has not changed as much as the earnings gap between men and women has in the last half century. The remaining racial gap seems related both to continuing differences in education levels and to the presence of discrimination. Table 14.9 shows that the percentage of Black people who complete a four-year college degree remains substantially lower than the percentage of White people who complete college. According to the U.S. Census, both White and Black people have higher levels of educational attainment than Hispanic people and lower levels than Asian people. The lower average levels of education for Black workers surely explain part of the earnings gap. In fact, Black women who have the same levels of education and experience as White women receive, on average, about the same level of pay. One study shows that White and Black college graduates have identical salaries immediately after college; however, the racial wage gap widens over time, an outcome that suggests the possibility of continuing discrimination. Other researchers conducted a field experiment by responding to job advertisements with fictitious resumes using names that were either commonly associated with Black/African American people or names commonly associated with White people; they found that the White-associated names received 50 percent more callbacks for interviews. This is suggestive of discrimination in job opportunities. Further, as the following Clear It Up feature explains, there is evidence to support that discrimination in the housing market is connected to employment discrimination.
White Hispanic Black Asian
Completed four years of high school or more 93.8% 73.0% 87.2% 91.0%
Completed four years of college or more 37.6% 16.8% 23.7% 54.7%
Table 14.9 Educational Attainment by Race and Ethnicity for Individuals Aged 18 and Above in 2019
Clear It Up
How is discrimination in the housing market connected to employment discrimination?
A recent study by the Housing and Urban Development (HUD) department found that realtors showed Black homebuyers 18 percent fewer homes compared to White homebuyers. Realtors showed Asian homebuyers 19 percent fewer properties. Additionally, Hispanic people experience more discrimination in renting apartments and undergo stiffer credit checks than White renters. In a 2012 study by the U.S. Department of Housing and Urban Development and the nonprofit Urban Institute, Hispanic testers who contacted agents about advertised rental units received information about 12 percent fewer units available and were shown seven percent fewer units than White renters. The \$9 million study, based on research in 28 metropolitan areas, concluded that blatant “door slamming” forms of discrimination are on the decline but that the discrimination that does exist is harder to detect, and as a result, more difficult to remedy. According to the Chicago Tribune, HUD Secretary Shaun Donovan, who served in his role from 2009-2014, told reporters, “Just because it’s taken on a hidden form doesn’t make it any less harmful. You might not be able to move into that community with the good schools.”
These practices are viewed as a continuation of redlining, which is the intentional and discriminatory withholding of services or products based on race or other factors. Redlining was practiced extensively by banks and other lenders who refused to issue mortgages or other loans to people from racial or ethnic minorities living in neighborhoods that were deemed "hazardous" to investment, even though the same lenders would issue loans to White people with similar economic status. Redlining has lasting effects today, demonstrated by significant divides in educational and financial opportunity in certain neighborhoods or cities.
The lower levels of education for Black workers can also be a result of discrimination—although it may be pre-labor market discrimination, rather than direct discrimination by employers in the labor market. For example, if redlining and other discrimination in housing markets causes Black families to live clustered together in certain neighborhoods and those areas have under-resourced schools, then those children will continue to have lower educational attainment then their White counterparts and, consequently, not be able to obtain the higher paying jobs that require higher levels of education. Another element to consider is that in the past, when Black people were effectively barred from many high-paying jobs, obtaining additional education could have seemed not to be worth the investment, because the educational degrees would not pay off. While the government has legally abolished discriminatory labor practices, structures and systems take a very long time to eradicate.
Competitive Markets and Discrimination
Gary Becker (1930–2014), who won the Nobel Prize in economics in 1992, was one of the first to analyze discrimination in economic terms. Becker pointed out that while competitive markets can allow some employers to practice discrimination, it can also provide profit-seeking firms with incentives not to discriminate. Given these incentives, Becker explored the question of why discrimination persists.
If a business is located in an area with a large minority population and refuses to sell to minorities, it will cut into its own profits. If some businesses run by bigoted employers refuse to pay women and/or minorities a wage based on their productivity, then other profit-seeking employers can hire these workers. In a competitive market, if the business owners care more about the color of money than about the color of skin, they will have an incentive to make buying, selling, hiring, and promotion decisions strictly based on economic factors.
Do not underestimate the power of markets to offer at least a degree of freedom to oppressed groups. In many countries, cohesive minority population groups like Jewish people and emigrant Chinese people have managed to carve out a space for themselves through their economic activities, despite legal and social discrimination against them. Many immigrants, including those who come to the United States, have taken advantage of economic freedom to make new lives for themselves. However, history teaches that market forces alone are unlikely to eliminate discrimination. After all, discrimination against African Americans persisted in the market-oriented U.S. economy during the century between the ratification of the 13th Amendment, which abolished slavery in 1865, and the passage of the Civil Rights Act of 1964—and has continued since then, too.
Why does discrimination persist in competitive markets? Gary Becker sought to explain this persistence. Discriminatory impulses can emerge at a number of levels: among managers, among workers, and among customers. Consider the situation of a store owner or manager who is not personally prejudiced, but who has many customers who are prejudiced. If that manager treats all groups fairly, the manager may find it drives away prejudiced customers. In such a situation, a policy of nondiscrimination could reduce the firm’s profits. After all, a business firm is part of society, and a firm that does not follow the societal norms is likely to suffer.
As economist William A. Darity Jr. points out, however, the "prejudiced customer" rationale falls apart when considering the many jobs that have no customer contact. Darity examined several theories regarding the persistence of employment discrimination, including rationales regarding group membership and employers' lack of information about candidates of other genders or races. Darity also directly studies and interprets others' work on discrimination in other countries, such as wage disparities between Sikh and Hindu men in India. Darity concludes that the competitive forces of the market have not been enough to overcome employment and wage discrimination, and, on their own, are unlikely to end such discrimination in the future.
Link It Up
Read this article to learn more about wage discrimination.
Public Policies to Reduce Discrimination
A first public policy step against discrimination in the labor market is to make it illegal. For example, the Equal Pay Act of 1963 said that employers must pay men and women who do equal work the same. The Civil Rights Act of 1964 prohibits employment discrimination based on race, color, religion, sex, or national origin. The Age Discrimination in Employment Act of 1967 prohibited discrimination on the basis of age against individuals who are 40 years of age or older. The Civil Rights Act of 1991 provides monetary damages in cases of intentional employment discrimination. The Pregnancy Discrimination Act of 1978 was aimed at prohibiting discrimination against people in the workplace who are planning pregnancy, are pregnant, or are returning after pregnancy. Passing a law, however, is only part of the answer, since discrimination by prejudiced employers may be less important than broader social patterns and systems.
The 1964 Civil Rights Act created an important government organization, the Equal Employment Opportunity Commission, to investigate employment discrimination and protect workers who filed complaints against employers. Economist Phyllis Ann Wallace, who had previously worked for U.S. intelligence services, was appointed as the commission's chief of technical studies. In this role she collected and organized a massive amount of public and private sector data, as well as mentored and directed economists and other analysts in their investigations.
These laws against discrimination have reduced the gender wage gap. A 2007 Department of Labor study compared salaries of men and women who have similar educational achievement, work experience, and occupation and found that the gender wage gap is only 5%.
In the case of the earnings gap between Black people and White people (and also between Hispanic people and White people), probably the single largest step that could be taken at this point in U.S. history to close the earnings gap would be to reduce the gap in educational attainment. Part of the answer to this issue involves finding ways to improve the performance of schools, which is a highly controversial topic in itself. In addition, the education gap is unlikely to close unless Black and Hispanic families and peer groups strengthen their culture of support for educational attainment.
Affirmative action is the name given to active efforts by government or businesses that give special rights to minorities in hiring and promotion to make up for past discrimination. Affirmative action, in its limited and not especially controversial form, means making an effort to reach out to a broader range of minority candidates for jobs. In its more aggressive and controversial form, affirmative action required government and companies to hire a specific number or percentage of minority employees. However, the U.S. Supreme Court has ruled against state affirmative action laws. Today, the government applies affirmative action policies only to federal contractors who have lost a discrimination lawsuit. The federal Equal Employment Opportunity Commission (EEOC) enforces this type of redress.
An Increasingly Diverse Workforce
Racial and ethnic diversity is on the rise in the U.S. population and workforce. As Figure 14.16 shows, while the White Americans comprised 78% of the population in 2012, the U.S. Bureau of the Census projects that Whites will comprise 69% of the U.S. population by 2060. Forecasters predict that the proportion of U.S. citizens who are of Hispanic background to rise substantially. Moreover, in addition to expected changes in the population, workforce diversity is increasing as the women who entered the workforce in the 1970s and 1980s are now moving up the promotion ladders within their organizations.
Figure 14.16 Projected Changes in America’s Racial and Ethnic Diversity This figure shows projected changes in the ethnic makeup of the U.S. population by 2060. Note that “NHPI” stands for Native Hawaiian and Other Pacific Islander. “AIAN” stands for American Indian and Alaska Native. Source: US Department of Commerce
Regarding the future, optimists argue that the growing proportions of minority workers will break down remaining discriminatory barriers. The economy will benefit as an increasing proportion of workers from traditionally disadvantaged groups have a greater opportunity to fulfill their potential. Pessimists worry that the social tensions between different genders and between ethnic groups will rise and that workers will be less productive as a result. Anti-discrimination policy, at its best, seeks to help society move toward the more optimistic outcome.
The FRED database includes data on foreign and native born civilian population and labor force. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/14%3A_Labor_Markets_and_Income/14.06%3A_Employment_Discrimination.txt |
Most Americans would be outraged if a law prevented them from moving to another city or another state. However, when the conversation turns to crossing national borders and is about other people arriving in the United States, laws preventing such movement often seem more reasonable. Some of the tensions over immigration stem from worries over how it might affect a country’s culture, including differences in language, and patterns of family, authority, or gender relationships. Economics does not have much to say about such cultural issues. Some of the worries about immigration do, however, have to do with its effects on wages and income levels, and how it affects government taxes and spending. On those topics, economists have insights and research to offer.
Historical Patterns of Immigration
Supporters and opponents of immigration look at the same data and see different patterns. Those who express concern about immigration levels to the United States point to graphics like Figure 14.17 which shows total inflows of immigrants decade by decade through the twentieth and into the twenty-first century. Clearly, the level of immigration has been high and rising in recent years, reaching and exceeding the towering levels of the early twentieth century. However, those who are less worried about immigration point out that the high immigration levels of the early twentieth century happened when total population was much lower. Since the U.S. population roughly tripled during the twentieth century, the seemingly high levels in immigration in the 1990s and 2000s look relatively smaller when they are divided by the population.
Figure 14.17 Immigration Since 1900 The number of immigrants in each decade declined between 1900 and the 1940s, rose sharply through 2009 and started to decline from 2010 to the present. (Source: U.S. Census)
From where have the immigrants come? Immigrants from Europe were more than 90% of the total in the first decade of the twentieth century, but less than 20% of the total by the end of the century. By the 2000s, about half of U.S. immigration came from the rest of the Americas, especially Mexico, and about a quarter came from various countries in Asia.
Economic Effects of Immigration
A surge of immigration can affect the economy in a number of different ways. In this section, we will consider how immigrants might benefit the rest of the economy, how they might affect wage levels, and how they might affect government spending at the federal and local level.
To understand the economic consequences of immigration, consider the following scenario. Imagine that the immigrants entering the United States matched the existing U.S. population in age range, education, skill levels, family size, and occupations. How would immigration of this type affect the rest of the U.S. economy? Immigrants themselves would be much better off, because their standard of living would be higher in the United States. Immigrants would contribute to both increased production and increased consumption. Given enough time for adjustment, the range of jobs performed, income earned, taxes paid, and public services needed would not be much affected by this kind of immigration. It would be as if the population simply increased a little.
Now, consider the reality of recent immigration to the United States. Immigrants are not identical to the rest of the U.S. population. About one-third of immigrants over the age of 25 lack a high school diploma. As a result, many of the recent immigrants end up in jobs like restaurant and hotel work, lawn care, and janitorial work. This kind of immigration represents a shift to the right in the supply of unskilled labor for a number of jobs, which will lead to lower wages for these jobs. The middle- and upper-income households that purchase the services of these unskilled workers will benefit from these lower wages. However, low-skilled U.S. workers who must compete with low-skilled immigrants for jobs will tend to be negatively impacted by immigration.
The difficult policy questions about immigration are not so much about the overall gains to the rest of the economy, which seem to be real but small in the context of the U.S. economy, as they are about the disruptive effects of immigration in specific labor markets. One disruptive effect, as we noted, is that immigration weighted toward low-skill workers tends to reduce wages for domestic low-skill workers. A study by Michael S. Clune found that for each 10% rise in the number of employed immigrants with no more than a high school diploma in the labor market, high school students reduced their annual number of hours worked by 3%. The effects on wages of low-skill workers are not large—perhaps in the range of decline of about 1%. These effects are likely kept low, in part, because of the legal floor of federal and state minimum wage laws. In addition, immigrants are also thought to contribute to increased demand for local goods and services which can stimulate the local low skilled labor market. It is also possible that employers, in the face of abundant low-skill workers, may choose production processes which are more labor intensive than otherwise would have been. These various factors would explain the small negative wage effect that the native low-skill workers observed as a result of immigration.
Another potential disruptive effect is the impact on state and local government budgets. Many of the costs imposed by immigrants are costs that arise in state-run programs, like the cost of public schooling and of welfare benefits. However, many of the taxes that immigrants pay are federal taxes like income taxes and Social Security taxes. Many immigrants do not own property (such as homes and cars), so they do not pay property taxes, which are one of the main sources of state and local tax revenue. However, they do pay sales taxes, which are state and local, and the landlords of property they rent pay property taxes. According to the nonprofit Rand Corporation, the effects of immigration on taxes are generally positive at the federal level, but they are negative at the state and local levels in places where there are many low-skilled immigrants.
Link It Up
Visit this website to obtain more context regarding immigration.
Proposals for Immigration Reform
The Congressional Jordan Commission of the 1990s proposed reducing overall levels of immigration and refocusing U.S. immigration policy to give priority to immigrants with higher skill levels. In the labor market, focusing on high-skilled immigrants would help prevent any negative effects on low-skilled workers' wages. For government budgets, higher-skilled workers find jobs more quickly, earn higher wages, and pay more in taxes. Several other immigration-friendly countries, notably Canada and Australia, have immigration systems where those with high levels of education or job skills have a much better chance of obtaining permission to immigrate. For the United States, high tech companies regularly ask for a more lenient immigration policy to admit a greater quantity of highly skilled workers under the H1B visa program.
The Obama Administration proposed the so-called “DREAM Act” legislation, which would have offered a path to citizenship for those classified as illegal immigrants who were brought to the United States before the age of 16. Despite bipartisan support, the legislation failed to pass at the federal level. However, some state legislatures, such as California, have passed their own Dream Acts.
Between its plans for a border wall, increased deportation of undocumented immigrants, and even reductions in the number of highly skilled legal H1B immigrants, the Trump Administration had a much less positive approach to immigration. Most economists, whether conservative or liberal, believe that while immigration harms some domestic workers, the benefits to the nation exceed the costs. President Biden has been considerably more positive about immigration than his predecessor. However, given the presence of considerable disagreement within the overall population about the desirability of immigration, it is unlikely that any significant immigration reform will take place in the near future.
The FRED database includes data on the national origin of the civilian population (https://fred.stlouisfed.org/categories/104) and labor force (https://fred.stlouisfed.org/categories/32442).
Bring It Home
The Increasing Value of a College Degree
The cost of college has increased dramatically in recent decades, causing many college students to take student loans to afford it. Despite this, the value of a college degree has never been higher. How can we explain this?
We can estimate the value of a bachelor’s degree as the difference in lifetime earnings between the average holder of a bachelor’s degree and the average high school graduate. According to a 2021 report from the Georgetown University Center on Education and the Workforce, adults with a bachelor’s degree earn an average of \$2.8 million during their careers, \$1.2 million more than the median for workers with a high school diploma. College graduates also have a significantly lower unemployment rate than those with lower educational attainments.
While a college degree holder’s wages have increased somewhat, the major reason for the increase in value of a bachelor’s degree has been the plummeting value of a high school diploma. In the twenty-first century, the majority of jobs require at least some post-secondary education. This includes manufacturing jobs that in the past would have afforded workers a middle class income with only a high school diploma. Those jobs are increasingly scarce. This phenomenon has also no doubt contributed to the increasing inequality of income that we observe in the U.S. today. We will discuss that topic next, in Chapter 15. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/14%3A_Labor_Markets_and_Income/14.07%3A_Immigration.txt |
affirmative action
active efforts by government or businesses that give special rights to minorities in hiring, promotion, or access to education to make up for past discrimination
bilateral monopoly
a labor market with a monopsony on the demand side and a union on the supply side
collective bargaining
negotiations between unions and a firm or firms
discrimination
actions based on the belief that members of a certain group or groups are in some way inferior solely because of a factor such as race, gender, or religion
first rule of labor markets
an employer will never pay a worker more than the value of the worker's marginal productivity to the firm
monopsony
a labor market where there is only one employer
perfectly competitive labor market
a labor market where neither suppliers of labor nor demanders of labor have any market power; thus, an employer can hire all the workers they would like at the going market wage
14.09: Key Concepts and Summary
14.1 The Theory of Labor Markets
A firm demands labor because of the value of the labor’s marginal productivity. For a firm operating in a perfectly competitive output market, this will be the value of the marginal product, which we define as the marginal product of labor multiplied by the firm’s output price. For a firm which is not perfectly competitive, the appropriate concept is the marginal revenue product, which we define as the marginal product of labor multiplied by the firm’s marginal revenue. Profit maximizing firms employ labor up to the point where the market wage is equal to the firm’s demand for labor. In a competitive labor market, we determine market wage through the interaction between the market supply and market demand for labor.
14.2 Wages and Employment in an Imperfectly Competitive Labor Market
A monopsony is the sole employer in a labor market. The monopsony can pay any wage it chooses, subject to the market supply of labor. This means that if the monopsony offers too low a wage, they may not find enough workers willing to work for them. Since to obtain more workers, they must offer a higher wage, the marginal cost of additional labor is greater than the wage. To maximize profits, a monopsonist will hire workers up to the point where the marginal cost of labor equals their labor demand. This results in a lower level of employment than a competitive labor market would provide, but also a lower equilibrium wage.
14.3 Market Power on the Supply Side of Labor Markets: Unions
A labor union is an organization of workers that negotiates as a group with employers over compensation and work conditions. Union workers in the United States are paid more on average than other workers with comparable education and experience. Thus, either union workers must be more productive to match this higher pay or the higher pay will lead employers to find ways of hiring fewer union workers than they otherwise would. American union membership has been falling for decades. Some possible reasons include the shift of jobs to service industries; greater competition from globalization; the passage of worker-friendly legislation; and U.S. laws that are less favorable to organizing unions.
14.4 Bilateral Monopoly
A bilateral monopoly is a labor market with a union on the supply side and a monopsony on the demand side. Since both sides have monopoly power, the equilibrium level of employment will be lower than that for a competitive labor market, but the equilibrium wage could be higher or lower depending on which side negotiates better. The union favors a higher wage, while the monopsony favors a lower wage, but the outcome is indeterminate in the model.
14.5 Employment Discrimination
Discrimination occurs in a labor market when employers pay workers with the same economic characteristics, such as education,experience, and skill, are paid different amounts because of race, gender, religion, age, or disability status. In the United States, female workers on average earn less than male workers, and Black workers on average earn less than White workers. There is controversy over to which discrimination differences in factors like education and job experience can explain these earnings gaps. Free markets can allow discrimination to occur, but the threat of a loss of sales or a loss of productive workers can also create incentives for a firm not to discriminate. A range of public policies can be used to reduce earnings gaps between men and women or between White and other racial/ethnic groups: requiring equal pay for equal work, and attaining more equal educational outcomes.
14.6 Immigration
The recent level of U.S. immigration is at a historically high level if we measure it in absolute numbers, but not if we measure it as a share of population. The overall gains to the U.S. economy from immigration are real but relatively small. However, immigration also causes effects like slightly lower wages for low-skill workers and budget problems for certain state and local governments. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/14%3A_Labor_Markets_and_Income/14.08%3A_Key_Terms.txt |
1.
Table 14.10 shows levels of employment (Labor), the marginal product at each of those levels, and the price at which the firm can sell output in the perfectly competitive market where it operates.
Labor Marginal Product of Labor Price of the Product
1 10 \$4
2 8 \$4
3 7 \$4
4 5 \$4
5 3 \$4
6 1 \$4
Table 14.10
1. What is the value of the marginal product at each level of labor?
2. If the firm operates in a perfectly competitive labor market where the going market wage is \$12, what is the firm’s profit maximizing level of employment?
2.
Table 14.11 shows levels of employment (Labor), the marginal product at each of those levels, and a monopoly’s marginal revenue.
Labor Marginal Product of Labor Price of the Product
1 10 \$10
2 8 \$7
3 7 \$5
4 5 \$4
5 3 \$2
6 1 \$1
Table 14.11
1. What is the monopoly’s marginal revenue product at each level of employment?
2. If the monopoly operates in a perfectly competitive labor market where the going market wage is \$20, what is the firm’s profit maximizing level of employment?
3.
Table 14.12 shows the quantity demanded and supplied in the labor market for driving city buses in the town of Unionville, where all the bus drivers belong to a union.
Wage Per Hour Quantity of Workers Demanded Quantity of Workers Supplied
\$14 12,000 6,000
\$16 10,000 7,000
\$18 8,000 8,000
\$20 6,000 9,000
\$22 4,000 10,000
\$24 2,000 11,000
Table 14.12
1. What would the equilibrium wage and quantity be in this market if no union existed?
2. Assume that the union has enough negotiating power to raise the wage to \$4 per hour higher than it would otherwise be. Is there now excess demand or excess supply of labor?
4.
Do unions typically oppose new technology out of a fear that it will reduce the number of union jobs? Why or why not?
5.
Compared with the share of workers in most other high-income countries, is the share of U.S. workers whose wages are determined by union bargaining higher or lower? Why or why not?
6.
Are firms with a high percentage of union employees more likely to go bankrupt because of the higher wages that they pay? Why or why not?
7.
Do countries with a higher percentage of unionized workers usually have less growth in productivity because of strikes and other disruptions caused by the unions? Why or why not?
8.
Table 14.13 shows information from the supply curve for labor for a monopsonist, that is, the wage rate required at each level of employment.
Labor Wage
1 1
2 3
3 5
4 7
5 8
6 10
Table 14.13
1. What is the monopsonist’s marginal cost of labor at each level of employment?
2. If each unit of labor’s marginal revenue product is \$13, what is the firm’s profit maximizing level of employment and wage?
9.
Explain in each of the following situations how market forces might give a business an incentive to act in a less discriminatory fashion.
1. A local flower delivery business that had intentionally served only White customers notices that many of the local residents are Black.
2. An assembly line has traditionally only hired men, but it is having a hard time hiring sufficiently qualified workers.
3. A relationship counselor who had a strict policy of only serving straight couples notes the significant increase of LGBTQ people moving into the town.
10.
Does the earnings gap between the average wages of females and the average wages of males prove labor market discrimination? Why or why not?
11.
If immigration is reduced, what is the impact on the wage for low-skilled labor? Explain. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/14%3A_Labor_Markets_and_Income/14.10%3A_Self-Check_Questions.txt |
12.
What determines the demand for labor for a firm operating in a perfectly competitive output market?
13.
What determines the demand for labor for a firm with market power in the output market?
14.
What is a perfectly competitive labor market?
15.
What is a labor union?
16.
Why do employers have a natural advantage in bargaining with employees?
17.
What are some of the most important laws that protect employee rights?
18.
How does the presence of a labor union change negotiations between employers and workers?
19.
What is the long-term trend in American union membership?
20.
Would you expect the presence of labor unions to lead to higher or lower pay for worker-members? Would you expect a higher or lower quantity of workers hired by those employers? Explain briefly.
21.
What are the main causes for the recent trends in union membership rates in the United States? Why are union rates lower in the United States than in many other developed countries?
22.
What is a monopsony?
23.
What is the marginal cost of labor?
24.
How does monopsony affect the equilibrium wage and employment levels?
25.
What is a bilateral monopoly?
26.
How does a bilateral monopoly affect the equilibrium wage and employment levels compared to a perfectly competitive labor market?
27.
Describe how the earnings gap between men and women has evolved in recent decades.
28.
Describe how the earnings gap between Black and White people has evolved in recent decades.
29.
Does a gap between the average earnings of men and women, or between White and Black people, prove that employers are discriminating in the labor market? Explain briefly.
30.
Will a free market tend to encourage or discourage discrimination? Explain briefly.
31.
What policies, when used together with antidiscrimination laws, might help to reduce the earnings gap between men and women or between White and Black workers?
32.
Describe how affirmative action is applied in the labor market.
33.
What factors can explain the relatively small effect of low-skilled immigration on the wages of low-skilled workers?
34.
Have levels of immigration to the United States been relatively high or low in recent years? Explain.
35.
How would you expect immigration by primarily low-skill workers to affect American low-skilled workers?
14.12: Critical Thinking Questions
36.
What is the marginal cost of labor for a firm that operates in a competitive labor market? How does this compare with the MCL for a monopsony?
37.
Given the decline in union membership over the past 50 years, what does the theory of bilateral monopoly suggest will have happened to the equilibrium level of wages over time? Why?
38.
Are unions and technological improvements complementary? Why or why not?
39.
Will union membership continue to decline? Why or why not?
40.
If it is not profitable to discriminate, why does discrimination persist?
41.
If a company has discriminated against minorities in the past, should it be required to give priority to minority applicants today? Why or why not?
42.
If the United States allows a greater quantity of highly skilled workers, what will be the impact on the average wages of highly skilled employees?
43.
If all countries eliminated all barriers to immigration, would global economic growth increase? Why or why not? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/14%3A_Labor_Markets_and_Income/14.11%3A_Review_Questions.txt |
Figure 15.1 Occupying Wall Street On September 17, 2011, Occupy Wall Street began in New York City’s Wall Street financial district. (Credit: modification of “Occupy Wall Street Day 2 2011 Shankbone” by David Shankbone/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Drawing the Poverty Line
• The Poverty Trap
• The Safety Net
• Income Inequality: Measurement and Causes
• Government Policies to Reduce Income Inequality
Bring It Home
Occupy Wall Street
In September 2011, a group of protesters gathered in Zuccotti Park in New York City to decry what they perceived as increasing social and economic inequality in the United States. Calling their protest “Occupy Wall Street,” they argued that the concentration of wealth among the richest 1% in the United States was both economically unsustainable and inequitable, and needed to be changed. The protest then spread to other major cities, and the Occupy movement was born.
Why were people so upset? How much wealth is concentrated among the top 1% in our society? How did they acquire so much wealth? These are very real, very important questions in the United States now, and this chapter on poverty and economic inequality will help us address the causes behind this sentiment.
The labor markets that determine the pay that workers receive do not take into account how much income a family needs for food, shelter, clothing, and health care. Market forces do not worry about what happens to families when a major local employer goes out of business. Market forces do not take time to contemplate whether those who are earning higher incomes should pay an even higher share of taxes.
However, labor markets do create considerable income inequalities. In 2020, the median American household income was \$67,521 (the median is the level where half of all families had more than that level and half had less). For family households, the median was \$86,372; for non-family households, it was \$40,464. The Census Bureau also reported that in 2020, there were 37.2 million people living in poverty, representing 11.4% of the population. Think about a family of three—perhaps a single mother with two children—attempting to pay for the basics of life on perhaps \$17,916 per year. After paying for rent, healthcare, clothing, and transportation, such a family might have \$6,000 to spend on food. Spread over 365 days, the food budget for the entire family would be about \$17 per day. To put this in perspective, most cities have restaurants where \$17 will buy you an appetizer for one.
This chapter explores how the U.S. government defines poverty, the balance between assisting the poor without discouraging work, and how federal antipoverty programs work. It also discusses income inequality—how economists measure inequality, why inequality has changed in recent decades, the range of possible government policies to reduce inequality, and the danger of a tradeoff that too great a reduction in inequality may reduce incentives for producing output.
15.02: Drawing the Poverty Line
Learning Objectives
By the end of this section, you will be able to:
• Explain economic inequality and how the poverty line is determined
• Analyze the U.S. poverty rate over time, noting its prevalence among different groups of citizens
Comparisons of high and low incomes raise two different issues: economic inequality and poverty. Poverty is measured by the number of people who fall below a certain level of income—called the poverty line—that defines the income one needs for a basic standard of living. Income inequality compares the share of the total income (or wealth) in society that different groups receive. For example, one of numerous ways to look at income inequality is to compare the share of income that the top 10% receive to the share of income that the bottom 10% receive.
In the United States, the official definition of the poverty line traces back to a single person: Mollie Orshansky. In 1963, Orshansky, who was working for the Social Security Administration, published an article called “Children of the Poor” in a highly useful and dry-as-dust publication called the Social Security Bulletin. Orshansky’s idea was to define a poverty line based on the cost of a healthy diet.
Her previous job had been at the U.S. Department of Agriculture, where she had worked in an agency called the Bureau of Home Economics and Human Nutrition. One task of this bureau had been to calculate how much it would cost to feed a nutritionally adequate diet to a family. Orshansky found that the average family spent one-third of its income on food. She then proposed that the poverty line be the amount one requires to buy a nutritionally adequate diet, given the size of the family, multiplied by three.
The current U.S. poverty line is essentially the same as the Orshansky poverty line, although the government adjusts the dollar amounts to represent the same buying power over time. The U.S. poverty line in 2021 ranged from \$12,880 for a single individual to \$26,500 for a household of four people.
Figure 15.2 shows the U.S. poverty rate over time; that is, the percentage of the population below the poverty line in any given year. The poverty rate declined through the 1960s, rose in the early 1980s and early 1990s, but seems to have been slightly lower since the mid-1990s. However, in no year in the last six decades has the poverty rate been less than 10.5% of the U.S. population—that is, at best almost one American in nine is below the poverty line. In recent years, the poverty rate peaked at 15.1% in 2010, before dropping to 10.5% in 2019. Table 15.1 compares poverty rates for different groups in 2011. As you will see when we delve further into these numbers, poverty rates are relatively low for White people, for the elderly, for the well-educated, and for male-headed households. Poverty rates for females, Hispanic people, and African Americans are much higher than for White people. While Hispanic people and African Americans have a higher percentage of individuals living in poverty than others, most people in the United States living below the poverty line are White people.
Link It Up
Visit this website for more information on U.S. poverty.
Figure 15.2 The U.S. Poverty Rate since 1960 The poverty rate fell dramatically during the 1960s, rose in the early 1980s and early 1990s, and, after declining in the 1990s through mid-2000s, rose to 15.1% in 2020, which is close to the 1960 levels. Between 2010 and 2019, the poverty rate declined to 10.5%, before rising to 11.4% in 2020 due to the onset of the COVID-19 pandemic in 2020. (Source: U.S. Census Bureau)
Group Poverty Rate
Females 12.6%
Males 10.2%
White (Non-Hispanic) 8.2%
Black 19.5%
Hispanic 17.0%
Under age 18 16.1%
Ages 18–64 10.4%
Ages 65+ 9.0%
Table 15.1 Poverty Rates by Group, 2020
The concept of a poverty line raises many tricky questions. In a vast country like the United States, should there be a national poverty line? After all, according to the Federal Register, the median household income for a family of four was \$109,113 in New Jersey and \$59,701 in Mississippi in 2017, and prices of some basic goods like housing are quite different between states. The poverty line is based on cash income, which means it does not account for government programs that provide non-cash assistance such as Medicaid (health care for low-income individuals and families) and food aid. Also, low-income families can qualify for federal housing assistance. (We will discuss these and other government aid programs in detail later in this chapter.)
Should the government adjust the poverty line to account for the value of such programs? Many economists and policymakers wonder whether we should rethink the concept of what poverty means in the twenty-first century. The following Clear It Up feature explains the poverty lines set by the World Bank for low-income countries around the world.
Clear It Up
How do economists measure poverty in low-income countries?
The World Bank sets two poverty lines for low-income countries around the world. One poverty line is set at an income of \$1.90/day per person. The other is at \$3.20/day. By comparison, the U.S. 2015 poverty line of \$20,090 annually for a family of three works out to \$18.35 per person per day.
Clearly, many people around the world are far poorer than Americans, as Table 15.2 shows. China and India both have more than a billion people; Nigeria is the most populous country in Africa; and Egypt is the most populous country in the Middle East. In all four of those countries, in the mid-2000s, a substantial share of the population subsisted on less than \$2/day. About half the world lives on less than \$2.50 a day, and 80 percent of the world lives on less than \$10 per day. (Of course, the cost of food, clothing, and shelter in those countries can be very different from those costs in the United States, so the \$2 and \$2.50 figures may mean greater purchasing power than they would in the United States.)
Country Year Percentage of Population with Income Less Than \$1.90/Day/Person Percentage of Population with Income Less Than \$3.20/Day/Person
Brazil 2019 4.6% 9.1%
China 2017 0.5% 5.4%
Egypt 2017 3.8% 28.9%
India 2011 22.5% 61.7%
Mexico 2018 1.7% 6.5%
Nigeria 2018 39.1% 71.0%
Table 15.2 Poverty Lines for Low-Income Countries, mid-2000s
Any poverty line will be somewhat arbitrary, and it is useful to have a poverty line whose basic definition does not change much over time. If Congress voted every few years to redefine poverty, then it would be difficult to compare rates over time. After all, would a lower poverty rate change the definition, or is it the case that people were actually better off? Government statisticians at the U.S. Census Bureau have ongoing research programs to address questions like these. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/15%3A_Poverty_and_Economic_Inequality/15.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the poverty trap, noting how government programs impact it
• Identify potential issues in government programs that seek to reduce poverty
• Calculate a budget constraint line that represents the poverty trap
Can you give people too much help, or the wrong kind of help? When people are provided with food, shelter, healthcare, income, and other necessities, assistance may reduce their incentive to work, particularly if their work is likely to offer low wages and reduce government assistance. Consider a program to fight poverty that works in this reasonable-sounding manner: the government provides assistance to the those who need it, but as the recipients earn income to support themselves, the government reduces the level of assistance it provides. With such a program, every time a person earns \$100, they lose \$100 in government support. As a result, the person experiences no net gain for working. Economists call this problem the poverty trap.
Consider the situation a single-parent family faces. Figure 15.3 illustrates a single mother (earning \$8 an hour) with two children. First, consider the labor-leisure budget constraint that this family faces in a situation without government assistance. On the horizontal axis is hours of leisure (or time spent with family responsibilities) increasing in quantity from left to right. Also on the horizontal axis is the number of hours at paid work, going from zero hours on the right to the maximum of 2,500 hours on the left. On the vertical axis is the amount of income per year rising from low to higher amounts of income. The budget constraint line shows that at zero hours of leisure and 2,500 hours of work, the maximum amount of income is \$20,000 (\$8 × 2,500 hours). At the other extreme of the budget constraint line, an individual would work zero hours, earn zero income, but enjoy 2,500 hours of leisure. At point A on the budget constraint line, by working 40 hours a week, 50 weeks a year, the utility-maximizing choice is to work a total of 2,000 hours per year and earn \$16,000.
Now suppose that a government antipoverty program guarantees every family with a single mother and two children \$18,000 in income. This is represented on the graph by a horizontal line at \$18,000. With this program, each time the mother earns \$1,000, the government will deduct \$1,000 of its support. Table 15.3 shows what will happen at each combination of work and government support.
Figure 15.3 The Poverty Trap in Action The original choice is 500 hours of leisure, 2,000 hours of work at point A, and income of \$16,000. With a guaranteed income of \$18,000, this family would receive \$18,000 whether it provides zero hours of work or 2,000 hours of work. Only if the family provides, say, 2,300 hours of work does its income rise above the guaranteed level of \$18,000—and even then, the marginal gain to income from working many hours is small.
Amount Worked (hours) Total Earnings Government Support Total Income
0 0 \$18,000 \$18,000
500 \$4,000 \$14,000 \$18,000
1,000 \$8,000 \$10,000 \$18,000
1,500 \$12,000 \$6,000 \$18,000
2,000 \$16,000 \$2,000 \$18,000
2,500 \$20,000 0 \$20,000
Table 15.3 Total Income at Various Combinations of Work and Support
The new budget line, with the antipoverty program in place, is the horizontal and heavy line that is flat at \$18,000. If the mother does not work at all, she receives \$18,000, all from the government. If she works full time, giving up 40 hours per week with her children, she still ends up with \$18,000 at the end of the year. Only if she works 2,300 hours in the year—which is an average of 44 hours per week for 50 weeks a year—does household income rise to \$18,400. Even in this case, all of her year’s work means that household income rises by only \$400 over the income she would receive if she did not work at all. She would need to work 50 hours a week to reach \$20,800.
The poverty trap is even stronger than this simplified example shows, because a working mother will have extra expenses like clothing, transportation, and child care that a nonworking mother will not face, making the economic gains from working even smaller. Moreover, those who do not work fail to build up job experience and contacts, which makes working in the future even less likely.
To reduce the poverty trap the government could design an antipoverty program so that, instead of reducing government payments by \$1 for every \$1 earned, the government would reduce payments by some smaller amount instead. Imposing requirements for work as a condition of receiving benefits and setting a time limit on benefits can also reduce the harshness of the poverty trap.
Figure 15.4 illustrates a government program that guarantees \$18,000 in income, even for those who do not work at all, but then reduces this amount by 50 cents for each \$1 earned. The new, higher budget line in Figure 15.4 shows that, with this program, additional hours of work will bring some economic gain. Because of the reduction in government income when an individual works, an individual earning \$8.00 will really net only \$4.00 per hour. The vertical intercept of this higher budget constraint line is at \$28,000 (\$18,000 + 2,500 hours × \$4.00 = \$28,000). The horizontal intercept is at the point on the graph where \$18,000 and 2500 hours of leisure is set. Table 15.4 shows the total income differences with various choices of labor and leisure.
However, this type of program raises other issues. First, even if it does not eliminate the incentive to work by reducing government payments by \$1 for every \$1 earned, enacting such a program may still reduce the incentive to work. At least some people who would be working 2,000 hours each year without this program might decide to work fewer hours but still end up with more income—that is, their choice on the new budget line would be like S, above and to the right of the original choice P. Of course, others may choose a point like R, which involves the same amount of work as P, or even a point to the left of R that involves more work.
The second major issue is that when the government phases out its support payments more slowly, the antipoverty program costs more money. Still, it may be preferable in the long run to spend more money on a program that retains a greater incentive to work, rather than spending less money on a program that nearly eliminates any gains from working.
Figure 15.4 Loosening the Poverty Trap: Reducing Government Assistance by 50 Cents for Every \$1 Earned On the original labor-leisure opportunity set, the lower, downward-sloping budget set, the preferred choice P is 500 hours of leisure and \$16,000 of income. Then, the government created an antipoverty program that guarantees \$18,000 in income even to those who work zero hours, shown by the hoizontal dashed line. In addition, every \$1 earned means phasing out 50 cents of benefits at \$18,000. This program leads to the higher budget set, which the diagram shows. The hope is that this program will provide incentives to work the same or more hours, despite receiving income assistance. However, it is possible that the recipients will choose a point on the new budget set like S, with less work, more leisure, and greater income, or a point like R, with the same work and greater income.
Amount Worked (hours) Total Earnings Government Support Total Income
0 0 \$18,000 \$18,000
500 \$4,000 \$16,000 \$20,000
1,000 \$8,000 \$14,000 \$22,000
1,500 \$12,000 \$12,000 \$24,000
2,000 \$16,000 \$10,000 \$26,000
2,500 \$20,000 \$8,000 \$28,000
Table 15.4 The Labor-Leisure Tradeoff with Assistance Reduced by 50 Cents for Every Dollar Earned
The next module will consider a variety of government support programs focused specifically on people experiencing poverty, including welfare, SNAP (Supplemental Nutrition Assistance Program), Medicaid, and the earned income tax credit (EITC). Although these programs vary from state to state, it is generally a true statement that in many states from the 1960s into the 1980s, if poor people worked, their level of income barely rose—or did not rise at all—after factoring in the reduction in government support payments. The following Work It Out feature shows how this happens. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/15%3A_Poverty_and_Economic_Inequality/15.03%3A_The_Poverty_Trap.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify the antipoverty government programs that comprise the safety net
• Explain the safety net programs' primary goals and how these programs have changed over time
• Discuss the complexities of these safety net programs and why they can be controversial
The U.S. government has implemented a number of programs to assist those below the poverty line and those who have incomes just above the poverty line. Such programs are called the safety net, to recognize that they offer some protection for those who find themselves without jobs or income.
Temporary Assistance for Needy Families
From the Great Depression until 1996, the United States’ most visible antipoverty program was Aid to Families with Dependent Children (AFDC), which provided cash payments to mothers with children who were below the poverty line. Many just called this program “welfare.” In 1996, Congress passed and President Bill Clinton signed into law the Personal Responsibility and Work Opportunity Reconciliation Act, more commonly called the “welfare reform act.” The new law replaced AFDC with Temporary Assistance for Needy Families (TANF).
Link It Up
Visit this website to watch a video of President Bill Clinton’s Welfare Reform speech.
TANF brought several dramatic changes in how welfare operated. Under the old AFDC program, states set the level of welfare benefits that they would pay to people experiencing poverty, and the federal government guaranteed it would chip in some of the money as well. The federal government’s welfare spending would rise or fall depending on the number of people in need, and on how each state set its own welfare contribution.
Under TANF, however, the federal government gives a fixed amount of money to each state. The state can then use the money for almost any program with an antipoverty component: for example, the state might use the money to give funds to families with low income, or to reduce teenage pregnancy, or even to raise the high school graduation rate. However, the federal government imposed two key requirements. First, if states are to keep receiving the TANF grants, they must impose work requirements so that most of those receiving TANF benefits are working (or attending school). Second, no one can receive TANF benefits with federal money for more than a total of five years over their lifetime. The old AFDC program had no such work requirements or time limits.
TANF attempts to avoid the poverty trap by requiring that welfare recipients work and by limiting the length of time they can receive benefits. In its first few years, the program was quite successful. The number of families receiving payments in 1995, the last year of AFDC, was 4.8 million. November 2020, according to the Congressional Research Service, the number of families receiving payments under TANF was 1.0 million—a decline of nearly 80%.
TANF benefits to poor families vary considerably across states. For example, again according to the Congressional Research Service, in July 2020 the highest monthly payment in New Hampshire to a single mother with one child was \$862, while in Mississippi the highest monthly payment to that family was \$146. In part, these payments reflect differences in states’ cost of living. As reported by the Department of Health and Human Services, in 1995 total spending on TANF was approximately \$19 billion. Spending increased yearly through 2001, then it was roughly flat at approximately \$26 billion until 2005, then it increased again through 2010, where it peaked at nearly \$35 billion. It then decreased again to around \$30 billion in 2020. When you take into account the effects of inflation, the decline is even greater. Moreover, there seemed little evidence that families were suffering a reduced standard of living as a result of TANF—although, on the other side, there was not much evidence that families had greatly improved their total levels of income, either.
The Earned Income Tax Credit (EITC)
The earned income tax credit (EITC), first passed in 1975, is a method of assisting the working poor through the tax system. The EITC is one of the largest assistance program for low-income groups, and as of December 2021, about 25 million eligible workers and families received about \$60 billion in EITC. For the 2021 tax year, the earned income credit ranges from \$1,502 to \$6,728 depending on tax-filing status, income, and number of children. The average amount of EITC received nationwide was about \$2,411. In 2021, for example, a single parent with two children would have received a tax credit of \$5,980 up to a modest income level. The amount of the tax break increases with the amount of income earned, up to a point. The earned income tax credit has often been popular with both economists and the general public because of the way it effectively increases the payment received for work.
What about the danger of the poverty trap that every additional \$1 earned will reduce government support payments by close to \$1? To minimize this problem, the earned income tax credit is phased out slowly. For example, according to the Tax Policy Center, for a single-parent family with two children in 2013, the credit is not reduced at all (but neither is it increased) as earnings rise from \$13,430 to \$17,530. Then, for every \$1 earned above \$17,530, the amount received from the credit is reduced by 21.06 cents, until the credit phases out completely at an income level of \$46,227.
Figure 15.5 illustrates that the earned income tax credits, child tax credits, and the TANF program all cost the federal government money—either in direct outlays or in loss of tax revenues. CTC stands for the government tax cuts for the child tax credit.
Figure 15.5 Real Federal Spending on CTC, EITC, and TANF, 1975–2016 EITC increased from under \$10 billion in the late 1980s to almost \$42 billion in 2000 and to over \$61 billion in 2016, far exceeding estimated 2016 outlays in the CTC (Child Tax Credits) and TANF of over \$25 billion and \$18 billion, respectively. (Source: Office of Management and Budget)
In recent years, the EITC has become a hugely expensive government program for providing income assistance to people below or near the poverty line, costing about \$60 billion in 2021. In that year, the EITC provided benefits to about 25 million families and individuals and, on average, is worth about \$2,411 per family (with children), according to the Tax Policy Center. One reason that the TANF law worked as well as it did is that the government greatly expanded EITC in the late 1980s and again in the early 1990s, which increased the returns to work for low-income Americans.
Supplemental Nutrition Assistance Program (SNAP)
Often called “food stamps,” Supplemental Nutrition Assistance Program (SNAP) is a federally funded program, started in 1964, in which each month people receive a card like a debit card that they can use to buy food. The amount of food aid for which a household is eligible varies by income, number of children, and other factors but, in general, households are expected to spend about 30% of their own net income on food, and if 30% of their net income is not enough to purchase a nutritionally adequate diet, then those households are eligible for SNAP.
SNAP can contribute to the poverty trap. For every \$100 earned, the government assumes that a family can spend \$30 more for food, and thus reduces its eligibility for food aid by \$30. This decreased benefit is not a complete disincentive to work—but combined with how other programs reduce benefits as income increases, it adds to the problem. SNAP, however, does try to address the poverty trap with its own set of work requirements and time limits.
Why give debit cards and not just cash? Part of the political support for SNAP comes from a belief that since recipients must spend the the cards on food, they cannot “waste” them on other forms of consumption. From an economic point of view, however, the belief that cards must increase spending on food seems wrong-headed. After all, say that a family is spending \$2,500 per year on food, and then it starts receiving \$1,000 per year in SNAP aid. The family might react by spending \$3,500 per year on food (income plus aid), or it might react by continuing to spend \$2,500 per year on food, but use the \$1,000 in food aid to free up \$1,000 that it can now spend on other goods. Thus, it is reasonable to think of SNAP cards as an alternative method, along with TANF and the earned income tax credit, of transferring income to those working but still experiencing poverty.
Anyone eligible for TANF is also eligible for SNAP, although states can expand eligibility for food aid if they wish to do so. In some states, where TANF welfare spending is relatively low, a poor family may receive more in support from SNAP than from TANF. In 2021, about 41.5 million people received food aid with total benefits of just over \$108 billion, which is an average monthly benefit of about \$287 per person per month. SNAP participation increased by 70% between 2007 and 2011, from 26.6 million participants to 45 million. According to the Congressional Budget Office, the 2008-2009 Great Recession and rising food prices caused this dramatic rise in participation. Likewise, between 2019 and 2021, the number of participants in SNAP increased by 5.8 million, the amount per person increased by 67%, and total benefits nearly doubled as a consequence of the sharp recession due to the onset of the COVID-19 pandemic in early 2020.
The federal government deploys a range of income security programs that it funds through departments such as Health and Human Services, Agriculture, and Housing and Urban Development (HUD) (see Figure 15.6). According to the Office of Management and Budget, collectively, these three departments provided an estimated \$62 billion of aid through programs such as supplemental feeding programs for women and children, subsidized housing, and energy assistance. The federal government also transfers funds to individual states through special grant programs.
Figure 15.6 Expenditure Comparison of TANF, SNAP, HUD, and Other Income Security Programs, 1988–2013 (est.) Total expenditures on income security continued to rise between 1988 and 2010, while payments for TANF have increased from \$13 billion in 1998 to an estimated \$17.3 billion in 2013. SNAP has seen relatively small increments. These two programs comprise a relatively small portion of the estimated \$106 billion dedicated to income security in 2013. Note that other programs and housing programs increased dramatically during the 2008 and 2010 time periods. (Source: Table 12.3 Section 600 Income Security, www.whitehouse.gov/sites/def...ssets/hist.pdf)
The safety net includes a number of other programs: government-subsidized school lunches and breakfasts for children from low-income families; the Special Supplemental Food Program for Women, Infants and Children (WIC), which provides food assistance for pregnant women and newborns; the Low Income Home Energy Assistance Program, which provides help with home heating bills; housing assistance, which helps pay the rent; and Supplemental Security Income, which provides cash support for people with disabilities and elderly people experiencing poverty.
Medicaid
Congress created Medicaid in 1965. This is a joint health insurance program between both the states and the federal government. The federal government helps fund Medicaid, but each state is responsible for administering the program, determining the level of benefits, and determining eligibility. It provides medical insurance for certain people with low incomes, including those below the poverty line, with a focus on families with children, the elderly, and people with disabilities. About one-third of Medicaid spending is for low-income mothers with children. While an increasing share of the program funding in recent years has gone to pay for nursing home costs for older people who cannot afford to pay for housing. The program ensures that participants receive a basic level of benefits, but because each state sets eligibility requirements and provides varying levels of service, the program differs from state to state.
In the past, a common problem has been that many low-paying jobs pay enough to a breadwinner so that a family could lose its eligibility for Medicaid, yet the job does not offer health insurance benefits. A parent considering such a job might choose not to work rather than lose health insurance for their children. In this way, health insurance can become a part of the poverty trap. Many states recognized this problem in the 1980s and 1990s and expanded their Medicaid coverage to include people earning up to 135% or even 185% of the poverty line. Some states also guaranteed that children would not lose coverage if their parents worked.
These expanded guarantees cost the government money, of course, but they also helped to encourage those on welfare to enter the labor force. As of 2014, approximately 69.7 million people participated in Medicaid. Of those enrolled, almost half are children. Healthcare expenditures, however, are highest for the elderly population, which comprises approximately 25% of participants. As Figure 15.7 (a) indicates, the largest number of households that enroll in Medicaid are those with children. Lower-income adults are the next largest group enrolled in Medicaid at 28%. People who are blind or have a disability account for 16% of those enrolled, and seniors are 9% of those enrolled. Figure 15.7 (b) shows how much actual Medicaid dollars the government spends for each group. Out of total Medicaid spending, the government spends more on seniors (20%) and people who are blind or have a disability (44%). Thus, 64% of all Medicaid spending goes to seniors, those who are blind, and people with disabilities. Children receive 21% of all Medicaid spending, followed by adults at 15%.
Figure 15.7 Medicaid Enrollment and Spending Part (a) shows the Medicaid enrollment by different populations, with children comprising the largest percentage at 47%, followed by adults at 28%, and those who are blind or have a disability at 16%. Part (b) shows that Medicaid spending is principally for those who are blind or have a disability, followed by the elderly. Although children are the largest population that Medicaid covers, expenditures on children are only at 19%. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/15%3A_Poverty_and_Economic_Inequality/15.04%3A_The_Safety_Net.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the distribution of income, and analyze the sources of income inequality in a market economy
• Measure income distribution in quintiles
• Calculate and graph a Lorenz curve
• Show income inequality through demand and supply diagrams
Poverty levels can be subjective based on the overall income levels of a country. Typically a government measures poverty based on a percentage of the median income. Income inequality, however, has to do with the distribution of that income, in terms of which group receives the most or the least income. Income inequality involves comparing those with high incomes, middle incomes, and low incomes—not just looking at those below or near the poverty line. In turn, measuring income inequality means dividing the population into various groups and then comparing the groups, a task that we can be carry out in several ways, as the next Clear It Up feature shows.
Clear It Up
How do you separate poverty and income inequality?
Poverty can change even when inequality does not move at all. Imagine a situation in which income for everyone in the population declines by 10%. Poverty would rise, since a greater share of the population would now fall below the poverty line. However, inequality would be the same, because everyone suffered the same proportional loss. Conversely, a general rise in income levels over time would keep inequality the same, but reduce poverty.
It is also possible for income inequality to change without affecting the poverty rate. Imagine a situation in which a large number of people who already have high incomes increase their incomes by even more. Inequality would rise as a result—but the number of people below the poverty line would remain unchanged.
Why did inequality of household income increase in the United States in recent decades? A trend toward greater income inequality has occurred in many countries around the world, although the effect has been more powerful in the U.S. economy. Economists have focused their explanations for the increasing inequality on two factors that changed more or less continually from the 1970s into the 2000s. One set of explanations focuses on the changing shape of American households. The other focuses on greater inequality of wages, what some economists call “winner take all” labor markets. We will begin with how we measure inequality, and then consider the explanations for growing inequality in the United States.
Measuring Income Distribution by Quintiles
One common way of measuring income inequality is to rank all households by income, from lowest to highest, and then to divide all households into five groups with equal numbers of people, known as quintiles. This calculation allows for measuring the distribution of income among the five groups compared to the total. The first quintile is the lowest fifth or 20%, the second quintile is the next lowest, and so on. We can measure income inequality by comparing what share of the total income each quintile earns.
U.S. income distribution by quintile appears in Table 15.5. In 2020, for example, the bottom quintile of the income distribution received 3.2% of income; the second quintile received 8.1%; the third quintile, 14.0%; the fourth quintile, 22.6%; and the top quintile, 52.2%. The final column of Table 15.5 shows what share of income went to households in the top 5% of the income distribution: 23.0% in 2020. Over time, from the late 1960s to the early 1980s, the top fifth of the income distribution typically received between about 43% to 44% of all income. The share of income that the top fifth received then begins to rise. Census Bureau researchers trace, much of this increase in the share of income going to the top fifth to an increase in the share of income going to the top 5%. The quintile measure shows how income inequality has increased in recent decades.
Year Lowest Quintile Second Quintile Third Quintile Fourth Quintile Highest Quintile Top 5%
1967 4.0 10.8 17.3 24.2 43.6 17.2
1970 4.1 10.8 17.4 24.5 43.3 16.6
1975 4.3 10.4 17.0 24.7 43.6 16.5
1980 4.2 10.2 16.8 24.7 44.1 16.5
1985 3.9 9.8 16.2 24.4 45.6 17.6
1990 3.8 9.6 15.9 24.0 46.6 18.5
1995 3.7 9.1 15.2 23.3 48.7 21.0
2000 3.6 8.9 14.8 23.0 49.8 22.1
2005 3.4 8.6 14.6 23.0 50.4 22.2
2010 3.3 8.5 14.6 23.4 50.3 21.3
2015 3.1 8.2 14.3 23.2 51.1 22.1
2020 3.0 8.1 14.0 22.6 52.2 23.0
Table 15.5 Share of Aggregate Income Received by Each Fifth and Top 5% of Households, 1967–2020 (Source: U.S. Census Bureau, https://www.census.gov/data/tables/t...ouseholds.html, Table H-1, All Races.)
It can also be useful to divide the income distribution in ways other than quintiles; for example, into tenths or even into percentiles (that is, hundredths). A more detailed breakdown can provide additional insights. For example, the last column of Table 15.5 shows the income received by the top 5% of the income distribution. Between 1980 and 2020, the share of income going to the top 5% increased by 6.5 percentage points (from 16.5% in 1980 to 23.0% in 2020). From 1980 to 2020 the share of income going to the top quintile increased by 8.1 percentage points (from 44.1% in 1980 to 52.2% in 2013). Thus, the top 20% of householders (the fifth quintile) received over half (51%) of all the income in the United States in 2020.
Lorenz Curve
We can present the data on income inequality in various ways. For example, you could draw a bar graph that showed the share of income going to each fifth of the income distribution. Figure 15.8 presents an alternative way of showing inequality data in a Lorenz curve. This curve shows the cumulative share of population on the horizontal axis and the cumulative percentage of total income received on the vertical axis.
Figure 15.8 The Lorenz Curve A Lorenz curve graphs the cumulative shares of income received by everyone up to a certain quintile. The income distribution in 1980 was closer to the perfect equality line than the income distribution in 2020—that is, the U.S. income distribution became more unequal over time.
Every Lorenz curve diagram begins with a line sloping up at a 45-degree angle. We show it as a dashed line in Figure 15.8. The points along this line show what perfect equality of the income distribution looks like. It would mean, for example, that the bottom 20% of the income distribution receives 20% of the total income, the bottom 40% gets 40% of total income, and so on. The other lines reflect actual U.S. data on inequality for 1980 and 2020.
The trick in graphing a Lorenz curve is that you must change the shares of income for each specific quintile, which we show in the first and third columns of numbers in Table 15.6, into cumulative income, which we show in the second and fourth columns of numbers. For example, the bottom 40% of the cumulative income distribution will be the sum of the first and second quintiles; the bottom 60% of the cumulative income distribution will be the sum of the first, second, and third quintiles, and so on. The final entry in the cumulative income column needs to be 100%, because by definition, 100% of the population receives 100% of the income.
Income Category Share of Income in 1980 (%) Cumulative Share of Income in 1980 (%) Share of Income in 2020 (%) Cumulative Share of Income in 2020 (%)
First quintile 4.2 4.2 3.0 3.0
Second quintile 10.2 14.4 8.1 11.1
Third quintile 16.8 31.2 14.0 25.1
Fourth quintile 24.7 55.9 22.6 47.7
Fifth quintile 44.1 100.0 52.2 100.0
Table 15.6 Calculating the Lorenz Curve
In a Lorenz curve diagram, a more unequal distribution of income will loop farther down and away from the 45-degree line, while a more equal distribution of income will move the line closer to the 45-degree line. Figure 15.8 illustrates the greater inequality of the U.S. income distribution between 1980 and 2020 because the Lorenz curve for 2020 is farther from the 45-degree line than the Lorenz curve for 1980. The Lorenz curve is a useful way of presenting the quintile data that provides an image of all the quintile data at once. The next Clear It Up feature shows how income inequality differs in various countries compared to the United States.
Clear It Up
How does economic inequality vary around the world?
The U.S. economy has a relatively high degree of income inequality by global standards. As Table 15.7 shows, based on a variety of national surveys for a selection of years in the second decade of this century, the U.S. economy has greater inequality than Germany (along with most Western European countries). The region of the world with the highest level of income inequality is Latin America, illustrated in the numbers for Brazil and Mexico. The level of inequality in the United States is higher than in some of the low-income countries of the world, like India and Nigeria, as well as in some middle-income countries, like China and Russia.
Country Survey Year First Quintile Second Quintile Third Quintile Fourth Quintile Fifth Quintile
United States 2020 3.0% 8.1% 14.0% 22.6% 52.2%
Germany 2016 7.6% 12.8% 17.1% 22.8% 39.6%
Brazil 2019 3.1% 7.4% 12.3% 19.4% 57.8%
Mexico 2018 5.4% 9.5% 13.5% 20.0% 51.7%
China 2016 6.5% 10.7% 15.3% 22.2% 45.3%
India 2011 8.1% 11.7% 15.2% 20.5% 44.4%
Russia 2018 7.1% 11.2% 15.2% 21.4% 45.1%
Nigeria 2018 7.1% 11.6% 16.2% 22.7% 42.4%
Table 15.7 Income Distribution in Select Countries (Source: U.S. data from U.S. Census Bureau Table H-1. Other data from The World Bank Poverty and Inequality Data Base, https://datatopics.worldbank.org/wor...nequality.html)
Link It Up
Visit this website to watch a video of wealth inequality across the world.
Causes of Growing Inequality: The Changing Composition of American Households
In 1970, 41% of married women were in the labor force, but by 2019, according to the Bureau of Labor Statistics, 58.6% of married women were in the labor force. One result of this trend is that more households have two earners. Moreover, it has become more common for one high earner to marry another high earner. A few decades ago, the common pattern featured a man with relatively high earnings, such as an executive or a doctor, marrying a woman who did not earn as much, like a secretary or a nurse. Often, the woman would leave paid employment, at least for a few years, to raise a family. However, now doctors are marrying doctors and executives are marrying executives, and mothers with high-powered careers are often returning to work while their children are quite young. This pattern of households with two high earners tends to increase the proportion of high-earning households.
According to data in the National Journal, even as two-earner couples have increased, so have single-parent households. Of all U.S. families, in 2021, about 23% were headed by single mothers. The poverty rate among single-parent households tends to be relatively high.
These changes in family structure, including the growth of single-parent families who tend to be at the lower end of the income distribution, and the growth of two-career high-earner couples near the top end of the income distribution, account for roughly half of the rise in income inequality across households in recent decades.
Link It Up
Visit this website to watch a video that illustrates the distribution of wealth in the United States.
Causes of Growing Inequality: A Shift in the Distribution of Wages
Another factor behind the rise in U.S. income inequality is that earnings have become less equal since the late 1970s. In particular, the earnings of high-skilled labor relative to low-skilled labor have increased. Winner-take-all labor markets result from changes in technology, which have increased global demand for “stars,”—whether the best CEO, doctor, basketball player, or actor. This global demand pushes salaries far above productivity differences associated with educational differences. One way to measure this change is to take workers' earnings with at least a four-year college bachelor’s degree (including those who went on and completed an advanced degree) and divide them by workers' earnings with only a high school degree. The result is that those in the 25–34 age bracket with college degrees earned about 1.85 times as much as high school graduates in 2020, up from 1.59 times in 1995, according to U.S. Census data. Winner-take-all labor market theory argues that the salary gap between the median and the top 1 percent is not due to educational differences.
Economists use the demand and supply model to reason through the most likely causes of this shift. According to the National Center for Education Statistics, in recent decades, the supply of U.S. workers with college degrees has increased substantially. For example, 840,000 four-year bachelor’s degrees were conferred on Americans in 1970. In 2018–2019, 2.0 million such degrees were conferred—an increase of over 138%. In Figure 15.9, this shift in supply to the right, from S0 to S1, by itself should result in a lower equilibrium wage for high-skilled labor. Thus, we can explain the increase in the price of high-skilled labor by a greater demand, like the movement from D0 to D1. Evidently, combining both the increase in supply and in demand has resulted in a shift from E0 to E1, and a resulting higher wage.
Figure 15.9 Why Would Wages Rise for High-Skilled Labor? The proportion of workers attending college has increased in recent decades, so the supply curve for high-skilled labor has shifted to the right, from S0 to S1. If the demand for high-skilled labor had remained at D0, then this shift in supply would have led to lower wages for high-skilled labor. However, the wages for high-skilled labor, especially if there is a large global demand, have increased even with the shift in supply to the right. The explanation must lie in a shift to the right in demand for high-skilled labor, from D0 to D1. The figure shows how a combination of the shift in supply, from S0 to S1, and the shift in demand, from D0 to D1, led to both an increase in the quantity of high-skilled labor hired and also to a rise in the wage for such labor, from W0 to W1.
What factors would cause the demand for high-skilled labor to rise? The most plausible explanation is that while the explosion in new information and communications technologies over the last several decades has helped many workers to become more productive, the benefits have been especially great for high-skilled workers like top business managers, consultants, and design professionals. The new technologies have also helped to encourage globalization, the remarkable increase in international trade over the last few decades, by making it more possible to learn about and coordinate economic interactions all around the world. In turn, the rising impact of foreign trade in the U.S. economy has opened up greater opportunities for high-skilled workers to sell their services around the world, and lower-skilled workers have to compete with a larger supply of similarly skilled workers around the globe.
We can view the market for high-skilled labor as a race between forces of supply and demand. Additional education and on-the-job training will tend to increase the high-skilled labor supply and to hold down its relative wage. Conversely, new technology and other economic trends like globalization tend to increase the demand for high-skilled labor and push up its relative wage. We can view the greater inequality of wages as a sign that demand for skilled labor is increasing faster than supply. Alternatively, if the supply of lower skilled workers exceeds the demand, then average wages in the lower quintiles of the income distribution will decrease. The combination of forces in the high-skilled and low-skilled labor markets leads to increased income disparity. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/15%3A_Poverty_and_Economic_Inequality/15.05%3A_Income_Inequality-_Measurement_and_Causes.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the arguments for and against government intervention in a market economy
• Identify beneficial ways to reduce the economic inequality in a society
• Show the tradeoff between incentives and income equality
No society should expect or desire complete equality of income at a given point in time, for a number of reasons. First, most workers receive relatively low earnings in their first few jobs, higher earnings as they reach middle age, and then lower earnings after retirement. Thus, a society with people of varying ages will have a certain amount of income inequality. Second, people’s preferences and desires differ. Some are willing to work long hours to have income for large houses, fast cars and computers, luxury vacations, and the ability to support children and grandchildren.
These factors all imply that a snapshot of inequality in a given year does not provide an accurate picture of how people’s incomes rise and fall over time. Even if we expect some degree of economic inequality at any point in time, how much inequality should there be? There is also the difference between income and wealth, as the following Clear It Up feature explains.
Clear It Up
How do you measure wealth versus income inequality?
Income is a flow of money received, often measured on a monthly or an annual basis. Wealth is the sum of the value of all assets, including money in bank accounts, financial investments, a pension fund, and the value of a home. In calculating wealth, one must subtract all debts, such as debt owed on a home mortgage and on credit cards. A retired person, for example, may have relatively little income in a given year, other than a pension or Social Security. However, if that person has saved and invested over time, the person’s accumulated wealth can be quite substantial.
In the United States, the wealth distribution is more unequal than the income distribution, because differences in income can accumulate over time to make even larger differences in wealth. However, we can measure the degree of inequality in the wealth distribution with the same tools we use to measure the inequality in the income distribution, like quintile measurements. Once every three years the Federal Reserve Bank publishes the Survey of Consumer Finance which reports a collection of data on wealth.
Even if they cannot answer the question of how much inequality is too much, economists can still play an important role in spelling out policy options and tradeoffs. If a society decides to reduce the level of economic inequality, it has three main sets of tools: redistribution from those with high incomes to those with low incomes; trying to assure that a ladder of opportunity is widely available; and a tax on inheritance.
Redistribution
Redistribution means taking income from those with higher incomes and providing income to those with lower incomes. Earlier in this chapter, we considered some of the key government policies that provide support for people experiencing poverty: the welfare program TANF, the earned income tax credit, SNAP, and Medicaid. If a reduction in inequality is desired, these programs could receive additional funding.
The federal income tax, which is a progressive tax system designed in such a way that the rich pay a higher percent in income taxes than the poor, funds the programs. Data from household income tax returns in 2018 shows that the top 1% of households had an average income of \$1,679,000 per year in pre-tax income and paid an average federal tax rate of 25.4%. The effective income tax, which is total taxes paid divided by total income (all sources of income such as wages, profits, interest, rental income, and government transfers such as veterans’ benefits), was much lower. The effective tax paid by that top 1% of householders paid was 20.4%, while the bottom two quintiles actually paid negative effective income taxes, because of provisions like the earned income tax credit. News stories occasionally report on a high-income person who has managed to pay very little in taxes, but while such individual cases exist, according to the Congressional Budget Office, the typical pattern is that people with higher incomes pay a higher average share of their income in federal income taxes.
Of course, the fact that some degree of redistribution occurs now through the federal income tax and government antipoverty programs does not settle the questions of how much redistribution is appropriate, and whether more redistribution should occur.
The Ladder of Opportunity
Economic inequality is perhaps most troubling when it is not the result of effort or talent, but instead is determined by the circumstances under which a child grows up. One child attends a well-run grade school and high school and heads on to college, while parents help out by supporting education and other interests, paying for college, a first car, and a first house, and offering work connections that lead to internships and jobs. Another child attends a poorly run grade school, barely makes it through a low-quality high school, does not go to college, and lacks family and peer support. These two children may be similar in their underlying talents and in the effort they put forth, but their economic outcomes are likely to be quite different.
Public policy can attempt to build a ladder of opportunities so that, even though all children will never come from identical families and attend identical schools, each child has a reasonable opportunity to attain an economic niche in society based on their interests, desires, talents, and efforts. Table 15.8 shows some of those initiatives.
Children College Level Adults
• Improved day care • Widespread loans and grants for those in financial need • Opportunities for retraining and acquiring new skills
• Enrichment programs for preschoolers • Public support for a range of institutions from two-year community colleges to large research universities • Prohibiting discrimination in job markets and housing on the basis of race, gender, age, and disability
• Improved public schools - -
• After school and community activities - -
• Internships and apprenticeships - -
Table 15.8 Public Policy Initiatives
Some have called the United States a land of opportunity. Although the general idea of a ladder of opportunity for all citizens continues to exert a powerful attraction, specifics are often quite controversial. Society can experiment with a wide variety of proposals for building a ladder of opportunity, especially for those who otherwise seem likely to start their lives in a disadvantaged position. The government needs to carry out such policy experiments in a spirit of open-mindedness, because some will succeed while others will not show positive results or will cost too much to enact on a widespread basis.
Inheritance Taxes
There is always a debate about inheritance taxes. It goes like this: Why should people who have worked hard all their lives and saved up a substantial nest egg not be able to give their money and possessions to their children and grandchildren? In particular, it would seem un-American if children were unable to inherit a family business or a family home. Alternatively, many Americans are far more comfortable with inequality resulting from high-income people who earned their money by starting innovative new companies than they are with inequality resulting from high-income people who have inherited money from rich parents.
The United States does have an estate tax—that is, a tax imposed on the value of an inheritance—which suggests a willingness to limit how much wealth one can pass on as an inheritance. However, in 2022 the estate tax applied only to those leaving inheritances of more than \$12.06 million and thus applies to only a tiny percentage of those with high levels of wealth.
The Tradeoff between Incentives and Income Equality
Government policies to reduce poverty or to encourage economic equality, if carried to extremes, can injure incentives for economic output. The poverty trap, for example, defines a situation where guaranteeing a certain level of income can eliminate or reduce the incentive to work. An extremely high degree of redistribution, with very high taxes on the rich, would be likely to discourage work and entrepreneurship. Thus, it is common to draw the tradeoff between economic output and equality, as Figure 15.10 (a) shows. In this formulation, if society wishes a high level of economic output, like point A, it must also accept a high degree of inequality. Conversely, if society wants a high level of equality, like point B, it must accept a lower level of economic output because of reduced incentives for production.
This view of the tradeoff between economic output and equality may be too pessimistic, and Figure 15.10 (b) presents an alternate vision. Here, the tradeoff between economic output and equality first slopes up, in the vicinity of choice C, suggesting that certain programs might increase both output and economic equality. For example, the policy of providing free public education has an element of redistribution, since the value of the public schooling received by children of low-income families is clearly higher than what low-income families pay in taxes. A well-educated population, however, is also an enormously powerful factor in providing the skilled workers of tomorrow and helping the economy to grow and expand. In this case, equality and economic growth may complement each other.
Moreover, policies to diminish inequality and soften the hardship of poverty may sustain political support for a market economy. After all, if society does not make some effort toward reducing inequality and poverty, the alternative might be that people would rebel against market forces. Citizens might seek economic security by demanding that their legislators pass laws forbidding employers from ever laying off workers or reducing wages, or laws that would impose price floors and price ceilings and shut off international trade. From this viewpoint, policies to reduce inequality may help economic output by building social support for allowing markets to operate.
Figure 15.10 The Tradeoff between Incentives and Economic Equality (a) Society faces a trade-off where any attempt to move toward greater equality, like moving from choice A to B, involves a reduction in economic output. (b) Situations can arise like point C, where it is possible both to increase equality and also to increase economic output, to a choice like D. It may also be possible to increase equality with little impact on economic output, like the movement from choice D to E. However, at some point, too aggressive a push for equality will tend to reduce economic output, as in the shift from E to F.
The tradeoff in Figure 15.10 (b) then flattens out in the area between points D and E, which reflects the pattern that a number of countries that provide similar levels of income to their citizens—the United States, Canada, European Union nations, Japan, and Australia—have different levels of inequality. The pattern suggests that countries in this range could choose a greater or a lesser degree of inequality without much impact on economic output. Only if these countries push for a much higher level of equality, like at point F, will they experience the diminished incentives that lead to lower levels of economic output. In this view, while a danger always exists that an agenda to reduce poverty or inequality can be poorly designed or pushed too far, it is also possible to discover and design policies that improve equality and do not injure incentives for economic output by very much—or even improve such incentives.
Bring It Home
Occupy Wall Street
The Occupy movement took on a life of its own over the last few months of 2011, bringing to light issues that many people faced on the lower end of the income distribution. The contents of this chapter indicate that there is a significant amount of income inequality in the United States. The question is: What should be done about it?
The 2008-2009 Great Recession caused unemployment to rise and incomes to fall. Many people attribute the recession to mismanagement of the financial system by bankers and financial managers—those in the 1% of the income distribution—but those in lower quintiles bore the greater burden of the recession through unemployment. This seemed to present the picture of inequality in a different light: the group that seemed responsible for the recession was not the group that seemed to bear the burden of the decline in output. A burden shared can bring a society closer together. A burden pushed off onto others can polarize it.
On one level, the problem with trying to reduce income inequality comes down to whether you still believe in the American Dream. If you believe that one day you will have your American Dream—a large income, large house, happy family, or whatever else you would like to have in life—then you do not necessarily want to prevent anyone else from living out their dream. You certainly would not want to run the risk that someone would want to take part of your dream away from you. Thus, there is some reluctance to engage in a redistributive policy to reduce inequality.
However, when those for whom the likelihood of living the American Dream is very small are considered, there are sound arguments in favor of trying to create greater balance. As the text indicated, a little more income equality, gained through long-term programs like increased education and job training, can increase overall economic output. Then everyone is made better off, and the 1% will not seem like such a small group any more. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/15%3A_Poverty_and_Economic_Inequality/15.06%3A_Government_Policies_to_Reduce_Income_Inequality.txt |
earned income tax credit (EITC)
a method of assisting the working poor through the tax system
effective income tax
percentage of total taxes paid divided by total income
estate tax
a tax imposed on the value of an inheritance
income
a flow of money received, often measured on a monthly or an annual basis
income inequality
when one group receives a disproportionate share of total income or wealth than others
Lorenz curve
a graph that compares the cumulative income actually received to a perfectly equal distribution of income; it shows the share of population on the horizontal axis and the cumulative percentage of total income received on the vertical axis
Medicaid
a federal–state joint program enacted in 1965 that provides medical insurance for certain (not all) people with a low-income, including those near the poverty line as well as those below the poverty line, and focusing on low-income families with children, the low-income elderly, and people with disabilities
poverty
the situation of being below a certain level of income one needs for a basic standard of living
poverty line
the specific amount of income one requires for a basic standard of living
poverty rate
percentage of the population living below the poverty line
poverty trap
antipoverty programs set up so that government benefits decline substantially as people earn more income—as a result, working provides little financial gain
progressive tax system
a tax system in which the rich pay a higher percentage of their income in taxes, rather than a higher absolute amount
quintile
dividing a group into fifths, a method economists often use to look at distribution of income
redistribution
taking income from those with higher incomes and providing income to those with lower incomes
safety net
the group of government programs that provide assistance to people at or near the poverty line
Supplemental Nutrition Assistance Program (SNAP)
a federally funded program, started in 1964, in which each month poor people receive SNAP cards they can use to buy food
wealth
the sum of the value of all assets, including money in bank accounts, financial investments, a pension fund, and the value of a home
15.08: Key Concepts and Summary
15.1 Drawing the Poverty Line
Wages are influenced by Supply and demand in labor markets influence wages. This can lead to very low incomes for some people and very high incomes for others. Poverty and income inequality are not the same thing. Poverty applies to the condition of people who cannot afford the necessities of life. Income inequality refers to the disparity between those with higher and lower incomes. The poverty rate is what percentage of the population lives below the poverty line, which the amount of income that it takes to purchase the necessities of life determines. Choosing a poverty line will always be somewhat controversial.
15.2 The Poverty Trap
A poverty trap occurs when government-support payments decline as the recipients earn more income. As a result, the recipients do not end up with much more income when they work, because the loss of government support largely or completely offsets any income that one earns by working. Phasing out government benefits more slowly, as well as imposing requirements for work as a condition of receiving benefits and a time limit on benefits can reduce the harshness of the poverty trap.
15.3 The Safety Net
We call the group of government programs that address poverty the safety net. In the United States, prominent safety net programs include Temporary Assistance to Needy Families (TANF), the Supplemental Nutrition Assistance Program (SNAP), the earned income tax credit (EITC), Medicaid, and the Special Supplemental Food Program for Women, Infants, and Children (WIC).
15.4 Income Inequality: Measurement and Causes
Measuring inequality involves making comparisons across the entire distribution of income. One way of doing this is to divide the population into groups, like quintiles, and then calculate what share of income each group receives. An alternative approach is to draw Lorenz curves, which compare the cumulative income actually received to a perfectly equal distribution of income. Income inequality in the United States increased substantially from the late 1970s and early 1980s into the 2000s. The two most common explanations that economists cite are changes in household structures that have led to more two-earner couples and single-parent families, and the effect of new information and communications technology on wages.
15.5 Government Policies to Reduce Income Inequality
Policies that can affect the level of economic inequality include redistribution between rich and poor, making it easier for people to climb the ladder of opportunity; and estate taxes, which are taxes on inheritances. Pushing too aggressively for economic equality can run the risk of decreasing economic incentives. However, a moderate push for economic equality can increase economic output, both through methods like improved education and by building a base of political support for market forces. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/15%3A_Poverty_and_Economic_Inequality/15.07%3A_Key_Terms.txt |
1.
Describe how each of these changes is likely to affect poverty and inequality:
1. Incomes rise for low-income and high-income workers, but rise more for the high-income earners.
2. Incomes fall for low-income and high-income workers, but fall more for high-income earners.
2.
Jonathon is a single father with one child. He can work as a server for \$6 per hour for up to 1,500 hours per year. He is eligible for welfare, and so if he does not earn any income, he will receive a total of \$10,000 per year. He can work and still receive government benefits, but for every \$1 of income, his welfare stipend is \$1 less. Create a table similar to Table 15.4 that shows Jonathan’s options. Use four columns, the first showing number of hours to work, the second showing his earnings from work, the third showing the government benefits he will receive, and the fourth column showing his total income (earnings + government support). Sketch a labor-leisure diagram of Jonathan’s opportunity set with and without government support.
3.
Imagine that the government reworks the welfare policy that was affecting Jonathan in question 1, so that for each dollar someone like Jonathan earns at work, his government benefits diminish by only 30 cents. Reconstruct the table from question 1 to account for this change in policy. Draw Jonathan’s labor-leisure opportunity sets, both for before this welfare program is enacted and after it is enacted.
4.
We have discovered that the welfare system discourages recipients from working because the more income they earn, the less welfare benefits they receive. How does the earned income tax credit attempt to loosen the poverty trap?
5.
How does the TANF attempt to loosen the poverty trap?
6.
A group of 10 people have the following annual incomes: \$24,000, \$18,000, \$50,000, \$100,000, \$12,000, \$36,000, \$80,000, \$10,000, \$24,000, \$16,000. Calculate the share of total income that each quintile receives from this income distribution. Do the top and bottom quintiles in this distribution have a greater or larger share of total income than the top and bottom quintiles of the U.S. income distribution?
7.
Table 15.9 shows the share of income going to each quintile of the income distribution for the United Kingdom in 1979 and 1991. Use this data to calculate what the points on a Lorenz curve would be, and sketch the Lorenz curve. How did inequality in the United Kingdom shift over this time period? How can you see the patterns in the quintiles in the Lorenz curves?
Share of Income 1979 1991
Top quintile 39.7% 42.9%
Fourth quintile 24.8% 22.7%
Middle quintile 17.0% 16.3%
Second quintile 11.5% 11.5%
Bottom quintile 7.0% 6.6%
Table 15.9 Income Distribution in the United Kingdom, 1979 and 1991
8.
Using two demand and supply diagrams, one for the low-wage labor market and one for the high-wage labor market, explain how information technology can increase income inequality if it is a complement to high-income workers like salespeople and managers, but a substitute for low-income workers like file clerks and telephone receptionists.
9.
Using two demand and supply diagrams, one for the low-wage labor market and one for the high-wage labor market, explain how a program that increased educational levels for a substantial number of low-skill workers could reduce income inequality.
10.
Here is one hypothesis: A well-funded social safety net can increase economic equality but will reduce economic output. Explain why this might be so, and sketch a production possibility curve that shows this tradeoff.
11.
Here is a second hypothesis: A well-funded social safety net may lead to less regulation of the market economy. Explain why this might be so, and sketch a production possibility curve that shows this tradeoff.
12.
Which set of policies is more likely to cause a tradeoff between economic output and equality: policies of redistribution or policies aimed at the ladder of opportunity? Explain how the production possibility frontier tradeoff between economic equality and output might look in each case.
13.
Why is there reluctance on the part of some in the United States to redistribute income so that greater equality can be achieved? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/15%3A_Poverty_and_Economic_Inequality/15.09%3A_Self-Check_Questions.txt |
14.
How is the poverty rate calculated?
15.
What is the poverty line?
16.
What is the difference between poverty and income inequality?
17.
How does the poverty trap discourage people from working?
18.
How can the effect of the poverty trap be reduced?
19.
How does the U.S. government specifically support elderly people experiencing poverty?
20.
What is the safety net?
21.
Briefly explain the differences between TANF, the earned income tax credit, SNAP, and Medicaid.
22.
Who is included in the top income quintile?
23.
What is measured on the two axes of a Lorenz curve?
24.
If a country had perfect income equality what would the Lorenz curve look like?
25.
How has the inequality of income changed in the U.S. economy since the late 1970s?
26.
What are some reasons why a certain degree of inequality of income would be expected in a market economy?
27.
What are the main reasons economists give for the increase in inequality of incomes?
28.
Identify some public policies that can reduce the level of economic inequality.
29.
Describe how a push for economic equality might reduce incentives to work and produce output. Then describe how a push for economic inequality might not have such effects.
15.11: Critical Thinking Questions
30.
What goods and services would you include in an estimate of the basic necessities for a family of four?
31.
If a family of three earned \$20,000, would they be able to make ends meet given the official poverty threshold?
32.
Exercise 15.2 and Exercise 15.3 asked you to describe the labor-leisure tradeoff for Jonathon. Since, in the first example, there is no monetary incentive for Jonathon to work, explain why he may choose to work anyway. Explain what the opportunity costs of working and not working might be for Jonathon in each example. Using your tables and graphs from Exercise 15.2 and Exercise 15.3, analyze how the government welfare system affects Jonathan’s incentive to work.
33.
Explain how you would create a government program that would give an incentive for labor to increase hours and keep labor from falling into the poverty trap.
34.
Many critics of government programs to help low-income individuals argue that these programs create a poverty trap. Explain how programs such as TANF, EITC, SNAP, and Medicaid will affect low-income individuals and whether or not you think these programs will benefit families and children.
35.
Think about the business cycle: during a recession, unemployment increases; it decreases in an expansionary phase. Explain what happens to TANF, SNAP, and Medicaid programs at each phase of the business cycle (recession, trough, expansion, and peak).
36.
Explain how a country may experience greater equality in the distribution of income, yet still experience high rates of poverty. Hint: Look at the Clear It Up "How do governments measure poverty in low-income countries?" and compare to Table 15.5.
37.
The demand for skilled workers in the United States has been increasing. To increase the supply of skilled workers, many argue that immigration reform to allow more skilled labor into the United States is needed. Explain whether you agree or disagree.
38.
Explain a situation using the supply and demand for skilled labor in which the increased number of college graduates leads to depressed wages. Given the rising cost of going to college, explain why a college education will or will not increase income inequality.
39.
What do you think is more important to focus on when considering inequality: income inequality or wealth inequality?
40.
To reduce income inequality, should the marginal tax rates on the top 1% be increased?
41.
Redistribution of income occurs through the federal income tax and government antipoverty programs. Explain whether or not this level of redistribution is appropriate and whether more redistribution should occur.
42.
How does a society or a country make the decision about the tradeoff between equality and economic output? Hint: Think about the political system.
43.
Explain what the long- and short-term consequences are of not promoting equality or working to reduce poverty.
15.12: Problems
44.
In country A, the population is 300 million and 50 million people are living below the poverty line. What is the poverty rate?
45.
In country B, the population is 900 million and 100 million people are living below the poverty line. What is the poverty rate?
46.
Susan is a single mother with three children. She can earn \$8 per hour and works up to 1,800 hours per year. However, if she does not earn any income at all, she will receive government benefits totaling \$16,000 per year. For every \$1 of income she earns, her level of government support will be reduced by \$1. Create a table, patterned after [link]. The first column should show Susan’s choices of how many hours to work per year, up to 1,800 hours. The second column should show her earnings from work. The third column should show her level of government support, given her earnings. The final column should show her total income, combining earnings and government support. Based on the table you created, what are the likely impacts of this kind of assistance program on Susan's incentive to work? Are there additional opportunity costs that may reduce her incentive to work?
47.
A group of 10 people have the following annual incomes: \$55,000, \$30,000, \$15,000, \$20,000, \$35,000, \$80,000, \$40,000, \$45,000, \$30,000, \$50,000. Calculate the share of total income each quintile of this income distribution received. Do the top and bottom quintiles in this distribution have a greater or larger share of total income than the top and bottom quintiles of the U.S. income distribution for 2005? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/15%3A_Poverty_and_Economic_Inequality/15.10%3A_Review_Questions.txt |
Figure 16.1 Former President Obama’s Health Care Reform The Patient Protection and Affordable Care Act (PPACA), more commonly known as Obamacare, relates strongly to the topic of this chapter. While originally a controversial topic, it has gained majority approval at 55% as of March 2022. (Credit: “Obama at Healthcare rally at UMD” by Daniel Borman/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• The Problem of Imperfect Information and Asymmetric Information
• Insurance and Imperfect Information
Bring It Home
What’s the Big Deal with Obamacare?
In August 2009, many members of the U.S. Congress used their summer recess to return to their home districts and hold town hall-style meetings to discuss President Obama’s proposed changes to the U.S. healthcare system. This was officially known as the Patient Protection and Affordable Care Act (PPACA) or as the Affordable Care Act (ACA), but was more popularly known as Obamacare. The bill’s opponents’ claims ranged from the charge that the changes were unconstitutional and would add \$750 billion to the deficit, to extreme claims about the inclusion of things like the implantation of microchips and so-called “death panels” that decide which critically-ill patients receive care and which do not.
Why did people react so strongly? After all, the intent of the law is to make healthcare insurance more affordable, to allow more people to obtain insurance, and to reduce the costs of healthcare. For each year from 2000 to 2011, these costs grew at least double the rate of inflation. In 2014, healthcare spending accounted for around 24% of all federal government spending. In the United States, we spend more for our healthcare than any other high-income nation, yet our health outcomes are worse than comparable high-income countries. In 2015, over 32 million people in the United States, about 12.8% of the non-elderly adult population, were without insurance. Even today, however, more than a decade after the Act was signed into law and after the Supreme Court mostly upheld it, a 2022 Kaiser Foundation poll found that 42% of likely voters viewed it unfavorably. Why is this?
The debate over the ACA and healthcare reform could take an entire textbook, but what this chapter will do is introduce the basics of insurance and the problems insurance companies face. It is these problems, and how insurance companies respond to them that, in part, explain the divided opinion about the ACA.
Every purchase is based on a belief about the satisfaction that the good or service will provide. In turn, these beliefs are based on the information that the buyer has available. For many products, the information available to the buyer or the seller is imperfect or unclear, which can either make buyers regret past purchases or avoid making future ones.
This chapter discusses how imperfect and asymmetric information affect markets. The first module of the chapter discusses how asymmetric information affects markets for goods, labor, and financial capital. When buyers have less information about the quality of the good (for example, a gemstone) than sellers do, sellers may be tempted to mislead buyers. If a buyer cannot have at least some confidence in the quality of what they are purchasing, then they will be reluctant or unwilling to purchase the products. Thus, we require mechanisms to bridge this information gap, so buyers and sellers can engage in a transaction.
The second module of the chapter discusses insurance markets, which also face similar problems of imperfect information. For example, a car insurance company would prefer to sell insurance only to those who are unlikely to have auto accidents—but it is hard for the firm to identify those perfectly safe drivers. Conversely, car insurance buyers would like to persuade the auto insurance company that they are safe drivers and should pay only a low price for coverage. If insurance markets cannot find ways to grapple with these problems of imperfect information, then even people who have low or average risks of making claims may not be able to purchase insurance. The chapter on financial markets (markets for stocks and bonds) will show that the problems of imperfect information can be especially poignant. We cannot eliminate imperfect information, but we can often manage it. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/16%3A_Information_Risk_and_Insurance/16.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Analyze the impact of both imperfect information and asymmetric information
• Evaluate the role of advertisements in creating imperfect information
• Identify ways to reduce the risk of imperfect information
• Explain how imperfect information can affect price, quantity, and quality
Consider a purchase that many people make at important times in their lives: buying expensive jewelry. In May 1994, celebrity psychologist Doree Lynn bought an expensive ring from a jeweler in Washington, D.C., which included an emerald that cost \$14,500. Several years later, the emerald fractured. Lynn took it to another jeweler who found that cracks in the emerald had been filled with an epoxy resin. Lynn sued the original jeweler in 1997 for selling her a treated emerald without telling her, and won. The case publicized a number of little-known facts about precious stones. Most emeralds have internal flaws, and so they are soaked in clear oil or an epoxy resin to hide the flaws and make the color more deep and clear. Clear oil can leak out over time, and epoxy resin can discolor with age or heat. However, using clear oil or epoxy to “fill” emeralds is completely legal, as long as it is disclosed.
After Doree Lynn’s lawsuit, the NBC news show “Dateline” bought emeralds at four prominent jewelry stores in New York City in 1997. All the sales clerks at these stores, unaware that they were being recorded on a hidden camera, said the stones were untreated. When the emeralds were tested at a laboratory, however, technicians discovered they had all been treated with oil or epoxy. Emeralds are not the only gemstones that are treated. Diamonds, topaz, and tourmaline are also often irradiated to enhance colors. The general rule is that all treatments to gemstones should be revealed, but often sellers do not disclose this. As such, many buyers face a situation of asymmetric information, where two parties involved in an economic transaction have an unequal amount of information (one party knows much more than the other).
Many economic transactions occur in a situation of imperfect information, where either the buyer, the seller, or both, are less than 100% certain about the qualities of what they are buying and selling. Also, one may characterize the transaction as asymmetric information, in which one party has more information than the other regarding the economic transaction. Let’s begin with some examples of how imperfect information complicates transactions in goods, labor, and financial capital markets. The presence of imperfect information can easily cause a decline in prices or quantities of products sold. However, buyers and sellers also have incentives to create mechanisms that will allow them to make mutually beneficial transactions even in the face of imperfect information.
If you are unclear about the difference between asymmetric information and imperfect information, read the following Clear It Up feature.
Clear It Up
What is the difference between imperfect and asymmetric information?
For a market to reach equilibrium sellers and buyers must have full information about the product’s price and quality. If there is limited information, then buyers and sellers may not be able to transact or will possibly make poor decisions.
Imperfect information refers to the situation where buyers and/or sellers do not have all of the necessary information to make an informed decision about the product's price or quality. The term imperfect information simply means that the buyers and/or sellers do not have all the information necessary to make an informed decision. Asymmetric information is the condition where one party, either the buyer or the seller, has more information about the product's quality or price than the other party. In either case (imperfect or asymmetric information) buyers or sellers need remedies to make more informed decisions.
“Lemons” and Other Examples of Imperfect Information
Consider Marvin, who is trying to decide whether to buy a used car. Let’s assume that Marvin is truly clueless about what happens inside a car’s engine. He is willing to do some background research, like reading Consumer Reports or checking websites that offer information about used car makes and models and what they should cost. He might pay a mechanic to inspect the car. Even after devoting some money and time collecting information, however, Marvin still cannot be absolutely sure that he is buying a high-quality used car. He knows that he might buy the car, drive it home, and use it for a few weeks before discovering that car is a “lemon,” which is slang for a defective product (especially a car).
Imagine that Marvin shops for a used car and finds two that look very similar in terms of mileage, exterior appearances, and age. One car costs \$4,000, while the other car costs \$4,600. Which car should Marvin buy?
If Marvin were choosing in a world of perfect information, the answer would be simple: he should buy the cheaper car. However, Marvin is operating in a world of imperfect information, where the sellers likely know more about the car’s problems than he does, and have an incentive to hide the information. After all, the more problems the sellers disclose, the lower the car’s selling price.
What should Marvin do? First, he needs to understand that even with imperfect information, prices still reflect information. Typically, used cars are more expensive on some dealer lots because the dealers have a trustworthy reputation to uphold. Those dealers try to fix problems that may not be obvious to their customers, in order to create good word of mouth about their vehicles’ long term reliability. The short term benefits of selling their customers a “lemon” could cause a quick collapse in the dealer’s reputation and a loss of long term profits. On other lots that are less well-established, one can find cheaper used cars, but the buyer takes on more risk when a dealer’s reputation has little at stake. The cheapest cars of all often appear on Craigslist, where the individual seller has no reputation to defend. In sum, cheaper prices do carry more risk, so Marvin should balance his appetite for risk versus the potential headaches of many more unanticipated trips to the repair shop.
Similar problems with imperfect information arise in labor and financial capital markets. Consider Greta, who is applying for a job. Her potential employer, like the used car buyer, is concerned about ending up with a “lemon”—in this case a poor quality employee. The employer will collect information about Greta’s academic and work history. In the end, however, a degree of uncertainty will inevitably remain regarding Greta’s abilities, which are hard to demonstrate without actually observing her on the job. How can a potential employer screen for certain attributes, such as motivation, timeliness, and ability to get along with others? Employers often look to trade schools and colleges to pre-screen candidates. Employers may not even interview a candidate unless he has a degree and, sometimes, a degree from a particular school. Employers may also view awards, a high grade point average, and other accolades as a signal of hard work, perseverance, and ability. Employers may also seek references for insights into key attributes such as energy level and work ethic.
How Imperfect Information Can Affect Equilibrium Price and Quantity
The presence of imperfect information can discourage both buyers and sellers from participating in the market. Buyers may become reluctant to participate because they cannot determine the product's quality. Sellers of high-quality or medium-quality goods may be reluctant to participate, because it is difficult to demonstrate the quality of their goods to buyers—and since buyers cannot determine which goods have higher quality, they are likely to be unwilling to pay a higher price for such goods.
Economists sometimes refer to a market with few buyers and few sellers as a thin market. By contrast, they call a market with many buyers and sellers a thick market. When imperfect information is severe and buyers and sellers are discouraged from participating, markets may become extremely thin as a relatively small number of buyer and sellers attempt to communicate enough information that they can agree on a price.
When Price Mixes with Imperfect Information about Quality
A buyer confronted with imperfect information will often believe that the price reveals something about the product's quality. For example, a buyer may assume that a gemstone or a used car that costs more must be of higher quality, even though the buyer is not an expert on gemstones. Think of the expensive restaurant where the food must be good because it is so expensive or the shop where the clothes must be stylish because they cost so much, or the gallery where the art must be great, because the price tags are high. If you are hiring a lawyer, you might assume that a lawyer who charges \$400 per hour must be better than a lawyer who charges \$150 per hour. In these cases, price can act as a signal of quality.
When buyers use the market price to draw inferences about the products' quality, then markets may have trouble reaching an equilibrium price and quantity. Imagine a situation where a used car dealer has a lot full of used cars that do not seem to be selling, and so the dealer decides to cut the car prices to sell a greater quantity. In a market with imperfect information, many buyers may assume that the lower price implies low-quality cars. As a result, the lower price may not attract more customers. Conversely, a dealer who raises prices may find that customers assume that the higher price means that cars are of higher quality. As a result of raising prices, the dealer might sell more cars. (Whether or not consumers always behave rationally, as an economist would see it, is the subject of the following Clear It Up feature.)
The idea that higher prices might cause a greater quantity demanded and that lower prices might cause a lower quantity demanded runs exactly counter to the basic model of demand and supply (as we outlined in the Demand and Supply chapter). These contrary effects, however, will reach natural limits. At some point, if the price is high enough, the quantity demanded will decline. Conversely, when the price declines far enough, buyers will increasingly find value even if the quality is lower. In addition, information eventually becomes more widely known. An overpriced restaurant that charges more than the quality of its food is worth to many buyers will not last forever.
Clear It Up
Is consumer behavior rational?
There is much human behavior that mainstream economists have tended to call “irrational” since it is consistently at odds with economists’ utility maximizing models. The typical response is for economists to brush these behaviors aside and call them “anomalies” or unexplained quirks.
“If only you knew more economics, you would not be so irrational,” is what many mainstream economists seem to be saying. A group known as behavioral economists has challenged this notion, because so much of this so-called “quirky” behavior is extremely common among us. For example, a conventional economist would say that if you lost a \$10 bill today, and also received an extra \$10 in your paycheck, you should feel perfectly neutral. After all, –\$10 + \$10 = \$0. You are the same financially as you were before. However, behavioral economists have conducted research that shows many people will feel some negative emotion—anger or frustration—after those two things happen. We tend to focus more on the loss than the gain. Economists Daniel Kahneman and Amos Tversky in a famous 1979 Econometrica paper called this "loss aversion", where a \$1 loss pains us 2.25 times more than a \$1 gain helps us. This has implications for investing, as people tend to “overplay” the stock market by reacting more to losses than to gains.
Behavioral economics also tries to explain why people make seemingly irrational decisions in the presence of different situations, or how they "frame" the decision. We outline a popular example here: Imagine you have the opportunity to buy an alarm clock for \$20 in Store A. Across the street, you learn, is the exact same clock at Store B for \$10. You might say it is worth your time—a five-minute walk—to save \$10. Now, take a different example: You are in Store A buying a \$300 phone. Five minutes away, at Store B, the same phone is \$290. You again save \$10 by taking a five-minute walk. Do you do it?
Surprisingly, it is likely that you would not. Mainstream economists would say “\$10 is \$10” and that it would be irrational to make a five minute walk for \$10 in one case and not the other. However, behavioral economists have pointed out that most of us evaluate outcomes relative to a reference point—here the cost of the product—and think of gains and losses as percentages rather than using actual savings.
Which view is right? Both have their advantages, but behavioral economists have at least shed a light on trying to describe and explain systematic behavior which some previously had dismissed as irrational. If most of us are engaged in some “irrational behavior,” perhaps there are deeper underlying reasons for this behavior in the first place.
Mechanisms to Reduce the Risk of Imperfect Information
If you were selling a good like emeralds or used cars where imperfect information is likely to be a problem, how could you reassure possible buyers? If you were buying a good where imperfect information is a problem, what would it take to reassure you? Buyers and sellers in the goods market rely on reputation as well as guarantees, warrantees, and service contracts to assure product quality. The labor market uses occupational licenses and certifications to assure competency, while the financial capital market uses cosigners and collateral as insurance against unforeseen, detrimental events.
In the goods market, the seller might offer a money-back guarantee, an agreement that functions as a promise of quality. This strategy may be especially important for a company that sells goods through mail-order catalogs or over the web, whose customers cannot see the actual products, because it encourages people to buy something even if they are not certain they want to keep it.
L.L. Bean started using money-back-guarantees in 1911, when the founder stitched waterproof shoe rubbers together with leather shoe tops, and sold them as hunting shoes. He guaranteed satisfaction. However, the stitching came apart and, out of the first batch of 100 pairs that were sold, customers returned 90 pairs. L.L. Bean took out a bank loan, repaired all of the shoes, and replaced them. The L.L. Bean reputation for customer satisfaction began to spread. Many firms today offer money-back-guarantees for a few weeks or months, but L.L. Bean offers a complete money-back guarantee. Customers can always return anything they have bought from L.L. Bean, no matter how many years later or what condition the product is in, for a full money-back guarantee.
L.L. Bean has very few stores. Instead, most of its sales are made by mail, telephone, or, now, through their website. For this kind of firm, imperfect information may be an especially difficult problem, because customers cannot see and touch what they are buying. A combination of a money-back guarantee and a reputation for quality can help for a mail-order firm to flourish.
Sellers may offer a warranty, which is a promise to fix or replace the good, at least for a certain time period. The seller may also offer a buyer a chance to buy a service contract, where the buyer pays an extra amount and the seller agrees to fix anything that goes wrong for a set time period. Service contracts are often an option for buyers of large purchases such as cars, appliances and even houses.
Guarantees, warranties, and service contracts are examples of explicit reassurance that sellers provide. In many cases, firms also offer unstated guarantees. For example, some movie theaters might refund the ticket cost to a customer who walks out complaining about the show. Likewise, while restaurants do not generally advertise a money-back guarantee or exchange policies, many restaurants allow customers to exchange one dish for another or reduce the price of the bill if the customer is not satisfied.
The rationale for these policies is that firms want repeat customers, who in turn will recommend the business to others. As such, establishing a good reputation is of paramount importance. When buyers know that a firm is concerned about its reputation, they are less likely to worry about receiving a poor-quality product. For example, a well-established grocery store with a good reputation can often charge a higher price than a temporary stand at a local farmer’s market, where the buyer may never see the seller again.
Sellers of labor provide information through resumes, recommendations, school transcripts, and examples of their work. The labor market also uses occupational licenses to establish quality in the labor market. Occupational licenses, which government agencies typically issue, show that a worker has completed a certain type of education or passed a certain test. Some of the professionals who must hold a license are doctors, teachers, nurses, engineers, accountants, and lawyers. In addition, most states require a license to work as a barber, an embalmer, a dietitian, a massage therapist, a hearing aid dealer, a counselor, an insurance agent, and a real estate broker. Some other jobs require a license in only one state. Minnesota requires a state license to be a field archaeologist. North Dakota has a state license for bait retailers. In Louisiana, one needs a state license to be a “stress analyst” and California requires a state license to be a furniture upholsterer. According to a 2013 study from the University of Chicago, about 29% of U.S. workers have jobs that require occupational licenses.
Occupational licenses have their downside as well, as they represent a barrier to entry to certain industries. This makes it more difficult for new entrants to compete with incumbents, which can lead to higher prices and less consumer choice. In occupations that require licenses, the government has decided that the additional information provided by licenses outweighs the negative effect on competition.
Clear It Up
Are advertisers allowed to benefit from imperfect information?
Many advertisements seem full of imperfect information—at least by what they imply. Driving a certain car, drinking a particular soda, or wearing a certain shoe are all unlikely to bring fashionable friends and fun automatically, if at all. The government rules on advertising, enforced by the Federal Trade Commission (FTC), allow advertising to contain a certain amount of exaggeration about the general delight of using a product. They, however, also demand that if one presents a claim as a fact, it must be true.
Legally, deceptive advertising dates back to the 1950s when Colgate-Palmolive created a television advertisement that seemed to show Rapid Shave shaving cream being spread on sandpaper and then the sand was shaved off the sandpaper. What the television advertisement actually showed was sand sprinkled on Plexiglas—without glue—and then scraped aside by the razor.
In the 1960s, in magazine advertisements for Campbell’s vegetable soup, the company was having problems getting an appetizing soup picture, because the vegetables kept sinking. To remedy this, they filled a bowl with marbles and poured the soup over the top, so that the bowl appeared to be crammed with vegetables.
In the late 1980s, the Volvo Company filmed a television advertisement that showed a monster truck driving over cars, crunching their roofs—all except for the Volvo, which did not crush. However, the FTC found in 1991 that the Volvo's roof from the filming had been reinforced with an extra steel framework, while they cut the roof supports on the other car brands.
The Wonder Bread Company ran television advertisements featuring “Professor Wonder,” who said that because Wonder Bread contained extra calcium, it would help children’s minds work better and improve their memory. The FTC objected, and in 2002 the company agreed to stop running the advertisements.
As we can see in each of these cases, the Federal Trade Commission (FTC) often checks factual claims about the product’s performance, at least to some extent. Language and images that are exaggerated or ambiguous, but not actually false, are allowed in advertising. Untrue “facts” are not permitted. In any case, an old Latin saying applies when watching advertisements: Caveat emptor—that is, “let the buyer beware.”
On the buyer’s side of the labor market, a standard precaution against hiring a “lemon” of an employee is to specify that the first few months of employment are officially a trial or probationary period, and that the employer can dismiss the worker for any reason or no reason during that time. Sometimes workers also receive lower pay during this trial period.
In the financial capital market, before a bank makes a loan, it requires a prospective borrower to fill out forms regarding incomes sources. In addition, the bank conducts a credit check on the individual’s past borrowing. Another approach is to require a cosigner on a loan; that is, another person or firm who legally pledges to repay some or all of the money if the original borrower does not do so. Another approach is to require collateral, often property or equipment that the bank would have a right to seize and sell if borrower does not repay the loan.
Buyers of goods and services cannot possibly become experts in evaluating the quality of gemstones, used cars, lawyers, and everything else they buy. Employers and lenders cannot be perfectly omniscient about whether possible workers will turn out well or potential borrowers will repay loans on time. However, the mechanisms that we mentioned above can reduce the risks associated with imperfect information so that the buyer and seller are willing to proceed. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/16%3A_Information_Risk_and_Insurance/16.02%3A_The_Problem_of_Imperfect_Information_and_Asymmetric_Information.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain how insurance works
• Identify and evaluate various forms of government and social insurance
• Discuss the problems caused by moral hazard and adverse selection
• Analyze the impact of government regulation of insurance
Insurance is a method that households and firms use to prevent any single event from having a significant detrimental financial effect. Generally, households or firms with insurance make regular payments, called premiums. The insurance company prices these premiums based on the probability of certain events occurring among a pool of people. Members of the group who then suffer a specified bad experience receive payments from this pool of money.
Many people have several kinds of insurance: health insurance that pays when they receive medical care; car insurance that pays if their car is in an automobile accident; house or renter’s insurance that pays for stolen possessions or items damaged by fire; and life insurance, which pays for the family if the insured individual dies. Table 16.1 lists a set of insurance markets.
Type of Insurance Who Pays for It? It Pays Out When . . .
Health insurance Employers and individuals Medical expenses are incurred
Life insurance Employers and individuals Policyholder dies
Automobile insurance Individuals Car is damaged, stolen, or causes damage to others
Property and homeowner’s insurance Homeowners and renters Dwelling is damaged or burglarized
Liability insurance Firms and individuals An injury occurs for which you are partly responsible
Malpractice insurance Doctors, lawyers, and other professionals A poor quality of service is provided that causes harm to others
Table 16.1 Some Insurance Markets
All insurance involves imperfect information in both an obvious way and in a deeper way. At an obvious level, we cannot predict future events with certainty. For example, we cannot know with certainty who will have a car accident, become ill, die, or have his home robbed in the next year. Imperfect information also applies to estimating the risk that something will happen to any individual. It is difficult for an insurance company to estimate the risk that, say, a particular 20-year-old male driver from New York City will have an accident, because even within that group, some drivers will drive more safely than others. Thus, adverse events occur out of a combination of people’s characteristics and choices that make the risks higher or lower and then the good or bad luck of what actually happens.
How Insurance Works
A simplified example of automobile insurance might work this way. Suppose we divide a group of 100 drivers into three groups. In a given year, 60 of those people have only a few door dings or chipped paint, which costs \$100 each. Another 30 of the drivers have medium-sized accidents that cost an average of \$1,000 in damages, and 10 of the drivers have large accidents that cost \$15,000 in damages. For the moment, let’s imagine that at the beginning of any year, there is no way of identifying the drivers who are low-risk, medium-risk, or high-risk. The total damage incurred by car accidents in this group of 100 drivers will be \$186,000, that is:
$Total damage = (60 × 100) + (30 × 1,000) + (10 × 15,000) = 6,000 + 30,000 + 150,000 = 186,000Total damage = (60 × 100) + (30 × 1,000) + (10 × 15,000) = 6,000 + 30,000 + 150,000 = 186,000$
If each of the 100 drivers pays a \$1,860 premium each year, the insurance company will collect the \$186,000 that is needed to cover the costs of the accidents that occur.
Since insurance companies have such a large number of clients, they are able to negotiate with health care and other service providers for lower rates than the individual would be able to get, thus increasing the benefit to consumers of becoming insured and saving the insurance company itself money when it pays out claims.
Insurance companies receive income, as Figure 16.2 shows, from insurance premiums and investment income. The companies derive income from investing the funds that insurance companies received in the past but did not pay out as insurance claims in prior years. The insurance company receives a rate of return from investing these funds or reserves. The companies typically invest in fairly safe, liquid (easy to convert into cash) investments, as the insurance companies need to be able to readily access these funds when a major disaster strikes.
Figure 16.2 An Insurance Company: What Comes In, What Goes Out Money flows into an insurance company through premiums and investments and out through the payment of claims and operating expenses.
Government and Social Insurance
Federal and state governments run a number of insurance programs. Some of the programs look much like private insurance, in the sense that the members of a group make steady payments into a fund, and those in the group who suffer an adverse experience receive payments. Other programs protect against risk, but without an explicit fund set up. Following are some examples.
• Unemployment insurance: Employers in every state pay a small amount for unemployment insurance, which goes into a fund to pay benefits to workers who lose their jobs and do not find new jobs, for a period of time, usually up to six months.
• Pension insurance: Employers that offer pensions to their retired employees are required by law to pay a small fraction of what they are setting aside for pensions to the Pension Benefit Guarantee Corporation, which pays at least some pension benefits to workers if a company goes bankrupt and cannot pay the pensions it has promised.
• Deposit insurance: Banks are required by law to pay a small fraction of their deposits to the Federal Deposit Insurance Corporation, which goes into a fund that pays depositors the value of their bank deposits up to \$250,000 (the amount was raised from \$100,000 to \$250,000 in 2008) if the bank should go bankrupt.
• Workman’s compensation insurance: Employers are required by law to pay a small percentage of the salaries that they pay into funds, typically run at the state level, that pay benefits to workers who suffer an injury on the job.
• Retirement insurance: All workers pay a percentage of their income into Social Security and into Medicare, which then provides income and health care benefits to the elderly. Social Security and Medicare are not literally “insurance” in the sense that those currently contributing to the fund are not eligible for benefits. They function like insurance, however, in the sense that individuals make regular payments into the programs today in exchange for benefits they will receive in the case of a later event—either becoming old or becoming sick when old. A name for such programs is “social insurance.”
The major additional costs to insurance companies, other than the payment of claims, are the costs of running a business: the administrative costs of hiring workers, administering accounts, and processing insurance claims. For most insurance companies, the insurance premiums coming in and the claims payments going out are much larger than the amounts earned by investing money or the administrative costs.
Thus, while factors like investment income earned on reserves, administrative costs, and groups with different risks complicate the overall picture, a fundamental law of insurance must hold true: The average person’s payments into insurance over time must cover 1) the average person’s claims, 2) the costs of running the company, and 3) leave room for the firm’s profits.
Risk Groups and Actuarial Fairness
Not all of those who purchase insurance face the same risks. Some people may be more likely, because of genetics or personal habits, to fall sick with certain diseases. Some people may live in an area where car theft or home robbery is more likely than in other areas. Some drivers are safer than others. A risk group can be defined as a group that shares roughly the same risks of an adverse event occurring.
Insurance companies often classify people into risk groups, and charge lower premiums to those with lower risks. If people are not separated into risk groups, then those with low risk must pay for those with high risks. In the simple example of how car insurance works, 60 drivers had very low damage of \$100 each, 30 drivers had medium-sized accidents that cost \$1,000 each, and 10 of the drivers had large accidents that cost \$15,000. If all 100 of these drivers pay the same \$1,860, then those with low damages are in effect paying for those with high damages.
If it is possible to classify drivers according to risk group, then the insurance company can charge each group according to its expected losses. For example, the insurance company might charge the 60 drivers who seem safest of all \$100 apiece, which is the average value of the damages they cause. Then the intermediate group could pay \$1,000 apiece and the high-cost group \$15,000 each. When the level of insurance premiums that someone pays is equal to the amount that an average person in that risk group would collect in insurance payments, the level of insurance is said to be “actuarially fair.”
Classifying people into risk groups can be controversial. For example, if someone had a major automobile accident last year, should the insurance company classify that person as a high-risk driver who is likely to have similar accidents in the future, or as a low-risk driver who was just extremely unlucky? The driver is likely to claim to be low-risk, and thus someone who should be in a risk group with those who pay low insurance premiums in the future. The insurance company is likely to believe that, on average, having a major accident is a signal of being a high-risk driver, and thus try to charge this driver higher insurance premiums. The next two sections discuss the two major problems of imperfect information in insurance markets—called moral hazard and adverse selection. Both problems arise from attempts to categorize those purchasing insurance into risk groups.
The Moral Hazard Problem
Moral hazard refers to the case when people engage in riskier behavior with insurance than they would if they did not have insurance. For example, if you have health insurance that covers the cost of visiting the doctor, you may be less likely to take precautions against catching an illness that might require a doctor’s visit. If you have car insurance, you will worry less about driving or parking your car in ways that make it more likely to get dented. In another example, a business without insurance might install absolute top-level security and fire sprinkler systems to guard against theft and fire. If it is insured, that same business might only install a minimum level of security and fire sprinkler systems.
We cannot eliminate moral hazard, but insurance companies have some ways of reducing its effect. Investigations to prevent insurance fraud are one way of reducing the extreme cases of moral hazard. Insurance companies can also monitor certain kinds of behavior. To return to the example from above, they might offer a business a lower rate on property insurance if the business installs a top-level security and fire sprinkler system and has those systems inspected once a year.
Another method to reduce moral hazard is to require the injured party to pay a share of the costs. For example, insurance policies often have deductibles, which is an amount that the insurance policyholder must pay out of their own pocket before the insurance coverage starts paying. For example, auto insurance might pay for all losses greater than \$500. Health insurance policies often have a copayment, in which the policyholder must pay a small amount. For example, a person might have to pay \$20 for each doctor visit, and the insurance company would cover the rest. Another method of cost sharing is coinsurance, which means that the insurance company covers a certain percentage of the cost. For example, insurance might pay for 80% of the costs of repairing a home after a fire, but the homeowner would pay the other 20%.
All of these forms of cost sharing discourage moral hazard, because people know that they will have to pay something out of their own pocket when they make an insurance claim. The effect can be powerful. One prominent study found that when people face moderate deductibles and copayments for their health insurance, they consume about one-third less in medical care than people who have complete insurance and do not pay anything out of pocket, presumably because deductibles and copayments reduce the level of moral hazard. However, those who consumed less health care did not seem to have any difference in health status.
A final way of reducing moral hazard, which is especially applicable to health care, is to focus on healthcare incentives of providers rather than consumers. Traditionally, most health care in the United States has been provided on a fee-for-service basis, which means that medical care providers are paid for the services they provide and are paid more if they provide additional services. However, in the last decade or so, the structure of healthcare provision has shifted to an emphasis on health maintenance organizations (HMOs). A health maintenance organization (HMO) provides healthcare that receives a fixed amount per person enrolled in the plan—regardless of how many services are provided. In this case, a patient with insurance has an incentive to demand more care, but the healthcare provider, which is receiving only a fixed payment, has an incentive to reduce the moral hazard problem by limiting the quantity of care provided—as long as it will not lead to worse health problems and higher costs later. Today, many doctors are paid with some combination of managed care and fee-for-service; that is, a flat amount per patient, but with additional payments for the treatment of certain health conditions.
Imperfect information is the cause of the moral hazard problem. If an insurance company had perfect information on risk, it could simply raise its premiums every time an insured party engages in riskier behavior. However, an insurance company cannot monitor all the risks that people take all the time and so, even with various checks and cost sharing, moral hazard will remain a problem.
Link It Up
Visit this website to read about the relationship between health care and behavioral economics.
The Adverse Selection Problem
Adverse selection refers to the problem in which insurance buyers have more information about whether they are high-risk or low-risk than the insurance company does. This creates an asymmetric information problem for the insurance company because buyers who are high-risk tend to want to buy more insurance, without letting the insurance company know about their higher risk. For example, someone purchasing health insurance or life insurance probably knows more about their family’s health history than an insurer can reasonably find out even with a costly investigation. Someone purchasing car insurance may know that they are a high-risk driver who has not yet had a major accident—but it is hard for the insurance company to collect information about how people actually drive.
To understand how adverse selection can strangle an insurance market, recall the situation of 100 drivers who are buying automobile insurance, where 60 drivers had very low damages of \$100 each, 30 drivers had medium-sized accidents that cost \$1,000 each, and 10 of the drivers had large accidents that cost \$15,000. That would equal \$186,000 in total payouts by the insurance company. Imagine that, while the insurance company knows the overall size of the losses, it cannot identify the high-risk, medium-risk, and low-risk drivers. However, the drivers themselves know their risk groups. Since there is asymmetric information between the insurance company and the drivers, the insurance company would likely set the price of insurance at \$1,860 per year, to cover the average loss (not including the cost of overhead and profit). The result is that those with low risks of only \$100 will likely decide not to buy insurance; after all, it makes no sense for them to pay \$1,860 per year when they are likely only to experience losses of \$100. Those with medium risks of a \$1,000 accident will not buy insurance either. Therefore, the insurance company ends up only selling insurance for \$1,860 to high-risk drivers who will average \$15,000 in claims apiece, and as a consequence, the insurance company ends up losing considerable money. If the insurance company tries to raise its premiums to cover the losses of those with high risks, then those with low or medium risks will be even more discouraged from buying insurance.
Rather than face such a situation of adverse selection, the insurance company may decide not to sell insurance in this market at all. If potential buyers are to receive insurance, then one of two things must happen. First, the insurance company might find some way of separating insurance buyers into risk groups with some degree of accuracy and charging them accordingly, which in practice often means that the insurance company tries not to sell insurance to those who may pose high risks. Another scenario is that those with low risks must buy insurance, even if they have to pay more than the actuarially fair amount for their risk group. The notion that people can be required to purchase insurance raises the issue of government laws and regulations that influence the insurance industry.
U.S. Health Care in an International Context
The United States is the only high-income country in the world where private firms pay and provide for most health insurance. Greater government involvement in the provision of health insurance is one possible way of addressing moral hazard and adverse selection problems.
The moral hazard problem with health insurance is that when people have insurance, they will demand higher quantities of health care. In the United States, private healthcare insurance tends to encourage an ever-greater demand for healthcare services, which healthcare providers are happy to fulfill. Table 16.2 shows that on a per-person basis, U.S. healthcare spending towers above healthcare spending of other countries. Note that while healthcare expenditures in the United States are far higher than healthcare expenditures in other countries, the health outcomes in the United States, as measured by life expectancy and lower rates of childhood mortality, tend to be lower. Health outcomes, however, may not be significantly affected by healthcare expenditures. Many studies have shown that a country’s health is more closely related to diet, exercise, and genetic factors than to healthcare expenditure. This fact further emphasizes that the United States is spending very large amounts on medical care with little obvious health gain.
In the U.S. health insurance market, the main way of solving this adverse selection problem is that health insurance is often sold through groups based on place of employment, or, under The Affordable Care Act, from a state government sponsored health exchange market. From an insurance company’s point of view, selling insurance through an employer mixes together a group of people—some with high risks of future health problems and some with lower risks—and thus reduces the insurance firm’s fear of attracting only those who have high risks. However, many small companies do not provide health insurance to their employees, and many lower-paying jobs do not include health insurance. Even after we take into account all U.S. government programs that provide health insurance for the elderly and people experiencing poverty, approximately 31 million Americans were without health insurance in 2020. While a government-controlled system can avoid the adverse selection problem entirely by providing at least basic health insurance for all, another option is to mandate that all Americans buy health insurance from some provider by preventing providers from denying individuals based on preexisting conditions. The Patient Protection and Affordable Care Act adopted this approach, which we will discuss later on in this chapter.
Country Health Care Spending per Person Life Expectancy at Birth (Male) Life Expectancy at Birth (Female) Infant Mortality Rate (Male & Female), per 1,000
United States \$10,948 75.5 80.2 5.7
Germany \$6,731 79.0 83.7 3.2
France \$5,564 79.2 85.3 3.5
Canada \$5,370 80.0 84.2 4.4
United Kingdom \$5,268 78.4 82.4 3.7
Table 16.2 A Comparison of Health Care Spending per Person, Life Expectancy at Birth, and Infant Mortality, 2020 (Source: 2020 OECD study and World Fact Book)
At its best, the largely private U.S. system of health insurance and healthcare delivery provides an extraordinarily high quality of care, along with generating a seemingly endless parade of life-saving innovations. However, the system also struggles to control its high costs and to provide basic medical care to all. Compared to the United States, other countries have lower costs, more equal access, and better mortality outcomes, but they often struggle to provide rapid access to health care and to offer the near-miracles of the most up-to-date medical care. The challenge is a healthcare system that strikes the right balance between quality, access, and cost.
Government Regulation of Insurance
The U.S. insurance industry is primarily regulated at the state level. Since 1871 there has been a National Association of Insurance Commissioners that brings together these state regulators to exchange information and strategies. The state insurance regulators typically attempt to accomplish two things: to keep the price of insurance low and to ensure that everyone has insurance. These goals, however, can conflict with each other and also become easily entangled in politics.
If insurance premiums are set at actuarially fair levels, so that people end up paying an amount that accurately reflects their risk group, certain people will end up paying considerable amounts. For example, if health insurance companies were trying to cover people who already have a chronic disease like AIDS, or who were elderly, they would charge these groups very high premiums for health insurance, because their expected health care costs are quite high. Women in the age bracket 18–44 consume, on average, about 65% more in health care spending than men. Young male drivers have more car accidents than young female drivers. Thus, actuarially fair insurance would tend to charge young men much more for car insurance than young women. Because people in high-risk groups would find themselves charged so heavily for insurance, they might choose not to buy insurance at all.
State insurance regulators have sometimes reacted by passing rules that attempt to set low premiums for insurance. Over time, however, the fundamental law of insurance must hold: the average amount individuals receive cannot exceed the average amount paid in premiums. When rules are passed to keep premiums low, insurance companies try to avoid insuring any high-risk or even medium-risk parties. If a state legislature passes strict rules requiring insurance companies to sell to everyone at low prices, the insurance companies always have the option of withdrawing from doing business in that state. For example, the insurance regulators in New Jersey are well-known for attempting to keep auto insurance premiums low, and more than 20 different insurance companies stopped doing business in the state in the late 1990s and early 2000s. Similarly, in 2009, State Farm announced that it was withdrawing from selling property insurance in Florida.
In short, government regulators cannot force companies to charge low prices and provide high levels of insurance coverage—and thus take losses—for a sustained period of time. If insurance premiums are set below the actuarially fair level for a certain group, some other group will have to make up the difference. There are two other groups who can make up the difference: taxpayers or other insurance buyers.
In some industries, the U.S. government has decided free markets will not provide insurance at an affordable price, and so the government pays for it directly. For example, private health insurance is too expensive for many people whose incomes are too low. To combat this, the U.S. government, together with the states, runs the Medicaid program, which provides health care to those with low incomes. Private health insurance also does not work well for the elderly, because their average health care costs can be very high. Thus, the U.S. government started the Medicare program, which provides health insurance to all those over age 65. Other government-funded health-care programs are aimed at military veterans, as an added benefit, and children in families with relatively low incomes.
Another common government intervention in insurance markets is to require that everyone buy certain kinds of insurance. For example, most states legally require car owners to buy auto insurance. Likewise, when a bank loans someone money to buy a home, the person is typically required to have homeowner’s insurance, which protects against fire and other physical damage (like hailstorms) to the home. A legal requirement that everyone must buy insurance means that insurance companies do not need to worry that those with low risks will avoid buying insurance. Since insurance companies do not need to fear adverse selection, they can set their prices based on an average for the market, and those with lower risks will, to some extent, end up subsidizing those with higher risks. However, even when laws are passed requiring people to purchase insurance, insurance companies cannot be compelled to sell insurance to everyone who asks—at least not at low cost. Thus, insurance companies will still try to avoid selling insurance to those with high risks whenever possible.
The government cannot pass laws that make the problems of moral hazard and adverse selection disappear, but the government can make political decisions that certain groups should have insurance, even though the private market would not otherwise provide that insurance. Also, the government can impose the costs of that decision on taxpayers or on other buyers of insurance.
The Patient Protection and Affordable Care Act
In March of 2010, President Obama signed into law the Patient Protection and Affordable Care Act (PPACA). The government started to phase in this highly contentious law over time starting in October of 2013. The goal of the act is to bring the United States closer to universal coverage. Some of the key features of the plan include:
• Individual mandate: All individuals, who do not receive health care through their employer or through a government program (for example, Medicare), were required to have health insurance or pay a fine. The individual mandate's goal was to reduce the adverse selection problem and keep prices down by requiring all consumers—even the healthiest ones—to have health insurance. Without the need to guard against adverse selection (whereby only the riskiest consumers buy insurance) by raising prices, health insurance companies could provide more reasonable plans to their customers. At the beginning of 2019, the fine for not having health insurance was eliminated.
• Each state is required to have health insurance exchanges, or utilize the federal exchange, whereby insurance companies compete for business. The goal of the exchanges is to improve competition in the market for health insurance.
• Employer mandate: All employers with more than 50 employees must offer health insurance to their employees.
The Affordable Care Act (ACA) is funded through additional taxes that include:
• Increasing the Medicare tax by 0.9 percent and adding a 3.8 percent tax on unearned income for high income taxpayers.
• Charging an annual fee on health insurance providers.
• Imposing other taxes such as a 2.3% tax on manufacturers and importers of certain medical devices.
Many people and politicians, including Donald Trump, have sought to overturn the bill. Those who oppose the bill believe it violates an individual’s right to choose whether to have insurance or not. In 2012, a number of states challenged the law on the basis that the individual mandate provision is unconstitutional. In June 2012, the U.S. Supreme Court ruled in a 5–4 decision that the individual mandate is actually a tax, so it is constitutional as the federal government has the right to tax the populace. At the same time, some of the taxes that were implemented as part of the ACA have been eliminated.
Bring It Home
What’s the Big Deal with Obamacare?
What is it that the Affordable Care Act (ACA) will actually do? To begin with, we should note that it is a massively complex law, with a large number of parts, some of which the Obama administration implemented immediately, and others that the government is supposed to phase in every year from 2013 through 2020. Three of these parts are coverage for the uninsured—those without health insurance, coverage for individuals with preexisting conditions, and the so-called employer and individual mandates, which require employers to offer and people to purchase health insurance. Under the Trump administration, several components of the ACA were repealed or overhauled, while under the Biden administration (and with the support of a majority of the population) the ACA has continued as a major element in provision of health care in the United States.
As we noted in the chapter, people face ever-increasing healthcare costs in the United States. Over the years, the ranks of the uninsured in the United States have grown as rising prices have pushed employers and individuals out of the market. Insurance companies have increasingly used pre-existing medical conditions to determine if someone is high risk, for whom insurance companies either charge higher prices, or they choose to deny insurance coverage to these individuals. Whatever the cause, we noted at the beginning of the chapter that prior to the ACA, more than 32 million Americans were uninsured. People who are uninsured tend to use emergency rooms for treatment—the most expensive form of healthcare, which has contributed significantly to rising costs.
The ACA introduced regulations designed to control increases in healthcare costs. One example is a cap on the amount healthcare providers can spend on administrative costs. Another is a requirement that healthcare providers switch to electronic medical records (EMRs), which will reduce administrative costs.
The ACA required that states establish health insurance exchanges, or markets, where people without health insurance, and businesses that do not provide it for their employees, can shop for different insurance plans. The purpose of these exchanges was to increase competition in insurance markets and thus reduce prices of policies.
Finally, the ACA mandated that people with preexisting conditions could no longer be denied health insurance. The U.S. Department of Health and Human Services estimates that the those without insurance in the US has fallen from 20.3% in 2012 to 11.5% in 2016. Accordingly, 20 million Americans gained coverage under the ACA. According to the Census, as of 2020, the share of the population without health insurance had fallen to 8.6%. So the ACA has resulted in a decline in the percentage of Americans without health insurance by almost 60%.
What was the cost of this increased coverage and how was it paid? An insurance policy works by insuring against the possibility of needing healthcare. If there are high risk individuals in the insurance pool, the pool must be expanded to include enough low risk individuals to keep average premiums affordable. To that end, the ACA imposed the individual mandate, requiring all individuals to purchase insurance (or pay a penalty) whether they were high risk or not. Many young adults would choose to skip health insurance since the likelihood of their needing significant healthcare is small. The individual mandate brought in a significant amount of money to pay for the ACA. However, despite the elimination of the penalty for not having insurance, ACA coverage has continued to increase. In addition, there were three other funding sources. The ACA took \$716 billion which otherwise would have gone to Medicare spending. The ACA also increased the Medicare tax that wealthy Americans paid by an additional 0.9%. Despite these funding sources, the Congressional Budget Office estimates that the ACA will increase the federal debt by \$137 billion over the next decade.
The impact of the Patient Protection and Affordable Care Act has been a rise in Americans with health insurance. However, due to the increased taxes to pay for the ACA and the increased deficit spending, the ACA faces continued opposition. The Trump administration vowed to repeal it on the campaign trail but no alternative bill has made its way before congress. Only time will tell if the Affordable Care Act will leave a legacy or will quickly be swept by the wayside, jeopardizing the 20 million newly insured Americans.
At the time of this writing, the final impact of the Patient Protection and Affordable Care Act is not clear. Millions of previously uninsured Americans now have coverage, but the increased taxes to pay for ACA and increased deficit spending have created significant political opposition. Whether or not that opposition eventually succeeds in overturning the ACA remains to be seen. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/16%3A_Information_Risk_and_Insurance/16.03%3A_Insurance_and_Imperfect_Information.txt |
adverse selection
when groups with inherently higher risks than the average person seek out insurance, thus straining the insurance system
asymmetric information
a situation where the seller or the buyer has more information than the other regarding the quality of the item for sale
coinsurance
when an insurance policyholder pays a percentage of a loss, and the insurance company pays the remaining cost
collateral
something valuable—often property or equipment—that a lender would have a right to seize and sell if the buyer does not repay the loan
copayment
when an insurance policyholder must pay a small amount for each service, before insurance covers the rest
cosigner
another person or firm who legally pledges to repay some or all of the money on a loan if the original borrower does not
deductible
an amount that the insurance policyholders must pay out of their own pocket before the insurance coverage pays anything
fee-for-service
when medical care providers are paid according to the services they provide
health maintenance organization (HMO)
an organization that provides health care and is paid a fixed amount per person enrolled in the plan—regardless of how many services are provided
imperfect information
a situation where either the buyer or the seller, or both, are uncertain about the qualities of what they are buying and selling
insurance
method of protecting a person from financial loss, whereby policy holders make regular payments to an insurance entity; the insurance firm then remunerates a group member who suffers significant financial damage from an event covered by the policy
money-back guarantee
a promise that the seller will refund the buyer’s money under certain conditions
moral hazard
when people have insurance against a certain event, they are less likely to guard against that event occurring
occupational license
licenses issued by government agencies, which indicate that a worker has completed a certain type of education or passed a certain test
premium
payment made to an insurance company
risk group
a group that shares roughly the same risks of an adverse event occurring
service contract
the buyer pays an extra amount and the seller agrees to fix anything specified in the contract that goes wrong for a set time period
warranty
a promise to fix or replace the good for a certain period of time
16.05: Key Concepts and Summary
16.1 The Problem of Imperfect Information and Asymmetric Information
Many make economic transactions in a situation of imperfect information, where either the buyer, the seller, or both are less than 100% certain about the qualities of what they are buying or selling. When information about the quality of products is highly imperfect, it may be difficult for a market to exist.
A “lemon” is a product that turns out, after the purchase, to have low quality. When the seller has more accurate information about the product's quality than the buyer, the buyer will be hesitant to buy, out of fear of purchasing a “lemon.”
Markets have many ways to deal with imperfect information. In goods markets, buyers facing imperfect information about products may depend upon money-back guarantees, warranties, service contracts, and reputation. In labor markets, employers facing imperfect information about potential employees may turn to resumes, recommendations, occupational licenses for certain jobs, and employment for trial periods. In capital markets, lenders facing imperfect information about borrowers may require detailed loan applications and credit checks, cosigners, and collateral.
16.2 Insurance and Imperfect Information
Insurance is a way of sharing risk. People in a group pay premiums for insurance against some unpleasant event, and those in the group who actually experience the unpleasant event then receive some compensation. The fundamental law of insurance is that what the average person pays in over time cannot be less than what the average person gets out. In an actuarially fair insurance policy, the premiums that a person pays to the insurance company are the same as the average amount of benefits for a person in that risk group. Moral hazard arises in insurance markets because those who are insured against a risk will have less reason to take steps to avoid the costs from that risk.
Many insurance policies have deductibles, copayments, or coinsurance. A deductible is the maximum amount that the policyholder must pay out-of-pocket before the insurance company pays the rest of the bill. A copayment is a flat fee that an insurance policy-holder must pay before receiving services. Coinsurance requires the policyholder to pay a certain percentage of costs. Deductibles, copayments, and coinsurance reduce moral hazard by requiring the insured party to bear some of the costs before collecting insurance benefits.
In a fee-for-service health financing system, medical care providers receive reimbursement according to the cost of services they provide. An alternative method of organizing health care is through health maintenance organizations (HMOs), where medical care providers receive reimbursement according to the number of patients they handle, and it is up to the providers to allocate resources between patients who receive more or fewer health care services. Adverse selection arises in insurance markets when insurance buyers know more about the risks they face than does the insurance company. As a result, the insurance company runs the risk that low-risk parties will avoid its insurance because it is too costly for them, while high-risk parties will embrace it because it looks like a good deal to them.
16.06: Self-Check Questions
1.
For each of the following purchases, say whether you would expect the degree of imperfect information to be relatively high or relatively low:
1. Buying apples at a roadside stand
2. Buying dinner at the neighborhood restaurant around the corner
3. Buying a used laptop computer at a garage sale
4. Ordering flowers over the internet for your friend in a different city
2.
Why is there asymmetric information in the labor market? What signals can an employer look for that might indicate the traits they are seeking in a new employee?
3.
Why is it difficult to measure health outcomes? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/16%3A_Information_Risk_and_Insurance/16.04%3A_Key_Terms.txt |
4.
Why might it be difficult for a buyer and seller to agree on a price when imperfect information exists?
5.
What do economists (and used-car dealers) mean by a “lemon”?
6.
What are some ways a seller of goods might reassure a possible buyer who is faced with imperfect information?
7.
What are some ways a seller of labor (that is, someone looking for a job) might reassure a possible employer who is faced with imperfect information?
8.
What are some ways that someone looking for a loan might reassure a bank that is faced with imperfect information about whether the borrower will repay the loan?
9.
What is an insurance premium?
10.
In an insurance system, would you expect each person to receive in benefits pretty much what they pay in premiums or is it just that the average benefits paid will equal the average premiums paid?
11.
What is an actuarially fair insurance policy?
12.
What is the problem of moral hazard?
13.
How can moral hazard lead to more costly insurance premiums than one was expected?
14.
Define deductibles, copayments, and coinsurance.
15.
How can deductibles, copayments, and coinsurance reduce moral hazard?
16.
What is the key difference between a fee-for-service healthcare system and a system based on health maintenance organizations?
17.
How might adverse selection make it difficult for an insurance market to operate?
18.
What are some of the metrics economists use to measure health outcomes?
16.08: Critical Thinking Questions
19.
You are on the board of directors of a private high school, which is hiring new tenth-grade science teachers. As you think about hiring someone for a job, what are some mechanisms you might use to overcome the problem of imperfect information?
20.
A website offers a place for people to buy and sell emeralds, but information about emeralds can be quite imperfect. The website then enacts a rule that all sellers in the market must pay for two independent examinations of their emerald, which are available to the customer for inspection.
1. How would you expect this improved information to affect demand for emeralds on this website?
2. How would you expect this improved information to affect the quantity of high-quality emeralds sold on the website?
21.
How do you think the problem of moral hazard might have affected the safety of sports such as football and boxing when safety regulations started requiring that players wear more padding?
22.
To what sorts of customers would an insurance company offer a policy with a high copay? What about a high premium with a lower copay?
16.09: Problems
23.
Using Exercise 16.20, sketch the effects in parts (a) and (b) on a single supply and demand diagram. What prediction would you make about how the improved information alters the equilibrium quantity and price?
24.
Imagine that you can divide 50-year-old men into two groups: those who have a family history of cancer and those who do not. For the purposes of this example, say that 20% of a group of 1,000 men have a family history of cancer, and these men have one chance in 50 of dying in the next year, while the other 80% of men have one chance in 200 of dying in the next year. The insurance company is selling a policy that will pay \$100,000 to the estate of anyone who dies in the next year.
1. If the insurance company were selling life insurance separately to each group, what would be the actuarially fair premium for each group?
2. If an insurance company were offering life insurance to the entire group, but could not find out about family cancer histories, what would be the actuarially fair premium for the group as a whole?
3. What will happen to the insurance company if it tries to charge the actuarially fair premium to the group as a whole rather than to each group separately? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/16%3A_Information_Risk_and_Insurance/16.07%3A_Review_Questions.txt |
Figure 17.1 Building Home Equity Many people choose to purchase their home rather than rent. This chapter explores how the global financial crisis has influenced home ownership. (Credit: “red sold sign” by Diana Parkhouse/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• How Businesses Raise Financial Capital
• How Households Supply Financial Capital
• How to Accumulate Personal Wealth
Bring It Home
The Housing Bubble and the 2007 Financial Crisis
In 2006, housing equity in the United States peaked at \$13 trillion. That means that the market prices of homes, less what was still owed on the loans they used to buy these houses, equaled \$13 trillion. This was a very good number, since the equity represented the value of the financial asset most U.S. citizens owned.
However, by 2008 this number declined to \$8.8 trillion, and it plummeted further still in 2009. Combined with the decline in value of other financial assets held by U.S. citizens, by 2010, U.S. homeowners’ wealth had shrunk \$14 trillion! This is a staggering result, and it affected millions of lives: people had to alter their retirement, housing, and other important consumption decisions. Just about every other large economy in the world suffered a decline in the market value of financial assets, as a result of the 2008-2009 global financial crisis.
This chapter will explain why people purchase houses (other than as a place to live), why they buy other types of financial assets, and why businesses sell those financial assets in the first place. The chapter will also give us insight into why financial markets and assets go through boom and bust cycles like the one we described here.
When a firm needs to buy new equipment or build a new facility, it often must go to the financial market to raise funds. Usually firms will add capacity during an economic expansion when profits are on the rise and consumer demand is high. Business investment is one of the critical ingredients needed to sustain economic growth. Even in the sluggish 2009 economy, U.S. firms invested \$1.4 trillion in new equipment and structures, in the hope that these investments would generate profits in the years ahead.
Between the end of the recession in 2009 through the second quarter 2013, profits for the S&P 500 companies grew by 9.7% despite the weak economy, with cost cutting and reductions in input costs driving much of that amount, according to the Wall Street Journal. Figure 17.2 shows corporate profits after taxes (adjusted for inventory and capital consumption). Despite the steep decline in quarterly net profit in 2008, profits have recovered and surpassed pre-recession levels.
Figure 17.2 Corporate Profits After Tax (Adjusted for Inventory and Capital Consumption) Prior to 2008, corporate profits after tax more often than not increased each year. There was a significant drop in profits during 2008 and into 2009. The profit trend has since continued to increase each year, though at a less steady or consistent rate. (Source: Federal Reserve Economic Data (FRED) https://research.stlouisfed.org/fred2/series/CPATAX)
Many firms, from huge companies like General Motors to startup firms writing computer software, do not have the financial resources within the firm to make all the desired investments. These firms need financial capital from outside investors, and they are willing to pay interest for the opportunity to obtain a rate of return on the investment of that financial capital.
On the other side of the financial capital market, financial capital suppliers, like households, wish to use their savings in a way that will provide a return. Individuals cannot, however, take the few thousand dollars that they save in any given year, write a letter to General Motors or some other firm, and negotiate to invest their money with that firm. Financial capital markets bridge this gap: that is, they find ways to take the inflow of funds from many separate financial capital suppliers and transform it into the funds of financial capital demanders desire. Such financial markets include stocks, bonds, bank loans, and other financial investments.
Corporate Profits After Tax (Adjusted for Inventory and Capital Consumption)
Link It Up
Visit this website to read more about financial markets.
Our perspective then shifts to consider how these financial investments appear to capital suppliers such as the households that are saving funds. Households have a range of investment options: bank accounts, certificates of deposit, money market mutual funds, bonds, stocks, stock and bond mutual funds, housing, and even tangible assets like gold. Finally, the chapter investigates two methods for becoming rich: a quick and easy method that does not work very well at all, and a slow, reliable method that can work very well over a lifetime. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/17%3A_Financial_Markets/17.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Describe financial capital and how it relates to profits
• Discuss the purpose and process of borrowing, bonds, and corporate stock
• Explain how firms choose between sources of financial capital
Firms often make decisions that involve spending money in the present and expecting to earn profits in the future. Examples include when a firm buys a machine that will last 10 years, or builds a new plant that will last for 30 years, or starts a research and development project. Firms can raise the financial capital they need to pay for such projects in four main ways: (1) from early-stage investors; (2) by reinvesting profits; (3) by borrowing through banks or bonds; and (4) by selling stock. When business owners choose financial capital sources, they also choose how to pay for them.
Early-Stage Financial Capital
Firms that are just beginning often have an idea or a prototype for a product or service to sell, but few customers, or even no customers at all, and thus are not earning profits. Such firms face a difficult problem when it comes to raising financial capital: How can a firm that has not yet demonstrated any ability to earn profits pay a rate of return to financial investors?
For many small businesses, the original source of money is the business owner. Someone who decides to start a restaurant or a gas station, for instance, might cover the startup costs by dipping into their own bank account, or by borrowing money (perhaps using a home as collateral). Alternatively, many cities have a network of well-to-do individuals, known as “angel investors,” who will put their own money into small new companies at an early development stage, in exchange for owning some portion of the firm.
Venture capital firms make financial investments in new companies that are still relatively small in size, but that have potential to grow substantially. These firms gather money from a variety of individual or institutional investors, including banks, institutions like college endowments, insurance companies that hold financial reserves, and corporate pension funds. Venture capital firms do more than just supply money to small startups. They also provide advice on potential products, customers, and key employees. Typically, a venture capital fund invests in a number of firms, and then investors in that fund receive returns according to how the fund as a whole performs.
The amount of money invested in venture capital fluctuates substantially from year to year: as one example, venture capital firms invested more than \$48.3 billion in 2014, according to the National Venture Capital Association. All early-stage investors realize that the majority of small startup businesses will never hit it big; many of them will go out of business within a few months or years. They also know that getting in on the ground floor of a few huge successes like a Netflix or an Amazon.com can make up for multiple failures. Therefore, early-stage investors are willing to take large risks in order to position themselves to gain substantial returns on their investment.
Profits as a Source of Financial Capital
If firms are earning profits (their revenues are greater than costs), they can choose to reinvest some of these profits in equipment, structures, and research and development. For many established companies, reinvesting their own profits is one primary source of financial capital. Companies and firms just getting started may have numerous attractive investment opportunities, but few current profits to invest. Even large firms can experience a year or two of earning low profits or even suffering losses, but unless the firm can find a steady and reliable financial capital source so that it can continue making real investments in tough times, the firm may not survive until better times arrive. Firms often need to find financial capital sources other than profits.
Borrowing: Banks and Bonds
When a firm has a record of at least earning significant revenues, and better still of earning profits, the firm can make a credible promise to pay interest, and so it becomes possible for the firm to borrow money. Firms have two main borrowing methods: banks and bonds.
A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house. The firm borrows an amount of money and then promises to repay it, including some rate of interest, over a predetermined period of time. If the firm fails to make its loan payments, the bank (or banks) can often take the firm to court and require it to sell its buildings or equipment to make the loan payments.
Another source of financial capital is a bond. A bond is a financial contract: a borrower agrees to repay the amount that it borrowed and also an interest rate over a period of time in the future. A corporate bond is issued by firms, but bonds are also issued by various levels of government. For example, a municipal bond is issued by cities, a state bond by U.S. states, and a Treasury bond by the federal government through the U.S. Department of the Treasury. A bond specifies an amount that one will borrow, the interest rate that one will pay, and the time until repayment.
A large company, for example, might issue bonds for \$10 million. The firm promises to make interest payments at an annual rate of 8%, or \$800,000 per year and then, after 10 years, will repay the \$10 million it originally borrowed. When a firm issues bonds, it may choose to issue many bonds in smaller amounts that together reach the total amount it wishes to raise. A firm that seeks to borrow \$50 million by issuing bonds, might actually issue 10,000 bonds of \$5,000 each. In this way, an individual investor could, in effect, loan the firm \$5,000, or any multiple of that amount. Anyone who owns a bond and receives the interest payments is called a bondholder. If a firm issues bonds and fails to make the promised interest payments, the bondholders can take the firm to court and require it to pay, even if the firm needs to raise the money by selling buildings or equipment. However, there is no guarantee the firm will have sufficient assets to pay off the bonds. The bondholders may recoup only a portion of what they loaned the firm.
Bank borrowing is more customized than issuing bonds, so it often works better for relatively small firms. The bank can get to know the firm extremely well—often because the bank can monitor sales and expenses quite accurately by looking at deposits and withdrawals. Relatively large and well-known firms often issue bonds instead. They use bonds to raise new financial capital that pays for investments, or to raise capital to pay off old bonds, or to buy other firms. However, the idea that firms or individuals use banks for relatively smaller loans and bonds for larger loans is not an ironclad rule: sometimes groups of banks make large loans and sometimes relatively small and lesser-known firms issue bonds.
Corporate Stock and Public Firms
A corporation is a business that “incorporates”—that is owned by shareholders that have limited liability for the company's debt but share in its profits (and losses). Corporations may be private or public, and may or may not have publicly traded stock. They may raise funds to finance their operations or new investments by raising capital through selling stock or issuing bonds.
Those who buy the stock become the firm's owners, or shareholders. Stock represents firm ownership; that is, a person who owns 100% of a company’s stock, by definition, owns the entire company. The company's stock is divided into shares. Corporate giants like IBM, AT&T, Ford, General Electric, Microsoft, Merck, and Exxon all have millions of stock shares. In most large and well-known firms, no individual owns a majority of the stock shares. Instead, large numbers of shareholders—even those who hold thousands of shares—each have only a small slice of the firm's overall ownership.
When a large number of shareholders own a company, there are three questions to ask:
1. How and when does the company obtain money from its sale of stock?
2. What rate of return does the company promise to pay when it sells stock?
3. Who makes decisions in a company owned by a large number of shareholders?
First, a firm receives money from the stock sale only when the company sells its own stock to the public (the public includes individuals, mutual funds, insurance companies, and pension funds). We call a firm’s first stock sale to the public an initial public offering (IPO). The IPO is important for two reasons. For one, the IPO, and any stock issued thereafter, such as stock held as treasury stock (shares that a company keeps in their own treasury) or new stock issued later as a secondary offering, provides the funds to repay the early-stage investors, like the angel investors and the venture capital firms. A venture capital firm may have a 40% ownership in the firm. When the firm sells stock, the venture capital firm sells its part ownership of the firm to the public. A second reason for the importance of the IPO is that it provides the established company with financial capital for substantially expanding its operations.
However, most of the time when one buys and sells corporate stock the firm receives no financial return at all. If you buy General Motors stock, you almost certainly buy it from the current share owner, and General Motors does not receive any of your money. This pattern should not seem particularly odd. After all, if you buy a house, the current owner receives your money, not the original house builder. Similarly, when you buy stock shares, you are buying a small slice of the firm's ownership from the existing owner—and the firm that originally issued the stock is not a part of this transaction.
Second, when a firm decides to issue stock, it must recognize that investors will expect to receive a rate of return. That rate of return can come in two forms. A firm can make a direct payment to its shareholders, called a dividend. Alternatively, a financial investor might buy a share of stock in Wal-Mart for \$45 and then later sell it to someone else for \$60, for \$15 gain. We call the increase in the stock value (or of any asset) between when one buys and sells it a capital gain.
Third: Who makes the decisions about when a firm will issue stock, or pay dividends, or re-invest profits? To understand the answers to these questions, it is useful to separate firms into two groups: private and public.
A private company is frequently owned by the people who generally run it on a day-to-day basis. Individuals can run a private company. We call this a sole proprietorship. If a group runs it, we call it a partnership. A private company can also be a corporation, but with no publicly issued stock. A small law firm run by one person, even if it employs some other lawyers, would be a sole proprietorship. Partners may jointly own a larger law firm. Most private companies are relatively small, but there are some large private corporations, with tens of billions of dollars in annual sales, that do not have publicly issued stock, such as farm products dealer Cargill, the Mars candy company, and the Bechtel engineering and construction firm.
When a firm decides to sell stock, which financial investors can buy and sell, we call it a public company. Shareholders own a public company. Since the shareholders are a very broad group, often consisting of thousands or even millions of investors, the shareholders vote for a board of directors, who in turn hire top executives to run the firm on a day-to-day basis. The more stock a shareholder owns, the more votes that shareholder is entitled to cast for the company’s board of directors.
In theory, the board of directors helps to ensure that the firm runs in the interests of the true owners—the shareholders. However, the top executives who run the firm have a strong voice in choosing the candidates who will serve on their board of directors. After all, few shareholders are knowledgeable enough or have enough personal incentive to spend energy and money nominating alternative board members.
How Firms Choose between Financial Capital Sources
There are clear patterns in how businesses raise financial capital. We can explain these patterns in terms of imperfect information, which as we discussed in Information, Risk, and Insurance, is a situation where buyers and sellers in a market do not both have full and equal information. Those who are actually running a firm will almost always have more information about whether the firm is likely to earn profits in the future than outside investors who provide financial capital.
Any young startup firm is a risk. Some startup firms are only a little more than an idea on paper. The firm’s founders inevitably have better information than anyone else about how hard they are willing to work, and whether the firm is likely to succeed. When the founders invested their own money into the firm, they demonstrate a belief in its prospects. At this early stage, angel investors and venture capitalists try to overcome the imperfect information, at least in part, by knowing the managers and their business plan personally and by giving them advice.
Accurate information is sometimes not available because corporate governance, the name economists give to the institutions that are supposed to watch over top executives, fails, as the following Clear It Up feature on Lehman Brothers shows.
Clear It Up
How did lack of corporate governance lead to the Lehman Brothers failure?
In 2008, Lehman Brothers was the fourth largest U.S. investment bank, with 25,000 employees. The firm had been in business for 164 years. On September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy protection. There are many causes of the Lehman Brothers failure. One area of apparent failure was the lack of oversight by the Board of Directors to keep managers from undertaking excessive risk. We can attribute part of the oversight failure, according to Tim Geithner’s April 10, 2010, testimony to Congress, to the Executive Compensation Committee’s emphasis on short-term gains without enough consideration of the risks. In addition, according to the court examiner’s report, the Lehman Brother’s Board of Directors paid too little attention to the details of the operations of Lehman Brothers and also had limited financial service experience.
The board of directors, elected by the shareholders, is supposed to be the first line of corporate governance and oversight for top executives. A second institution of corporate governance is the auditing firm the company hires to review the company's financial records and certify that everything looks reasonable. A third institution of corporate governance is outside investors, especially large shareholders like those who invest large mutual funds or pension funds. In the case of Lehman Brothers, corporate governance failed to provide investors with accurate financial information about the firm’s operations.
As a firm becomes at least somewhat established and its strategy appears likely to lead to profits in the near future, knowing the individual managers and their business plans on a personal basis becomes less important, because information has become more widely available regarding the company’s products, revenues, costs, and profits. As a result, other outside investors who do not know the managers personally, like bondholders and shareholders, are more willing to provide financial capital to the firm.
At this point, a firm must often choose how to access financial capital. It may choose to borrow from a bank, issue bonds, or issue stock. The great disadvantage of borrowing money from a bank or issuing bonds is that the firm commits to scheduled interest payments, whether or not it has sufficient income. The great advantage of borrowing money is that the firm maintains control of its operations and is not subject to shareholders. Issuing stock involves selling off company ownership to the public and becoming responsible to a board of directors and the shareholders.
The benefit of issuing stock is that a small and growing firm increases its visibility in the financial markets and can access large amounts of financial capital for expansion, without worrying about repaying this money. If the firm is successful and profitable, the board of directors will need to decide upon a dividend payout or how to reinvest profits to further grow the company. Issuing and placing stock is expensive, requires the expertise of investment bankers and attorneys, and entails compliance with reporting requirements to shareholders and government agencies, such as the federal Securities and Exchange Commission (SEC). | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/17%3A_Financial_Markets/17.02%3A_How_Businesses_Raise_Financial_Capital.txt |
Learning Objectives
By the end of this section, you will be able to:
• Show the relationship between savers, banks, and borrowers
• Calculate bond yield
• Contrast bonds, stocks, mutual funds, and assets
• Explain the tradeoffs between return and risk
The ways in which firms would prefer to raise funds are only half the story of financial markets. The other half is what those households and individuals who supply funds desire, and how they perceive the available choices. The focus of our discussion now shifts from firms on the demand side of financial capital markets to households on the supply side of those markets. We can divide the mechanisms for savings available to households into several categories: deposits in bank accounts; bonds; stocks; money market mutual funds; stock and bond mutual funds; and housing and other tangible assets like owning gold. We need to analyze each of these investments in terms of three factors: (1) the expected rate of return it will pay; (2) the risk that the return will be much lower or higher than expected; and (3) the investment's liquidity, which refers to how easily one can exchange money or financial assets for a good or service. We will do this analysis as we discuss each of these investments in the sections below. First, however, we need to understand the difference between expected rate of return, risk, and actual rate of return.
Expected Rate of Return, Risk, and Actual Rate of Return
The expected rate of return refers to how much a project or an investment is expected to return to the investor, either in future interest payments, capital gains, or increased profitability. It is usually the average return over a period of time, usually in years or even decades. We normally measure it as a percentage rate. Risk measures the uncertainty of that project’s profitability. There are several types of risk, including default risk and interest rate risk. Default risk, as its name suggests, is the risk that the borrower fails to pay back the bond or loan. Interest rate risk is the danger that you might buy a long term bond at a 6% interest rate right before market rates suddenly rise, so had you waited, you could have received a similar bond that paid 9%. A high-risk investment is one for which a wide range of potential payoffs is reasonably probable. A low-risk investment may have actual returns that are fairly close to its expected rate of return year after year. A high-risk investment will have actual returns that are much higher than the expected rate of return in some months or years and much lower in other months or years. The actual rate of return refers to the total rate of return, including capital gains and interest paid on an investment at the end of a time period.
Bank Accounts
An intermediary is one who stands between two other parties. For example, a person who arranges a blind date between two other people is one kind of intermediary. In financial capital markets, banks are an example of a financial intermediary—that is, an institution that operates between a saver who deposits funds in a bank and a borrower who receives a loan from that bank. When a bank serves as a financial intermediary, unlike the situation with a couple on a blind date, the saver and the borrower never meet. In fact, it is not even possible to make direct connections between those who deposit funds in banks and those who borrow from banks, because all deposited funds end up in one big pool, which the financial institution then lends out.
Figure 17.3 illustrates the position of banks as a financial intermediary, with a pattern of deposits flowing into a bank and loans flowing out, and then repayment of the loans flowing back to the bank, with interest payments for the original savers.
Figure 17.3 Banks as Financial Intermediaries Banks are a financial intermediary because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments and withdraw money. Borrowers receive loans from banks, and repay the loans with interest.
Banks offer a range of accounts to serve different needs. A checking account typically pays little or no interest, but it facilitates transactions by giving you easy access to your money, either by writing a check or by using a debit card (that is, a card which works like a credit card, except that purchases are immediately deducted from your checking account rather than billed separately through a credit card company). A savings account typically pays some interest rate, but getting the money typically requires you to make a trip to the bank or an automatic teller machine (or you can access the funds electronically). The lines between checking and savings accounts have blurred in the last couple of decades, as many banks offer checking accounts that will pay an interest rate similar to a savings account if you keep a certain minimum amount in the account, or conversely, offer savings accounts that allow you to write at least a few checks per month.
Another way to deposit savings at a bank is to use a certificate of deposit (CD). With a CD, you agree to deposit a certain amount of money, often measured in thousands of dollars, in the account for a stated period of time, typically ranging from a few months to several years. In exchange, the bank agrees to pay a higher interest rate than for a regular savings account. While you can withdraw the money before the allotted time, as the advertisements for CDs always warn, there is “a substantial penalty for early withdrawal.”
Figure 17.4 shows the annual rate of interest paid on a six-month, one-year, and five-year CD since 1984, as reported by Bankrate.com. The interest rates that savings accounts pay are typically a little lower than the CD rate, because financial investors need to receive a slightly higher rate of interest as compensation for promising to leave deposits untouched for a period of time in a CD, and thus forfeiting some liquidity.
Figure 17.4 Interest Rates on Six-Month, One-Year, and Five-Year Certificates of Deposit The interest rates on certificates of deposit have fluctuated over time. The high interest rates of the early 1980s are indicative of the relatively high inflation rate in the United States at that time. Interest rates fluctuate with the business cycle, typically increasing during expansions and decreasing during a recession. Note the steep decline in CD rates since 2008, the beginning of the Great Recession.
The great advantages of bank accounts are that financial investors have very easy access to their money, and also money in bank accounts is extremely safe. In part, this safety arises because a bank account offers more security than keeping a few thousand dollars in the toe of a sock in your underwear drawer. In addition, the Federal Deposit Insurance Corporation (FDIC) protects the savings of the average person. Every bank is required by law to pay a fee to the FDIC, based on the size of its deposits. Then, if a bank should go bankrupt and not be able to repay depositors, the FDIC guarantees that all customers will receive their deposits back up to \$250,000.
The bottom line on bank accounts looks like this: low risk means low rate of return but high liquidity.
Bonds
An investor who buys a bond expects to receive a rate of return. However, bonds vary in the rates of return that they offer, according to the riskiness of the borrower. We always can divide an interest rate into three components (as we explained in Choice in a World of Scarcity): compensation for delaying consumption, an adjustment for an inflationary rise in the overall level of prices, and a risk premium that takes the borrower’s riskiness into account.
The U.S. government is an extremely safe borrower, so when the U.S. government issues Treasury bonds, it can pay a relatively low interest rate. Firms that appear to be safe borrowers, perhaps because of their sheer size or because they have consistently earned profits over time, will pay a higher interest rate than the U.S. government. Firms that appear to be riskier borrowers, perhaps because they are still growing or their businesses appear shaky, will pay the highest interest rates when they issue bonds. We call bonds that offer high interest rates to compensate for their relatively high chance of default high-yield bonds or junk bonds. A number of today’s well-known firms issued junk bonds in the 1980s when they were starting to grow, including Turner Broadcasting and Microsoft.
Link It Up
Visit this website to read about Treasury bonds.
A bond issued by the U.S. government or a large corporation may seem to be relatively low risk: after all, the bond issuer has promised to make certain payments over time, and except for rare bankruptcy cases, these payments will occur. If a corporate bond issuer fails to make the payments that it owes to its bondholders, the bondholders can require that the company declare bankruptcy, sell off its assets, and pay them as much as it can. Even in the case of junk bonds, a wise investor can reduce the risk by purchasing bonds from a wide range of different companies since, even if a few firms go broke and do not pay, they are not all likely to go bankrupt.
As we noted before, bonds carry an interest rate risk. For example, imagine you decide to buy a 10-year bond for \$1,000 that would pay an annual interest rate of 8%. Soon after you buy the bond, interest rates on bonds rise, so that now similar companies are paying an annual rate of 12%. Anyone who buys a \$1,000 bond now can receive annual payments of \$120 per year, but since your bond was issued at an interest rate of 8%, you have tied up \$1,000 and receive payments of only \$80 per year. In the meaningful sense of opportunity cost, you are missing out on the higher payments that you could have received. Furthermore, you can calculate the amount you should be willing to pay now for future payments. To place a present discounted value on a future payment, decide what you would need in the present to equal a certain amount in the future. This calculation will require an interest rate. For example, if the interest rate is 25%, then a payment of \$125 a year from now will have a present discounted value of \$100—that is, you could take \$100 in the present and have \$125 in the future. (We discuss this further in the appendix on Present Discounted Value.)
In financial terms, a bond has several parts. A bond is basically an “I owe you” note that an investor receives in exchange for capital (money). The bond has a face value. This is the amount the borrower agrees to pay the investor at maturity. The bond has a coupon rate or interest rate, which is usually semi-annual, but can be paid at different times throughout the year. (Bonds used to be paper documents with coupons that investors clipped and turned in to the bank to receive interest.) The bond has a maturity date when the borrower will pay back its face value as well as its last interest payment. Combining the bond’s face value, interest rate, and maturity date, and market interest rates, allows a buyer to compute a bond’s present value, which is the most that a buyer would be willing to pay for a given bond. This may or may not be the same as the face value.
The bond yield measures the rate of return a bond is expected to pay over time. Investors can buy bonds when they are issued and they can buy and sell them during their lifetimes. When buying a bond that has been around for a few years, investors should know that the interest rate printed on a bond is often not the same as the bond yield, even on new bonds. Read the next Work It Out feature to see how this happens.
Work It Out
Calculating the Bond Yield
You have bought a \$1,000 bond whose coupon rate is 8%. To calculate your return or yield, follow these steps:
1. Assume the following:
Face value of a bond: \$1,000
Coupon rate: 8 %
Annual payment: \$80 per year
2. Consider the risk of the bond. If this bond carries no risk, then it would be safe to assume that the bond will sell for \$1,000 when it is issued and pay the purchaser \$80 per year until its maturity, at which time the final interest payment will be made and the original \$1,000 will be repaid. Now, assume that over time the interest rates prevailing in the economy rise to 12% and that there is now only one year left to this bond’s maturity. This makes the bond an unattractive investment, since an investor can find another bond that perhaps pays 12%. To induce the investor to buy the 8% bond, the bond seller will lower its price below its face value of \$1,000.
3. Calculate the bond's price when its interest rate is less than the market interest rate. The expected payments from the bond one year from now are \$1,080, because in the bond’s last year the bond's issuer will make the final interest payment and then also repay the original \$1,000. Given that interest rates are now 12%, you know that you could invest \$964 in an alternative investment and receive \$1,080 a year from now; that is, \$964(1 + 0.12) = \$1080. Therefore, you will not pay more than \$964 for the original \$1,000 bond.
4. Consider that the investor will receive the \$1,000 face value, plus \$80 for the last year’s interest payment. The yield on the bond will be (\$1080 – \$964)/\$964 = 12%. The yield, or total return, means interest payments, plus capital gains. Note that the interest or coupon rate of 8% did not change. When interest rates rise, bonds previously issued at lower interest rates will sell for less than face value. Conversely, when interest rates fall, bonds previously issued at higher interest rates will sell for more than face value.
Figure 17.5 shows bond yield for two kinds of bonds: 10-year Treasury bonds (which are officially called “notes”) and corporate bonds issued by firms that have been given an AAA rating as relatively safe borrowers by Moody’s, an independent firm that publishes such ratings. Even though corporate bonds pay a higher interest rate, because firms are riskier borrowers than the federal government, the rates tend to rise and fall together. Treasury bonds typically pay more than bank accounts, and corporate bonds typically pay a higher interest rate than Treasury bonds.
Figure 17.5 Interest Rates for Corporate Bonds and Ten-Year U.S. Treasury Bonds The interest rates for corporate bonds and U.S. Treasury bonds (officially “notes”) rise and fall together, depending on conditions for borrowers and lenders in financial markets for borrowing. The corporate bonds always pay a higher interest rate, to make up for the higher risk they have of defaulting compared with the U.S. government.
The bottom line for bonds: rate of return—low to moderate, depending on the borrower's risk; risk—low to moderate, depending on whether interest rates in the economy change substantially after the bond is issued; liquidity—moderate, because the investor needs to sell the bond before the investor regains the cash.
Stocks
As we stated earlier, the rate of return on a financial investment in a share of stock can come in two forms: as dividends paid by the firm and as a capital gain achieved by selling the stock for more than you paid. The range of possible returns from buying stock is mind-bending. Firms can decide to pay dividends or not. A stock price can rise to a multiple of its original price or sink all the way to zero. Even in short periods of time, well-established companies can see large movements in their stock prices. For example, on July 1, 2011, Netflix stock peaked at \$295 per share; one year later, on July 30, 2012, it was at \$53.91 per share; in 2022, it had recovered to \$199. When Facebook went public, its shares of stock sold for around \$40 per share, but in 2022, they were selling for slightly over \$212.
We will discuss the reasons why stock prices fall and rise so abruptly below, but first you need to know how we measure stock market performance. There are a number of different ways to measure the overall performance of the stock market, based on averaging different subsets of companies' stock prices. Perhaps the best-known stock market measure is the Dow Jones Industrial Average, which is based on 30 large U.S. companies' stock prices. Another stock market performance gauge, the Standard & Poor’s 500, follows the stock prices of the 500 largest U.S. companies. The Wilshire 5000 tracks the stock prices of essentially all U.S. companies that have stock the public can buy and sell.
Other stock market measures focus on where stocks are traded. For example, the New York Stock Exchange monitors the performance of stocks that are traded on that exchange in New York City. The Nasdaq stock market includes about 3,600 stocks, with a concentration of technology stocks. Table 17.1 lists some of the most commonly cited measures of U.S. and international stock markets.
Measure of the Stock Market Comments
Dow Jones Industrial Average (DJIA): https://www.spglobal.com/spdji/en/ Based on 30 large companies from a diverse set of representative industries, chosen by analysts at Dow Jones and Company. The index was started in 1896.
Standard & Poor’s 500: http://www.standardandpoors.com Based on 500 large U.S. firms, chosen by analysts at Standard & Poor’s to represent the economy as a whole.
Wilshire 5000: http://www.wilshire.com Includes essentially all U.S. companies with stock ownership. Despite the name, this index includes about 7,000 firms.
New York Stock Exchange: http://www.nyse.com The oldest and largest U.S. stock market, dating back to 1792. It trades stocks for 2,800 companies of all sizes. It is located at 18 Broad St. in New York City.
NASDAQ: www.nasdaq.com Founded in 1971 as an electronic stock market, allowing people to buy or sell from many physical locations. It has about 3,600 companies.
FTSE: http://www.ftse.com Includes the 100 largest companies on the London Stock Exchange. Pronounced “footsie.” Originally stood for Financial Times Stock Exchange.
Nikkei: http://www.nikkei.co.jp/nikkeiinfo/en/ Nikkei stands for Nihon Keizai Shimbun, which translates as the Japan Economic Journal, a major business newspaper in Japan. Index includes the 225 largest and most actively traded stocks on the Tokyo Stock Exchange.
DAX: http://www.exchange.de Tracks 30 of the largest companies on the Frankfurt, Germany, stock exchange. DAX is an abbreviation for Deutscher Aktien Index (German Stock Index).
Table 17.1 Some Stock Market Measures
The trend in the stock market is generally up over time, but with some large dips along the way. Figure 17.6 shows the path of the Standard & Poor’s 500 index (which is measured on the left-hand vertical axis) and the Dow Jones Index (which is measured on the right-hand vertical axis). Broad stock market measures, like the ones we list here, tend to move together. The S&P 500 Index is the weighted average market capitalization of the firms selected to be in the index. The Dow Jones Industrial Average is the price weighted average of 30 industrial stocks tracked on the New York Stock Exchange.
When the Dow Jones average rises from 5,000 to 10,000, you know that the average price of the stocks in that index has roughly doubled. Figure 17.6 shows that stock prices did not rise much in the 1970s, but then started a steady climb in the 1980s. From 2000 to 2013, stock prices bounced up and down, but ended up at about the same level.
Figure 17.6 The Dow Jones Industrial Index and the Standard & Poor’s 500, 1965–2021 Stock prices rose dramatically from the 1980s up to about 2000. From 2000 to 2013, stock prices bounced up and down, but ended up at about the same level. Since 2009, both indexes have for the most part increased.
Table 17.2 shows the total annual rate of return an investor would have received from buying the stocks in the S&P 500 index over recent decades. The total return here includes both dividends paid by these companies and also capital gains arising from increases in the stock value. (For technical reasons related to how we calculate the numbers, the dividends and capital gains do not add exactly to the total return.) From the 1950s to the 1980s, the average firm paid annual dividends equal to about 4% of its stock value. Since the 1990s, dividends have dropped and now often provide a return closer to 1% to 2%. In the 1960s and 1970s, the gap between percent earned on capital gains and dividends was much closer than it has been since the 1980s. In the 1980s and 1990s, capital gains were far higher than dividends. In the 2000s, dividends remained low and, while stock prices fluctuated, they ended the decade roughly where they had started. In the 2010s, dividends remained low and stock prices increased, and this continued at the beginning of the 2020s.
Period Total Annual Return Capital Gains Dividends
1950–1959 19.25% 13.58% 4.99%
1960–1969 7.78% 4.39% 3.25%
1970–1979 5.88% 1.60% 4.20%
1980–1989 17.55% 12.59% 4.40%
1990–1999 18.21% 15.31% 2.51%
2000–2009 −1.00% −2.70% 1.70%
2010–2019 12.65% 10.35% 2.30%
2020 18.40% 16.26% 2.14%
2021 28.71% 26.89% 1.82%
Table 17.2 Annual Returns on S&P 500 Stocks, 1950–2021
The overall pattern is that stocks as a group have provided a high rate of return over extended periods of time, but this return comes with risks. The market value of individual companies can rise and fall substantially, both over short time periods and over the long run. During extended periods of time like the 1970s or the first decade of the 2000s, the overall stock market return can be quite modest. The stock market can sometimes fall sharply, as it did in 2008.
The bottom line on investing in stocks is that the rate of return over time will be high, but the risks are also high, especially in the short run. Liquidity is also high since one can sell stock in publicly held companies readily for spendable money.
Mutual Funds
Buying stocks or bonds issued by a single company is always somewhat risky. An individual firm may find itself buffeted by unfavorable supply and demand conditions or hurt by unlucky or unwise managerial decisions. Thus, a standard recommendation from financial investors is diversification, which means buying stocks or bonds from a wide range of companies. A saver who diversifies is following the old proverb: “Don’t put all your eggs in one basket.” In any broad group of companies, some firms will do better than expected and some will do worse—but the diversification has a tendency to cancel out extreme increases and decreases in value.
Purchasing a diversified group of stocks or bonds has become easier in the internet age, but it remains something of a task. To simplify the process, companies offer mutual funds, which consist of a variety of stocks or bonds from different companies. The financial investor buys mutual fund shares, and then receives a return based on how the fund as a whole performs. In 2021, according to the Investment Company Factbook, just over 47% of U.S. households had a financial investment in a mutual fund—including many people who have their retirement savings or pension money invested in this way.
Mutual funds can focus in certain areas: one mutual fund might invest only in company stocks based in Indonesia, or only in bonds issued by large manufacturing companies, or only in biotechnology companies' stock. At the other end of the spectrum, a mutual fund might be quite broad. At the extreme, some mutual funds own a tiny share of every firm in the stock market, and thus the mutual fund's value will fluctuate with the overall stock market's average. We call a mutual fund that seeks only to mimic the market's overall performance an index fund.
Diversification can offset some of the risks of individual stocks rising or falling. Even investors who buy an indexed mutual fund designed to mimic some measure of the broad stock market, like the Standard & Poor’s 500, had better prepare against some ups and downs, like those the stock market experienced in the first decade of the 2000s. In 2008 average U.S. stock funds declined 38%, reducing individual and household wealth. This steep drop in value hit hardest those who were close to retirement and were counting on their stock funds to supplement retirement income.
The bottom line on investing in mutual funds is that the rate of return over time will be high. The risks are also high, but the risks and returns for an individual mutual fund will be lower than those for an individual stock. As with stocks, liquidity is also high provided the mutual fund or stock index fund is readily traded.
Housing and Other Tangible Assets
Households can also seek a rate of return by purchasing tangible assets, especially housing. About two-thirds of U.S. households own their own home. An owner’s equity in a house is the monetary value the owner would have after selling the house and repaying any outstanding bank loans they used to buy the house. For example, imagine that you buy a house for \$200,000, paying 10% of the price as a down payment and taking out a bank loan for the remaining \$180,000. Over time, you pay off some of your bank loan, so that only \$100,000 remains, and the house's value on the market rises to \$250,000. At that point, your equity in the home is the value of the home minus the value of the loan outstanding, which is \$150,000. For many middle-class Americans, home equity is their single greatest financial asset. The total value of all home equity held by U.S. households was \$23.6 trillion as of the middle of 2021, according to Federal Reserve data.
Investment in a house is tangibly different from bank accounts, stocks, and bonds because a house offers both a financial and a nonfinancial return. If you buy a house to live in, part of the return on your investment occurs from your consumption of “housing services”—that is, having a place to live. (Of course, if you buy a home and rent it out, you receive rental payments for the housing services you provide, which would offer a financial return.) Buying a house to live in also offers the possibility of a capital gain from selling the house in the future for more than you paid for it. There can, however, be different outcomes, as the Clear It Up on the housing market shows.
Housing prices have usually risen steadily over time. For example, the median sales price for an existing one-family home was \$122,900 in 1990, but 232,000 at the end of December 2016, according to FRED® Economic Data. Over these 24 years, home prices increased an average of 3.1% per year, which is an average financial return over this time. Figure 17.7 shows U.S. Census data for the average sales price of a new home in the United States from 1965 to 2021.
Link It Up
Go to this website to experiment with a compound annual growth rate calculator.
However, the possible capital gains from rising housing prices are riskier than these national price averages. Certain regions of the country or metropolitan areas have seen drops in housing prices over time. The median housing price for the United States as a whole fell almost 7% in 2008 and again in 2009, dropping the median price from \$247,900 to \$216,700. As of 2016, home values had recovered and even exceeded their pre-recession levels, and they have continued to increase into the early 2020s.
Link It Up
Visit this website to watch the trailer for Inside Job, a movie that explores the modern financial crisis.
Figure 17.7 The Median Average Sales Price for New Single-Family Homes, 1990–2015 The median price is the price where half of sales prices are higher and half are lower. The median sales price for a new one-family home was \$122,900 in 1990. It rose as high as \$248,000 in 2007, before falling to \$232,000 in 2008. In 2015, the median sales price was \$294,000. Of course, this national figure conceals many local differences, like the areas where housing prices are higher or lower, or how housing prices have risen or fallen at certain times. (Source: U.S. Census)
Investors can also put money into other tangible assets such as gold, silver, and other precious metals, or in duller commodities like sugar, cocoa, coffee, orange juice, oil, and natural gas. The return on these investments derives from the saver’s hope of buying low, selling high, and receiving a capital gain. Investing in, say, gold or coffee offers relatively little in the way of nonfinancial benefits to the user (unless the investor likes to caress gold or gaze upon a warehouse full of coffee). Typically, investors in these commodities never even see the physical good. Instead, they sign a contract that takes ownership of a certain quantity of these commodities, which are stored in a warehouse, and later they sell the ownership to someone else. As one example, from 1981 to 2005, the gold prices generally fluctuated between about \$300 and \$500 per ounce, but then rose sharply to over \$1,100 per ounce by early 2010. In January 2017, prices were hovering around \$1,191 per ounce, and they have since increased, reaching over \$1,900 by early 2022.
A final area of tangible assets consists of “collectibles” like paintings, fine wine, jewelry, antiques, or even baseball cards. Most collectibles provide returns both in the form of services or of a potentially higher selling price in the future. You can use paintings by hanging them on the wall; jewelry by wearing it; baseball cards by displaying them. You can also hope to sell them someday for more than you paid for them. However, the evidence on prices of collectibles, while scanty, is that while they may go through periods where prices skyrocket for a time, you should not expect to make a higher-than-average rate of return over a sustained period of time from investing in this way.
The bottom line on investing in tangible assets: rate of return—moderate, especially if you can receive nonfinancial benefits from, for example, living in the house; risk—moderate for housing or high if you buy gold or baseball cards; liquidity—low, because it often takes considerable time and energy to sell a house or a piece of fine art and turn your capital gain into cash. The next Clear It Up feature explains the issues in the recent U.S. housing market crisis.
Clear It Up
What was all the commotion in the recent U.S. housing market?
The cumulative average annual growth rate in housing prices from 1981 to 2000 was 5.1%. The price of an average U.S. home then took off from 2003 to 2005, rising more than 10% per year. No serious analyst believed this rate of growth was sustainable; after all, if housing prices grew at, say, 11% per year over time, the average price of a home would more than double every seven years. However, at the time many serious analysts saw no reason for deep concern. After all, housing prices often change in fits and starts, like all prices, and a price surge for a few years is often followed by prices that are flat or even declining a bit as local markets adjust.
The sharp rise in housing prices was driven by a high level of demand for housing. Interest rates were low, so financial institutions encouraged people to borrow money to buy a house. Banks became much more flexible in their lending, making what were called “subprime” loans. Banks loaned money with low, or sometimes no down payment. They offered loans with very low payments for the first two years, but then much higher payments after that. The idea was that housing prices would keep rising, so the borrower would just refinance the mortgage two years in the future, and thus would not ever have to make the higher payments. Some banks even offered so-called NINJA loans, which meant a financial institution issued a loan even though the borrower had no income, no job, nor assets.
In retrospect, these loans seem outlandish. Many borrowers figured, however, that as long as housing prices kept rising, it made sense to buy. Many lenders used a process called “securitizing,” in which they sold their mortgages to financial companies, which put all the mortgages into a big pool, creating large financial securities, and then re-sold these mortgage-backed securities to investors. In this way, the lenders off-loaded the mortgage risks to investors. Investors were interested in mortgage-backed securities as they appeared to offer a steady stream of income, provided the borrowers repaid them. Investors relied on the ratings agencies to assess the credit risk associated with the mortgage-backed securities. In hindsight, it appears that the credit agencies were far too lenient in their ratings of many of the securitized loans. Bank and financial regulators watched the steady rise in the market for mortgage-backed securities, but saw no reason at the time to intervene.
When housing prices turned down, many households that had borrowed when prices were high found that what they owed the bank was more than what their home was worth. Many banks believed that they had diversified by selling their individual loans and instead buying securities based on mortgage loans from all over the country. After all, banks thought back in 2005, the average house price had not declined at any time since the Great Depression in the 1930s. These securities based on mortgage loans, however, turned out to be far riskier than expected. The bust in housing prices weakened both bank and household finances, and thus helped bring on the 2008–2009 Great Recession.
The Tradeoffs between Return and Risk
The discussion of financial investments has emphasized the expected rate of return, the risk, and the liquidity of each investment. Table 17.3 summarizes these characteristics.
Financial Investment Return Risk Liquidity
Checking account Very low Very little Very high
Savings account Low Very little High
Certificate of deposit Low to medium Very little Medium
Stocks High Medium to high Medium
Bonds Medium Low to medium Medium
Mutual funds Medium to high Medium to high Medium to high
Housing Medium Medium Low
Gold Medium High Low
Collectibles Low to medium High Low
Table 17.3 Key Characteristics of Financial Investments
The household investment choices listed here display a tradeoff between the expected return and the degree of risk involved. Bank accounts have very low risk and very low returns; bonds have higher risk but higher returns; and stocks are riskiest of all but have the potential for still higher returns. In effect, the higher average return compensates for the higher degree of risk. If risky assets like stocks did not also offer a higher average return, then few investors would want them.
This tradeoff between return and risk complicates the task of any financial investor: Is it better to invest safely or to take a risk and go for the high return? Ultimately, choices about risk and return will be based on personal preferences. However, it is often useful to examine risk and return in the context of different time frames.
The high returns of stock market investments refer to a high average return that we can expect over a period of several years or decades. The high risk of such investments refers to the fact that in shorter time frames, from months to a few years, the rate of return may fluctuate a great deal. Thus, a person near retirement age, who already owns a house, may prefer reduced risk and certainty about retirement income. For young workers, just starting to make a reasonably profitable living, it may make sense to put most of their savings for retirement in mutual funds. Mutual funds are able to take advantage of their buying and selling size and thereby reduce transaction costs for investors. Stocks are risky in the short term, to be sure, but when the worker can look forward to several decades during which stock market ups and downs can even out, stocks will typically pay a much higher return over that extended period than will bonds or bank accounts. Thus, one must consider tradeoffs between risk and return in the context of where the investor is in life. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/17%3A_Financial_Markets/17.03%3A_How_Households_Supply_Financial_Capital.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the random walk theory
• Calculate simple and compound interest
• Evaluate how capital markets transform financial capital
Getting rich may seem straightforward enough. Figure out what companies are going to grow and earn high profits in the future, or figure out what companies are going to become popular for everyone else to buy. Those companies are the ones that will pay high dividends or whose stock price will climb in the future. Then, buy stock in those companies. Presto! Multiply your money!
Why is this path to riches not as easy as it sounds? This module first discusses the problems with picking stocks, and then discusses a more reliable but undeniably duller method of accumulating personal wealth.
Why It Is Hard to Get Rich Quick: The Random Walk Theory
The chief problem with attempting to buy stock in companies that will have higher prices in the future is that many other financial investors are trying to do the same thing. Thus, in attempting to get rich in the stock market, it is no help to identify a company that is going to earn high profits if many other investors have already reached the same conclusion, because the stock price will already be high, based on the expected high level of future profits.
The idea that stock prices are based on expectations about the future has a powerful and unexpected implication. If expectations determine stock price, then shifts in expectations will determine shifts in the stock price. Thus, what matters for predicting whether the stock price of a company will do well is not whether the company will actually earn profits in the future. Instead, you must find a company that analysts widely believe at present to have poor prospects, but that will actually turn out to be a shining star. Brigades of stock market analysts and individual investors are carrying out such research 24 hours a day.
The fundamental problem with predicting future stock winners is that, by definition, no one can predict the future news that alters expectations about profits. Because stock prices will shift in response to unpredictable future news, these prices will tend to follow what mathematicians call a “random walk with a trend.” The “random walk” part means that, on any given day, stock prices are just as likely to rise as to fall. “With a trend” means that over time, the upward steps tend to be larger than the downward steps, so stocks do gradually climb.
If stocks follow a random walk, then not even financial professionals will be able to choose those that will beat the average consistently. While some investment advisers are better than average in any given year, and some even succeed for a number of years in a row, the majority of financial investors do not outguess the market. If we look back over time, it is typically true that half or two-thirds of the mutual funds that attempted to pick stocks which would rise more than the market average actually ended up performing worse than the market average. For the average investor who reads the newspaper business pages over a cup of coffee in the morning, the odds of doing better than full-time professionals is not very good at all. Trying to pick the stocks that will gain a great deal in the future is a risky and unlikely way to become rich.
Getting Rich the Slow, Boring Way
Many U.S. citizens can accumulate a large amount of wealth during their lifetimes, if they make two key choices. The first is to complete additional education and training. In 2020, the Bureau of Labor Statistics reported median weekly usual earnings for full-time wage and salary workers age 25 and over that corresponded to annual income of \$40,612 for those with a high school diploma, \$48,776 for those with a two-year associate degree, and \$67,860 for those with a four-year bachelor’s degree. Learning is not only good for you, but it pays off financially, too.
The second key choice is to start saving money early in life, and to give the power of compound interest a chance. Imagine that at age 25, you save \$3,000 and place that money into an account that you do not touch. In the long run, it is not unreasonable to assume a 7% real annual rate of return (that is, 7% above the rate of inflation) on money invested in a well-diversified stock portfolio. After 40 years, using the formula for compound interest, the original \$3,000 investment will have multiplied nearly fifteen fold:
$3,000 (1+.07) 40 =44,923 3,000 (1+.07) 40 =44,923$
Having \$45,000 does not make you a millionaire. Notice, however, that this tidy sum is the result of saving \$3,000 exactly once. Saving that amount every year for several decades—or saving more as income rises—will multiply the total considerably. This type of wealth will not rival the riches of Microsoft CEO Bill Gates, but remember that only half of Americans have any money in mutual funds at all. Accumulating hundreds of thousands of dollars by retirement is a perfectly achievable goal for a well-educated person who starts saving early in life—and that amount of accumulated wealth will put you at or near the top 10% of all American households. The following Work It Out feature shows the difference between simple and compound interest, and the power of compound interest.
Work It Out
Simple and Compound Interest
Simple interest is an interest rate calculation only on the principal amount.
Step 1. Learn the formula for simple interest:
$Principal×Rate×Time=InterestPrincipal×Rate×Time=Interest$
Step 2. Practice using the simple interest formula.
Example 1: \$100 Deposit at a simple interest rate of 5% held for one year is:
$100×0.05×1=5100×0.05×1=5$
Simple interest in this example is \$5.
Example 2: \$100 Deposit at a simple interest rate of 5% held for three years is:
$100×0.05×3=15100×0.05×3=15$
Simple interest in this example is \$15.
Step 3. Calculate the total future amount using this formula:
$Total future amount=principal+interestTotal future amount=principal+interest$
Step 4. Put the two simple interest formulas together.
$Total future amount (with simple interest)=Principal+(Principal×Rate×Time)Total future amount (with simple interest)=Principal+(Principal×Rate×Time)$
Step 5. Apply the simple interest formula to our three year example.
$Total future amount (with simple interest)=100+(100×0.05×3)=115Total future amount (with simple interest)=100+(100×0.05×3)=115$
Compound interest is an interest rate calculation on the principal plus the accumulated interest.
Step 6. To find the compound interest, we determine the difference between the future value and the present value of the principal. This is accomplished as follows:
$Future Value=Principal × (1 + interest rate) time Future Value=Principal × (1 + interest rate) time$ $Compound interest=Future Value –Present ValveCompound interest=Future Value –Present Valve$
Step 7. Apply this formula to our three-year scenario. Follow the calculations in
Table 17.4
Year 1
Amount in Bank \$100
Bank Interest Rate 5%
Total \$105
\$100 + (\$100 × 0.05)
Year 2
Amount in Bank \$105
Bank Interest Rate 5%
Total \$110.25
\$105 + (\$105 × .05)
Year 3
Amount in Bank \$110.25
Bank Interest Rate 5%
Total \$115.75
\$110.25 + (\$110.25 × .05)
Compound interest \$115.76 – \$100 = \$15.76
Table 17.4
Step 8. Note that, after three years, the total is \$115.76. Therefore the total compound interest is \$15.76. This is \$0.76 more than we obtained with simple interest. While this may not seem like much, keep in mind that we were only working with \$100 and over a relatively short time period. Compound interest can make a huge difference with larger sums of money and over longer periods of time.
Obtaining additional education and saving money early in life obviously will not make you rich overnight. Additional education typically means deferring earning income and living as a student for more years. Saving money often requires choices like driving an older or less expensive car, living in a smaller apartment or buying a smaller house, and making other day-to-day sacrifices. For most people, the tradeoffs for achieving substantial personal wealth will require effort, patience, and sacrifice.
How Capital Markets Transform Financial Flows
Financial capital markets have the power to repackage money as it moves from those who supply financial capital to those who demand it. Banks accept checking account deposits and turn them into long-term loans to companies. Individual firms sell shares of stock and issue bonds to raise capital. Firms make and sell an astonishing array of goods and services, but an investor can receive a return on the company’s decisions by buying stock in that company. Financial investors sell and resell stocks and bonds to one another. Venture capitalists and angel investors search for promising small companies. Mutual funds combine the stocks and bonds—and thus, indirectly, the products and investments—of many different companies.
Link It Up
Visit this website to read an article about how austerity can work. Then visit this website for another perspective on austerity.
In this chapter, we discussed the basic mechanisms of financial markets. (A more advanced course in economics or finance will consider more sophisticated tools.) The fundamentals of those financial capital markets remain the same: Firms are trying to raise financial capital and households are looking for a desirable combination of rate of return, risk, and liquidity. Financial markets are society’s mechanisms for bringing together these forces of demand and supply.
Bring It Home
The Housing Bubble and the Financial Crisis of 2007
The housing boom and bust in the United States, and the resulting multi-trillion-dollar decline in home equity, began with the fall of home prices starting in 2007. As home values dipped, many home prices fell below the amount the borrower owed on the mortgage and owners stopped paying and defaulted on their loan. Banks found that their assets (loans) became worthless. Many financial institutions around the world had invested in mortgage-backed securities, or had purchased insurance on mortgage-backed securities. When housing prices collapsed, the value of those financial assets collapsed as well. The asset side of the banks’ balance sheets dropped, causing bank failures and bank runs. Around the globe, financial institutions were bankrupted or nearly so. The result was a large decrease in lending and borrowing, or a freezing up of available credit. When credit dries up, the economy is on its knees. The crisis was not limited to the United States. Iceland, Ireland, the United Kingdom, Spain, Portugal, and Greece all had similar housing boom and bust cycles, and similar credit freezes.
If businesses cannot access financial capital, they cannot make physical capital investments. Those investments ultimately lead to job creation. When credit dried up, businesses invested less, and they ultimately laid off millions of workers. This caused incomes to drop, which caused demand to drop. In turn businesses sold less, so they laid off more workers. Compounding these events, as economic conditions worsened, financial institutions were even less likely to make loans.
To make matters even worse, as businesses sold less, their expected future profit decreased, and this led to a drop in stock prices. Combining all these effects led to major decreases in incomes, demand, consumption, and employment, and to the Great Recession, which in the United States officially lasted from December 2007 to June 2009. During this time, the unemployment rate rose from 5% to a peak of 10.1%. Four years after the recession officially ended, unemployment was still stubbornly high, at 7.6%, and 11.8 million people were still unemployed.
As the world’s leading consumer, if the United States goes into recession, it usually drags other countries down with it. The Great Recession was no exception. With few exceptions, U.S. trading partners also entered into recessions of their own, of varying lengths, or suffered slower economic growth. Like the United States, many European countries also gave direct financial assistance, so-called bailouts, to the institutions that make up their financial markets. There was good reason to do this. Financial markets bridge the gap between demanders and suppliers of financial capital. These institutions and markets need to function in order for an economy to invest in new financial capital.
However, much of this bailout money was borrowed, and this borrowed money contributed to another crisis in Europe. Because of the impact on their budgets of the financial crisis and the resulting bailouts, many countries found themselves with unsustainably high deficits. They chose to undertake austerity measures, large decreases in government spending and large tax increases, in order to reduce their deficits. Greece, Ireland, Spain, and Portugal all had to undertake relatively severe austerity measures. The ramifications of this crisis have spread. Economists even called into question the euro’s viability. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/17%3A_Financial_Markets/17.04%3A_How_to_Accumulate_Personal_Wealth.txt |
actual rate of return
the total rate of return, including capital gains and interest paid on an investment at the end of a time period
bond
a financial contract through which a borrower like a corporation, a city or state, or the federal government agrees to repay the amount that it borrowed and also a rate of interest over a period of time in the future
bond yield
the rate of return a bond is expected to pay at the time of purchase
bondholder
someone who owns bonds and receives the interest payments
capital gain
a financial gain from buying an asset, like a share of stock or a house, and later selling it at a higher price
certificate of deposit (CD)
a mechanism for a saver to deposit funds at a bank and promise to leave them at the bank for a time, in exchange for a higher interest rate
checking account
a bank account that typically pays little or no interest, but that gives easy access to money, either by writing a check or by using a “debit card”
compound interest
an interest rate calculation on the principal plus the accumulated interest
corporate bond
a bond issued by firms that wish to borrow
corporate governance
the name economists give to the institutions that are supposed to watch over top executives in companies that shareholders own
corporation
a business owned by shareholders who have limited liability for the company’s debt yet a share of the company’s profits; may be private or public and may or may not have publicly-traded stock
coupon rate
the interest rate paid on a bond; can be annual or semi-annual
debit card
a card that lets the person make purchases, and the financial institution immediately deducts cost from that person’s checking account
diversification
investing in a wide range of companies to reduce the level of risk
dividend
a direct payment from a firm to its shareholders
equity
the monetary value a homeowner would have after selling the house and repaying any outstanding bank loans used to buy the house
expected rate of return
how much a project or an investment is expected to return to the investor, either in future interest payments, capital gains, or increased profitability
face value
the amount that the bond issuer or borrower agrees to pay the investor
financial intermediary
an institution, like a bank, that receives money from savers and provides funds to borrowers
high-yield bonds
bonds that offer relatively high interest rates to compensate for their relatively high chance of default
index fund
a mutual fund that seeks only to mimic the market's overall performance
initial public offering (IPO)
the first sale of shares of stock by a firm to outside investors
junk bonds
see high-yield bonds
liquidity
refers to how easily one can exchange money or financial assets for a good or service
maturity date
the date that a borrower must repay a bond
municipal bonds
a bond issued by cities that wish to borrow
mutual funds
funds that buy a range of stocks or bonds from different companies, thus allowing an investor an easy way to diversify
partnership
a company run by a group as opposed to an individual
present value
a bond’s current price at a given time
private company
a firm frequently owned by the people who generally run it on a day-to-day basis
public company
a firm that has sold stock to the public, which in turn investors then can buy and sell
risk
a measure of the uncertainty of that project’s profitability
savings account
a bank account that pays an interest rate, but withdrawing money typically requires a trip to the bank or an automatic teller machine
shareholders
people who own at least some shares of stock in a firm
shares
a firm's stock, divided into individual portions
simple interest
an interest rate calculation only on the principal amount
sole proprietorship
a company run by an individual as opposed to a group
stock
a specific firm's claim on partial ownership
Treasury bond
a bond issued by the federal government through the U.S. Department of the Treasury
venture capital
financial investments in new companies that are still relatively small in size, but that have potential to grow substantially | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/17%3A_Financial_Markets/17.05%3A_Key_Terms.txt |
17.1 How Businesses Raise Financial Capital
Companies can raise early-stage financial capital in several ways: from their owners’ or managers’ personal savings, or credit cards and from private investors like angel investors and venture capital firms.
A bond is a financial contract through which a borrower agrees to repay the amount that it borrowed. A bond specifies an amount that one will borrow, the amounts that one will repay over time based on the interest rate when the bond is issued, and the time until repayment. Corporate bonds are issued by firms; municipal bonds are issued by cities, state bonds by U.S. states, and Treasury bonds by the federal government through the U.S. Department of the Treasury.
Stock represents firm ownership. A company's stock is divided into shares. A firm receives financial capital when it sells stock to the public. We call a company’s first stock sale to the public the initial public offering (IPO). However, a firm does not receive any funds when one shareholder sells stock in the firm to another investor. One receives the rate of return on stock in two forms: dividends and capital gains.
A private company is usually owned by the people who run it on a day-to-day basis, although hired managers can run it. We call a private company owned and run by an individual a sole proprietorship, while a firm owned and run by a group is a partnership. When a firm decides to sell stock that financial investors can buy and sell, then the firm is owned by its shareholders—who in turn elect a board of directors to hire top day-to-day management. We call this a public company. Corporate governance is the name economists give to the institutions that are supposed to watch over top executives, though it does not always work.
17.2 How Households Supply Financial Capital
We can categorize all investments according to three key characteristics: average expected return, degree of risk, and liquidity. To obtain a higher rate of return, an investor must typically accept either more risk or less liquidity. Banks are an example of a financial intermediary, an institution that operates to coordinate supply and demand in the financial capital market. Banks offer a range of accounts, including checking accounts, savings accounts, and certificates of deposit. Under the Federal Deposit Insurance Corporation (FDIC), banks purchase insurance against the risk of a bank failure.
A typical bond promises the financial investor a series of payments over time, based on the interest rate at the time the financial institution issues the bond, and when the borrower repays it. Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high-yield or junk bonds. The bond yield is the rate of return that a bond promises to pay at the time of purchase. Even when bonds make payments based on a fixed interest rate, they are somewhat risky, because if interest rates rise for the economy as a whole, an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss.
Changes in the stock price depend on changes in expectations about future profits. Investing in any individual firm is somewhat risky, so investors are wise to practice diversification, which means investing in a range of companies. A mutual fund purchases an array of stocks and/or bonds. An investor in the mutual fund then receives a return depending on the fund's overall performance as a whole. A mutual fund that seeks to imitate the overall behavior of the stock market is called an index fund.
We can also regard housing and other tangible assets as forms of financial investment, which pay a rate of return in the form of capital gains. Housing can also offer a nonfinancial return—specifically, you can live in it.
17.3 How to Accumulate Personal Wealth
It is extremely difficult, even for financial professionals, to predict changes in future expectations and thus to choose the stocks whose price will rise in the future. Most Americans can accumulate considerable financial wealth if they follow two rules: complete significant additional education and training after graduating from high school and start saving money early in life. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/17%3A_Financial_Markets/17.06%3A_Key_Concepts_and_Summary.txt |
1.
Answer these three questions about early-stage corporate finance:
1. Why do very small companies tend to raise money from private investors instead of through an IPO?
2. Why do small, young companies often prefer an IPO to borrowing from a bank or issuing bonds?
3. Who has better information about whether a small firm is likely to earn profits, a venture capitalist or a potential bondholder, and why?
2.
From a firm’s point of view, how is a bond similar to a bank loan? How are they different?
3.
Calculate the equity each of these people has in their home:
1. Eva just bought a house for \$200,000 by putting 10% as a down payment and borrowing the rest from the bank.
2. Freda bought a house for \$150,000 in cash, but if she were to sell it now, it would sell for \$250,000.
3. Ben bought a house for \$100,000. He put 20% down and borrowed the rest from the bank. However, the value of the house has now increased to \$160,000 and he has paid off \$20,000 of the bank loan.
4.
Which has a higher average return over time: stocks, bonds, or a savings account? Explain your answer.
5.
Investors sometimes fear that a high-risk investment is especially likely to have low returns. Is this fear true? Does a high risk mean the return must be low?
6.
What is the total amount of interest from a \$5,000 loan after three years with a simple interest rate of 6%?
7.
If you receive \$500 in simple interest on a loan that you made for \$10,000 for five years, what was the interest rate you charged?
8.
You open a 5-year CD for \$1,000 that pays 2% interest, compounded annually. What is the value of that CD at the end of the five years?
17.08: Review Questions
9.
What are the most common ways for start-up firms to raise financial capital?
10.
Why can firms not just use their own profits for financial capital, with no need for outside investors?
11.
Why are banks more willing to lend to well-established firms?
12.
What is a bond?
13.
What does a share of stock represent?
14.
When do firms receive money from a stock sale in their firm and when do they not receive money?
15.
What is a dividend?
16.
What is a capital gain?
17.
What is the difference between a private company and a public company?
18.
How do the shareholders who own a company choose the actual company managers?
19.
Why are banks called “financial intermediaries”?
20.
Name several different kinds of bank account. How are they different?
21.
Why are bonds somewhat risky to buy, even though they make predetermined payments based on a fixed rate of interest?
22.
Why should a financial investor care about diversification?
23.
What is a mutual fund?
24.
What is an index fund?
25.
How is buying a house to live in a type of financial investment?
26.
Why is it hard to forecast future movements in stock prices?
27.
What are the two key choices U.S. citizens need to make that determines their relative wealth?
28.
Is investing in housing always a very safe investment? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/17%3A_Financial_Markets/17.07%3A_Self-Check_Questions.txt |
29.
If you owned a small firm that had become somewhat established, but you needed a surge of financial capital to carry out a major expansion, would you prefer to raise the funds through borrowing or by issuing stock? Explain your choice.
30.
Explain how a company can fail when the safeguards that should be in place fail.
31.
What are some reasons why the investment strategy of a 30-year-old might differ from the investment strategy of a 65-year-old?
32.
Explain why a financial investor in stocks cannot earn high capital gains simply by buying companies with a demonstrated record of high profits.
33.
Explain what happens in an economy when the financial markets limit access to capital. How does this affect economic growth and employment?
34.
You and your friend have opened an account on E-Trade and have each decided to select five similar companies in which to invest. You are diligent in monitoring your selections, tracking prices, current events, and actions the company has taken. Your friend chooses his companies randomly, pays no attention to the financial news, and spends his leisure time focused on everything besides his investments. Explain what might be the performance for each of your portfolios at the end of the year.
35.
How do bank failures cause the economy to go into recession?
17.10: Problems
36.
The Darkroom Windowshade Company has 100,000 shares of stock outstanding. The investors in the firm own the following numbers of shares: investor 1 has 20,000 shares; investor 2 has 18,000 shares; investor 3 has 15,000 shares; investor 4 has 10,000 shares; investor 5 has 7,000 shares; and investors 6 through 11 have 5,000 shares each. What is the minimum number of investors it would take to vote to change the company's top management? If investors 1 and 2 agree to vote together, can they be certain of always getting their way in how the company will be run?
37.
Imagine that a local water company issued \$10,000 ten-year bond at an interest rate of 6%. You are thinking about buying this bond one year before the end of the ten years, but interest rates are now 9%.
1. Given the change in interest rates, would you expect to pay more or less than \$10,000 for the bond?
2. Calculate what you would actually be willing to pay for this bond.
38.
Suppose Ford Motor Company issues a five year bond with a face value of \$5,000 that pays an annual coupon payment of \$150.
1. What is the interest rate Ford is paying on the borrowed funds?
2. Suppose the market interest rate rises from 3% to 4% a year after Ford issues the bonds. Will the value of the bond increase or decrease?
39.
How much money do you have to put into a bank account that pays 10% interest compounded annually to have \$10,000 in ten years?
40.
Many retirement funds charge an administrative fee each year equal to 0.25% on managed assets. Suppose that Alexx and Spenser each invest \$5,000 in the same stock this year. Alexx invests directly and earns 5% a year. Spenser uses a retirement fund and earns 4.75%. After 30 years, how much more will Alexx have than Spenser? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/17%3A_Financial_Markets/17.09%3A_Critical_Thinking_Questions.txt |
Figure 18.1 Domestic Tires? While these tires may all appear similar, some are made in the United States and others are not. Those that are not could be subject to a tariff that could cause the cost of all tires to be higher. (Credit: "Tires" by Jayme del Rosario/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Voter Participation and Costs of Elections
• Special Interest Politics
• Flaws in the Democratic System of Government
Bring It Home
Chinese Tire Tariffs
Do you know where the tires on your car are made? If they were imported, they may be subject to a tariff (a tax on imported goods) that could raise the price of your car. What do you think about that tariff? Would you write to your representative or your senator about it? Would you start a Facebook or Twitter campaign?
Most people are unlikely to fight this kind of tax or even inform themselves about the issue in the first place. In The Logic of Collective Action (1965), economist Mancur Olson challenged the popular idea that, in a democracy, the majority view will prevail, and in doing so launched the modern study of public economy, sometimes referred to as public choice, a subtopic of microeconomics. In this chapter, we will look at the economics of government policy, why smaller, more organized groups have an incentive to work hard to enact certain policies, and why lawmakers ultimately make decisions that may result in bad economic policy.
As President Abraham Lincoln famously said in his 1863 Gettysburg Address, democratic governments are supposed to be “of the people, by the people, and for the people.” Can we rely on democratic governments to enact sensible economic policies? After all, they react to voters, not to analyses of demand and supply curves. The main focus of an economics course is, naturally enough, to analyze the characteristics of markets and purely economic institutions. However, political institutions also play a role in allocating society’s scarce resources, and economists have played an active role, along with other social scientists, in analyzing how such political institutions work.
Other chapters of this book discuss situations in which market forces can sometimes lead to undesirable results: monopoly, imperfect competition, and antitrust policy; negative and positive externalities; poverty and inequality of incomes; failures to provide insurance; and financial markets that may go from boom to bust. Many of these chapters suggest that the government's economic policies could address these issues.
However, just as markets can face issues and problems that lead to undesirable outcomes, a democratic system of government can also make mistakes, either by enacting policies that do not benefit society as a whole or by failing to enact policies that would have benefited society as a whole. This chapter discusses some practical difficulties of democracy from an economic point of view: we presume the actors in the political system follow their own self-interest, which is not necessarily the same as the public good. For example, many of those who are eligible to vote do not, which obviously raises questions about whether a democratic system will reflect everyone’s interests. Benefits or costs of government action are sometimes concentrated on small groups, which in some cases may organize and have a disproportionately large impact on politics and in other cases may fail to organize and end up neglected. A legislator who worries about support from voters in their district may focus on spending projects specific to the district without sufficient concern for whether this spending is in the nation's interest.
When more than two choices exist, the principle that the majority of voters should decide may not always make logical sense, because situations can arise where it becomes literally impossible to decide what the “majority” prefers. Government may also be slower than private firms to correct its mistakes, because government agencies do not face competition or the threat of new entry. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/18%3A_Public_Economy/18.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the significance of rational ignorance
• Evaluate the impact of election expenses
In U.S. presidential elections over the last few decades, about 55% to 65% of voting-age citizens actually voted, according to the U.S. Census. In congressional elections when there is no presidential race, or in local elections, the turnout is typically lower, often less than half the eligible voters. In other countries, the share of adults who vote is often higher. For example, in national elections since the 1980s in Germany, Spain, and France, about 75% to 80% of those of voting age cast ballots. Even this total falls well short of 100%. Some countries have laws that require voting, among them Australia, Belgium, Italy, Greece, Turkey, Singapore, and most Latin American nations. At the time the United States was founded, voting was mandatory in Virginia, Maryland, Delaware, and Georgia. Even if the law can require people to vote, however, no law can require that each voter cast an informed or a thoughtful vote. Moreover, in the United States and in most countries around the world, the freedom to vote has also typically meant the freedom not to vote.
Why do people not vote? Perhaps they do not care too much about who wins, or they are uninformed about who is running, or they do not believe their vote will matter or change their lives in any way. These reasons are probably tied together, since people who do not believe their vote matters will not bother to become informed or care who wins. Economists have suggested why a utility-maximizing person might rationally decide not to vote or not to become informed about the election. While a single vote may decide a few elections in very small towns, in most elections of any size, the Board of Elections measures the margin of victory in hundreds, thousands, or even millions of votes. A rational voter will recognize that one vote is extremely unlikely to make a difference. This theory of rational ignorance holds that people will not vote if the costs of becoming informed and voting are too high, or they feel their vote will not be decisive in the election.
In a 1957 work, An Economic Theory of Democracy, the economist Anthony Downs stated the problem this way: “It seems probable that for a great many citizens in a democracy, rational behavior excludes any investment whatever in political information per se. No matter how significant a difference between parties is revealed to the rational citizen by his free information, or how uncertain he is about which party to support, he realizes that his vote has almost no chance of influencing the outcome… He will not even utilize all the free information available, since assimilating it takes time.” In his classic 1948 novel Walden Two, the psychologist B. F. Skinner puts the issue even more succinctly via one of his characters, who states: “The chance that one man’s vote will decide the issue in a national election…is less than the chance that he will be killed on his way to the polls.” The following Clear It Up feature explores another aspect of the election process: spending.
Clear It Up
How much is too much to spend on an election?
In the 2020 elections, it is estimated that spending for president, Congress, and state and local offices amounted to \$14.4 billion, more than twice what had been spent in 2016. The money raised went to the campaigns, including advertising, fundraising, travel, and staff. Many people worry that politicians spend too much time raising money and end up entangled with special interest groups that make major donations. Critics would prefer a system that restricts what candidates can spend, perhaps in exchange for limited public campaign financing or free television advertising time.
How much spending on campaigns is too much? Five billion dollars will buy many potato chips, but in the U.S. economy, which was nearly \$21 trillion in 2020, the \$14.4 billion spent on political campaigns was about 1/15th of 1% of the overall economy. Here is another way to think about campaign spending. Total government spending programs in 2020, including federal and state governments, was about \$8.8 trillion, so the cost of choosing the people who would determine how to spend this money was less than 2/10 of 1% of that. In the context of the enormous U.S. economy, \$14.4 billion is not as much money as it sounds. U.S. consumers spend almost \$2 billion per year on toothpaste and \$7 billion on hair care products. In 2020, Proctor and Gamble spent almost \$5 billion on advertising. It may seem peculiar that one company’s spending on advertisements amounts to one third of what is spent on presidential and other elections.
Whatever we believe about whether candidates and their parties spend too much or too little on elections, the U.S. Supreme Court has placed limits on how government can limit campaign spending. In a 1976 decision, Buckley v. Valeo, the Supreme Court emphasized that the First Amendment to the U.S. Constitution specifies freedom of speech. The federal government and states can offer candidates a voluntary deal in which government makes some public financing available to candidates, but only if the candidates agree to abide by certain spending limits. Of course, candidates can also voluntarily agree to set certain spending limits if they wish. However, government cannot forbid people or organizations to raise and spend money above these limits if they choose.
In 2002, Congress passed and President George W. Bush signed into law the Bipartisan Campaign Reform Act (BCRA). The relatively noncontroversial portions of the act strengthen the rules requiring full and speedy disclosure of who contributes money to campaigns. However, some controversial portions of the Act limit the ability of individuals and groups to make certain kinds of political donations and they ban certain kinds of advertising in the months leading up to an election. Some called these bans into question after the release of two films: Michael Moore’s Fahrenheit 9/11 and Citizens United’s Hillary: The Movie. At question was whether each film sought to discredit political candidates for office too close to an election, in violation of the BCRA. The lower courts found that Moore’s film did not violate the Act, while Citizens United’s did. The fight reached the Supreme Court, as Citizens United v. Federal Election Commission, saying that the First Amendment protects the rights of corporations as well as individuals to donate to political campaigns. The Court ruled, in a 5–4 decision, that the spending limits were unconstitutional. This controversial decision, which essentially allows unlimited contributions by corporations to political action committees, overruled several previous decisions and will likely be revisited in the future, due to the strength of the public reaction. For now, it has resulted in a sharp increase in election spending.
While many U.S. adults do not bother to vote in presidential elections, more than half do. What motivates them? Research on voting behavior has indicated that people who are more settled or more “connected” to society tend to vote more frequently. According to the Washington Post, more married people vote than single people. Those with a job vote more than the unemployed. Those who have lived longer in a neighborhood are more likely to vote than newcomers. Those who report that they know their neighbors and talk to them are more likely to vote than socially isolated people. Those with a higher income and level of education are also more likely to vote. These factors suggest that politicians are likely to focus more on the interests of married, employed, well-educated people with at least a middle-class level of income than on the interests of other groups. For example, those who vote may tend to be more supportive of financial assistance for the two-year and four-year colleges they expect their children to attend than they are of medical care or public school education aimed at families of unemployed people and those experiencing poverty.
Link It Up
Visit this website to see a breakdown of how different groups voted in 2020.
There have been many proposals to encourage greater voter turnout: making it easier to register to vote, keeping the polls open for more hours, or even moving Election Day to the weekend, when fewer people need to worry about jobs or school commitments. However, such changes do not seem to have caused a long-term upward trend in the number of people voting. After all, casting an informed vote will always impose some costs of time and energy. It is not clear how to strengthen people’s feeling of connectedness to society in a way that will lead to a substantial increase in voter turnout. Without greater voter turnout, however, politicians elected by the votes of 60% or fewer of the population may not enact economic policy in the best interests of 100% of the population. Meanwhile, countering a long trend toward making voting easier, many states have recently enacted new voting laws that critics say are actually barriers to voting. States have passed laws reducing early voting, restricting groups who are organizing get-out-the-vote efforts, enacted strict photo ID laws, as well as laws that require showing proof of U.S. citizenship. The ACLU argues that while these laws profess to prevent voter fraud, they are in effect making it harder for individuals to cast their vote. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/18%3A_Public_Economy/18.02%3A_Voter_Participation_and_Costs_of_Elections.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain how special interest groups and lobbyists can influence campaigns and elections
• Describe pork-barrel spending and logrolling
Many political issues are of intense interest to a relatively small group, as we noted above. For example, many U.S. drivers do not much care where their car tires were made—they just want good quality as inexpensively as possible. In September 2009, President Obama and Congress enacted a tariff (taxes added on imported goods) on tires imported from China that would increase the price by 35 percent in its first year, 30 percent in its second year, and 25 percent in its third year. Interestingly, the U.S. companies that make tires did not favor this step, because most of them also import tires from China and other countries. (See Globalization and Protectionism for more on tariffs.) However, the United Steelworkers union, which had seen jobs in the tire industry fall by 5,000 over the previous five years, lobbied fiercely for the tariff. With this tariff, the cost of all tires increased significantly. (See the closing Bring It Home feature at the end of this chapter for more information on the tire tariff.)
Special interest groups are groups that are small in number relative to the nation, but quite well organized and focused on a specific issue. A special interest group can pressure legislators to enact public policies that do not benefit society as a whole. Imagine an environmental rule to reduce air pollution that will cost 10 large companies \$8 million each, for a total cost of \$80 million. The social benefits from enacting this rule provide an average benefit of \$10 for every person in the United States, for a total of about \$3 trillion. Even though the benefits are far higher than the costs for society as a whole, the 10 companies are likely to lobby much more fiercely to avoid \$8 million in costs than the average person is to argue for \$10 worth of benefits.
As this example suggests, we can relate the problem of special interests in politics to an issue we raised in Environmental Protection and Negative Externalities about economic policy with respect to negative externalities and pollution—the problem called regulatory capture (which we defined in Monopoly and Antitrust Policy). In legislative bodies and agencies that write laws and regulations about how much corporations will pay in taxes, or rules for safety in the workplace, or instructions on how to satisfy environmental regulations, you can be sure the specific industry affected has lobbyists who study every word and every comma. They talk with the legislators who are writing the legislation and suggest alternative wording. They contribute to the campaigns of legislators on the key committees—and may even offer those legislators high-paying jobs after they have left office. As a result, it often turns out that those regulated can exercise considerable influence over the regulators.
Link It Up
Visit this website to read about lobbying.
In the early 2000s, about 40 million people in the United States were eligible for Medicare, a government program that provides health insurance for those 65 and older. On some issues, the elderly are a powerful interest group. They donate money and time to political campaigns, and in the 2020 presidential election, 76% of those ages 65–74 voted, while just 51% of those aged 18 to 24 cast a ballot, according to the U.S. Census.
In 2003, Congress passed and President George Bush signed into law a substantial expansion of Medicare that helped the elderly to pay for prescription drugs. The prescription drug benefit cost the federal government about \$40 billion in 2006, and the Medicare system projected that the annual cost would rise to \$121 billion by 2016. The political pressure to pass a prescription drug benefit for Medicare was apparently quite high, while the political pressure to assist the 40 million with no health insurance at all was considerably lower. One reason might be that the American Association for Retired People AARP, a well-funded and well-organized lobbying group represents senior citizens, while there is no umbrella organization to lobby for those without health insurance.
In the battle over passage of the 2010 Affordable Care Act (ACA), which became known as “Obamacare,” there was heavy lobbying on all sides by insurance companies and pharmaceutical companies. However, labor unions and community groups financed a lobby group, Health Care for America Now (HCAN), to offset corporate lobbying. HCAN, spending \$60 million dollars, was successful in helping pass legislation which added new regulations on insurance companies and a mandate that all individuals will obtain health insurance by 2014. The following Work It Out feature further explains voter incentives and lobbyist influence.
Work It Out
Paying To Get Your Way
Suppose Congress proposes a tax on carbon emissions for certain factories in a small town of 10,000 people. Congress estimates the tax will reduce pollution to such an extent that it will benefit each resident by an equivalent of \$300. The tax will also reduce profits to the town’s two large factories by \$1 million each. How much should the factory owners be willing to spend to fight the tax passage, and how much should the townspeople be willing to pay to support it? Why is society unlikely to achieve the optimal outcome?
Step 1. The two factory owners each stand to lose \$1 million if the tax passes, so each should be willing to spend up to that amount to prevent the passage, a combined sum of \$2 million. Of course, in the real world, there is no guarantee that lobbying efforts will be successful, so the factory owners may choose to invest an amount that is substantially lower.
Step 2. There are 10,000 townspeople, each standing to benefit by \$300 if the tax passes. Theoretically, then, they should be willing to spend up to \$3 million (10,000 × \$300) to ensure passage. (Again, in the real world with no guarantees of success, they may choose to spend less.)
Step 3. It is costly and difficult for 10,000 people to coordinate in such a way as to influence public policy. Since each person stands to gain only \$300, many may feel lobbying is not worth the effort.
Step 4. The two factory owners, however, find it very easy and profitable to coordinate their activities, so they have a greater incentive to do so.
Special interests may develop a close relationship with one political party, so their ability to influence legislation rises and falls as that party moves in or out of power. A special interest may even hurt a political party if it appears to a number of voters that the relationship is too cozy. In a close election, a small group that has been under-represented in the past may find that it can tip the election one way or another—so that group will suddenly receive considerable attention. Democratic institutions produce an ebb and flow of political parties and interests and thus offer both opportunities for special interests and ways of counterbalancing those interests over time.
Identifiable Winners, Anonymous Losers
A number of economic policies produce gains whose beneficiaries are easily identifiable, but costs that are partly or entirely shared by a large number who remain anonymous. A democratic political system probably has a bias toward those who are identifiable.
For example, policies that impose price controls—like rent control—may look as if they benefit renters and impose costs only on landlords. However, when landlords then decide to reduce the number of rental units available in the area, a number of people who would have liked to rent an apartment end up living somewhere else because no units were available. These would-be renters have experienced a cost of rent control, but it is hard to identify who they are.
Similarly, policies that block imports will benefit the firms that would have competed with those imports—and workers at those firms—who are likely to be quite visible. Consumers who would have preferred to purchase the imported products, and who thus bear some costs of the protectionist policy, are much less visible.
Specific tax breaks and spending programs also have identifiable winners and impose costs on others who are hard to identify. Special interests are more likely to arise from a group that is easily identifiable, rather than from a group where some of those who suffer may not even recognize they are bearing costs.
Pork Barrels and Logrolling
Politicians have an incentive to ensure that they spend government money in their home state or district, where it will benefit their constituents in a direct and obvious way. Thus, when legislators are negotiating over whether to support a piece of legislation, they commonly ask each other to include pork-barrel spending, legislation that benefits mainly a single political district. Pork-barrel spending is another case in which concentrated benefits and widely dispersed costs challenge democracy: the benefits of pork-barrel spending are obvious and direct to local voters, while the costs are spread over the entire country. Read the following Clear It Up feature for more information on pork-barrel spending.
Clear It Up
How much impact can pork-barrel spending have?
Many observers widely regard U.S. Senator Robert C. Byrd of West Virginia, who was originally elected to the Senate in 1958 and served until 2010, as one of the masters of pork-barrel politics, directing a steady stream of federal funds to his home state. A journalist once compiled a list of structures in West Virginia at least partly government funded and named after Byrd: “the Robert C. Byrd Highway; the Robert C. Byrd Locks and Dam; the Robert C. Byrd Institute; the Robert C. Byrd Life Long Learning Center; the Robert C. Byrd Honors Scholarship Program; the Robert C. Byrd Green Bank Telescope; the Robert C. Byrd Institute for Advanced Flexible Manufacturing; the Robert C. Byrd Federal Courthouse; the Robert C. Byrd Health Sciences Center; the Robert C. Byrd Academic and Technology Center; the Robert C. Byrd United Technical Center; the Robert C. Byrd Federal Building; the Robert C. Byrd Drive; the Robert C. Byrd Hilltop Office Complex; the Robert C. Byrd Library; and the Robert C. Byrd Learning Resource Center; the Robert C. Byrd Rural Health Center.” This list does not include government-funded projects in West Virginia that were not named after Byrd. Of course, we would have to analyze each of these expenditures in detail to figure out whether we should treat them as pork-barrel spending or whether they provide widespread benefits that reach beyond West Virginia. At least some of them, or a portion of them, certainly would fall into that category. Because there are currently no term limits for Congressional representatives, those who have been in office longer generally have more power to enact pork-barrel projects.
The amount that government spends on individual pork-barrel projects is small, but many small projects can add up to a substantial total. A nonprofit watchdog organization, called Citizens against Government Waste, produces an annual report, the Pig Book that attempts to quantify the amount of pork-barrel spending, focusing on items that only one member of Congress requested, that were passed into law without any public hearings, or that serve only a local purpose. Whether any specific item qualifies as pork can be controversial. The 2021 Congressional Pig Book identified 285 earmarks in FY 2021, with a cost of \$16.8 billion. Recent growth in earmarks and their cost is apparent: in FY 2017, there were 163 earmarks at a cost of \$6.8 billion. Hence, in only four years, there was a 75% increase in the number of earmarks and a 147% increase in the cost of those earmarks.
Logrolling, an action in which all members of a group of legislators agree to vote for a package of otherwise unrelated laws that they individually favor, can encourage pork barrel spending. For example, if one member of the U.S. Congress suggests building a new bridge or hospital in their own congressional district, the other members might oppose it. However, if 51% of the legislators come together, they can pass a bill that includes a bridge or hospital for every one of their districts.
As a reflection of this interest of legislators in their own districts, the U.S. government has typically spread out its spending on military bases and weapons programs to congressional districts all across the country. In part, the government does this to help create a situation that encourages members of Congress to vote in support of defense spending. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/18%3A_Public_Economy/18.03%3A_Special_Interest_Politics.txt |
Learning Objectives
By the end of this section, you will be able to:
• Assess the median voter theory
• Explain the voting cycle
• Analyze the interrelationship between markets and government
Most developed countries today have a democratic system of government: citizens express their opinions through votes and those votes affect the direction of the country. The advantage of democracy over other systems is that it allows everyone in a society an equal say and therefore may reduce the possibility of a small group of wealthy oligarchs oppressing the masses. There is no such thing as a perfect system, and democracy, for all its popularity, is not without its problems, a few of which we will examine here.
We sometimes sum up and oversimplify democracy in two words: “Majority rule.” When voters face three or more choices, however, then voting may not always be a useful way of determining what the majority prefers.
As one example, consider an election in a state where 60% of the population is liberal and 40% is conservative. If there are only two candidates, one from each side, and if liberals and conservatives vote in the same 60–40 proportions in which they are represented in the population, then the liberal will win. What if the election ends up including two liberal candidates and one conservative? It is possible that the liberal vote will split and victory will go to the minority party. In this case, the outcome does not reflect the majority’s preference.
Does the majority view prevail in the case of sugar quotas? Clearly there are more sugar consumers in the United States than sugar producers, but the U.S. domestic sugar lobby (www.sugarcane.org) has successfully argued for protection against imports since 1789. By law, therefore, U.S. cookie and candy makers must use 85% domestic sugar in their products. Meanwhile quotas on imported sugar restrict supply and keep the domestic sugar price up—raising prices for companies that use sugar in producing their goods and for consumers. The European Union allows sugar imports, and prices there are 40% lower than U.S. sugar prices. Sugar-producing countries in the Caribbean repeatedly protest the U.S. quotas at the World Trade Organization meetings, but each bite of cookie, at present, costs you more than if there were no sugar lobby. This case goes against the theory of the “median” voter in a democracy. The median voter theory argues that politicians will try to match policies to what pleases the median voter preferences. If we think of political positions along a spectrum from left to right, the median voter is in the middle of the spectrum. This theory argues that actual policy will reflect “middle of the road.” In the case of sugar lobby politics, the minority, not the median, dominates policy.
Sometimes it is not even clear how to define the majority opinion. Step aside from politics for a moment and think about a choice facing three families (the Ortegas, the Schmidts, and the Alexanders) who are planning to celebrate New Year’s Day together. They agree to vote on the menu, choosing from three entrees, and they agree that the majority vote wins. With three families, it seems reasonable that one producing choice will get a 2–1 majority. What if, however, their vote ends up looking like Table 18.1?
Clearly, the three families disagree on their first choice. However, the problem goes even deeper. Instead of looking at all three choices at once, compare them two at a time. (See Figure 18.2) In a vote of turkey versus beef, turkey wins by 2–1. In a vote of beef versus lasagna, beef wins 2–1. If turkey beats beef, and beef beats lasagna, then it might seem only logical that turkey must also beat lasagna. However, with the preferences, lasagna is preferred to turkey by a 2–1 vote, as well. If lasagna is preferred to turkey, and turkey beats beef, then surely it must be that lasagna also beats beef? Actually, no. Beef beats lasagna. In other words, the majority view may not win. Clearly, as any car salesperson will tell you, the way one presents choices to us influences our decisions.
Figure 18.2 A Voting Cycle Given these choices, voting will struggle to produce a majority outcome. Turkey is favored over roast beef by 2–1 and roast beef is favored over lasagna by 2–1. If turkey beats roast beef and roast beef beats lasagna, then it might seem that turkey must beat lasagna, too. However, given these preferences, lasagna is favored over turkey by 2–1.
The Ortega Family The Schmidt Family The Alexander Family
First Choice Turkey Roast beef Lasagna
Second Choice Roast beef Lasagna Turkey
Third Choice Lasagna Turkey Roast beef
Table 18.1 Circular Preferences
We call the situation in which Choice A is preferred by a majority over Choice B, Choice B is preferred by a majority over Choice C, and Choice C is preferred by a majority over Choice A a voting cycle. It is easy to imagine sets of government choices—say, perhaps the choice between increased defense spending, increased government spending on health care, and a tax cut—in which a voting cycle could occur. The result will be determined by the order in which interested parties present and vote on choices, not by majority rule, because every choice is both preferred to some alternative and also not preferred to another alternative.
Link It Up
Visit this website to read about ranked choice voting, a preferential voting system.
Where Is Government’s Self-Correcting Mechanism?
When a firm produces a product no one wants to buy or produces at a higher cost than its competitors, the firm is likely to suffer losses. If it cannot change its ways, it will go out of business. This self-correcting mechanism in the marketplace can have harsh effects on workers or on local economies, but it also puts pressure on firms for good performance.
Government agencies, however, do not sell their products in a market. They receive tax dollars instead. They are not challenged by competitors as are private-sector firms. If the U.S. Department of Education or the U.S. Department of Defense is performing poorly, citizens cannot purchase their services from another provider and drive the existing government agencies into bankruptcy. If you are upset that the Internal Revenue Service is slow in sending you a tax refund or seems unable to answer your questions, you cannot decide to pay your income taxes through a different organization. Of course, elected politicians can assign new leaders to government agencies and instruct them to reorganize or to emphasize a different mission. The pressure government faces, however, to change its bureaucracy, to seek greater efficiency, and to improve customer responsiveness is much milder than the threat of being put out of business altogether.
This insight suggests that when government provides goods or services directly, we might expect it to do so with less efficiency than private firms—except in certain cases where the government agency may compete directly with private firms. At the local level, for example, government can provide directly services like garbage collection, using private firms under contract to the government, or by a mix of government employees competing with private firms.
A Balanced View of Markets and Government
The British statesman Sir Winston Churchill (1874–1965) once wrote: “No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of government except for all of the other forms which have been tried from time to time.” In that spirit, the theme of this discussion is certainly not that we should abandon democratic government. A practical student of public policy needs to recognize that in some cases, like the case of well-organized special interests or pork-barrel legislation, a democratic government may seek to enact economically unwise projects or programs. In other cases, by placing a low priority on the problems of those who are not well organized or who are less likely to vote, the government may fail to act when it could do some good. In these and other cases, there is no automatic reason to believe that government will necessarily make economically sensible choices.
“The true test of a first-rate mind is the ability to hold two contradictory ideas at the same time,” wrote the American author F. Scott Fitzgerald (1896–1940). At this point in your study of microeconomics, you should be able to go one better than Fitzgerald and hold three somewhat contradictory ideas about the interrelationship between markets and government in your mind at the same time.
First, markets are extraordinarily useful and flexible institutions through which society can allocate its scarce resources. We introduced this idea with the subjects of international trade and demand and supply in other chapters and reinforced it in all the subsequent discussions of how households and firms make decisions.
Second, markets may sometimes produce unwanted results. A short list of the cases in which markets produce unwanted results includes monopoly and other cases of imperfect competition, pollution, poverty and inequality of incomes, discrimination, and failure to provide insurance.
Third, while government may play a useful role in addressing the problems of markets, government action is also imperfect and may not reflect majority views. Economists readily admit that, in settings like monopoly or negative externalities, a potential role exists for government intervention. However, in the real world, it is not enough to point out that government action might be a good idea. Instead, we must have some confidence that the government is likely to identify and carry out the appropriate public policy. To make sensible judgments about economic policy, we must see the strengths and weaknesses of both markets and government. We must not idealize or demonize either unregulated markets or government actions. Instead, consider the actual strengths and weaknesses of real-world markets and real-world governments.
These three insights seldom lead to simple or obvious political conclusions. As the famous British economist Joan Robinson wrote some decades ago: “[E]conomic theory, in itself, preaches no doctrines and cannot establish any universally valid laws. It is a method of ordering ideas and formulating questions.” The study of economics is neither politically conservative, nor moderate, nor liberal. There are economists who are Democrats, Republicans, libertarians, socialists, and members of every other political group you can name. Of course, conservatives may tend to emphasize the virtues of markets and the limitations of government, while liberals may tend to emphasize the shortcomings of markets and the need for government programs. Such differences only illustrate that the language and terminology of economics is not limited to one set of political beliefs, but can be used by all.
Bring It Home
Chinese Tire Tariffs
In April 2009, the union representing U.S. tire manufacturing workers filed a request with the U.S. International Trade Commission (ITC), asking it to investigate tire imports from China. Under U.S. trade law, if imports from a country increase to the point that they cause market disruption in the United States, as determined by the ITC, then it can also recommend a remedy for this market disruption. In this case, the ITC determined that from 2004 to 2008, U.S. tire manufacturers suffered declines in production, financial health, and employment as a direct result of increases in tire imports from China. The ITC recommended placing an additional tax on tire imports from China. President Obama and Congress agreed with the ITC recommendation, and in June 2009 tariffs on Chinese tires increased from 4% to 39%. In addition, tariffs on Chinese tires increased further as part of President Trump’s increases on a broad range of Chinese products.
Why would U.S. consumers buy imported tires from China in the first place? Most likely, because they are cheaper than tires produced domestically or in other countries. Therefore, this tariff increase should cause U.S. consumers to pay higher prices for tires, either because Chinese tires are now more expensive, or because U.S. consumers are pushed by the tariff to buy more expensive tires made by U.S. manufacturers or those from other countries. In the end, this tariff made U.S. consumers pay more for tires.
Was this tariff met with outrage expressed via social media, traditional media, or mass protests? Were there “Occupy Wall Street-type” demonstrations? The answer is a resounding “No”. Most U.S. tire consumers were likely unaware of the tariff increase, although they may have noticed the price increase, which was between \$4 and \$13 depending on the type of tire. Tire consumers are also potential voters. Conceivably, a tax increase, even a small one, might make voters unhappy. However, voters probably realized that it was not worth their time to learn anything about this issue or cast a vote based on it. They probably thought their vote would not matter in determining the outcome of an election or changing this policy.
Estimates of the impact of this tariff show it costs U.S. consumers around \$1.11 billion annually. Of this amount, roughly \$817 million ends up in the pockets of foreign tire manufacturers other than in China, and the remaining \$294 million goes to U.S. tire manufacturers. In other words, the tariff increase on Chinese tires may have saved 1,200 jobs in the domestic tire sector, but it cost 3,700 jobs in other sectors, as consumers had to reduce their spending because they were paying more for tires. People actually lost their jobs as a result of this tariff. Workers in U.S. tire manufacturing firms earned about \$40,000 in 2010. Given the number of jobs saved and the total cost to U.S. consumers, the cost of saving one job amounted to \$926,500!
This tariff caused a net decline in U.S. social surplus. (We discuss total surplus in the Demand and Supply chapter, and tariffs in the Introduction to International Trade chapter.) Instead of saving jobs, it cost jobs, and those jobs that it saved cost many times more than the people working in them could ever hope to earn. Why would the government do this?
The chapter answers this question by discussing the influence special interest groups have on economic policy. The steelworkers union, whose members make tires, saw increasingly more members lose their jobs as U.S. consumers consumed increasingly more cheap Chinese tires. By definition, this union is relatively small but well organized, especially compared to tire consumers. It stands to gain much for each of its members, compared to what each tire consumer may have to give up in terms of higher prices. Thus, the steelworkers union (joined by domestic tire manufacturers) has not only the means but the incentive to lobby economic policymakers and lawmakers. Given that U.S. tire consumers are a large and unorganized group, if they even are a group, it is unlikely they will lobby against higher tire tariffs. In the end, lawmakers tend to listen to those who lobby them, even though the results make for bad economic policy. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/18%3A_Public_Economy/18.04%3A_Flaws_in_the_Democratic_System_of_Government.txt |
logrolling
the situation in which groups of legislators all agree to vote for a package of otherwise unrelated laws that they individually favor
median voter theory
theory that politicians will try to match policies to what pleases the median voter preferences
pork-barrel spending
spending that benefits mainly a single political district
rational ignorance
the theory that rational people will not vote if the costs of becoming informed and voting are too high or because they know their vote will not be decisive in the election
special interest groups
groups that are small in number relative to the nation, but well organized and thus exert a disproportionate effect on political outcomes
voting cycle
the situation in which a majority prefers A over B, B over C, and C over A
18.06: Key Concepts and Summary
18.1 Voter Participation and Costs of Elections
The theory of rational ignorance says voters will recognize that their single vote is extremely unlikely to influence the outcome of an election. As a consequence, they will choose to remain uninformed about issues and not vote. This theory helps explain why voter turnout is so low in the United States.
18.2 Special Interest Politics
Special interest politics arises when a relatively small group, called a special interest group, each of whose members has a large interest in a political outcome, devotes considerable time and energy to lobbying for the group’s preferred choice. Meanwhile, the large majority, each of whose members has only a small interest in this issue, pays no attention.
We define pork--barrel spending as legislation whose benefits are concentrated on a single district while the costs are spread widely over the country. Logrolling refers to a situation in which two or more legislators agree to vote for each other’s legislation, which can then encourage pork-barrel spending in many districts.
18.3 Flaws in the Democratic System of Government
Majority votes can run into difficulties when more than two choices exist. A voting cycle occurs when, in a situation with at least three choices, choice A is preferred by a majority vote to choice B, choice B is preferred by a majority vote to choice C, and choice C is preferred by a majority vote to choice A. In such a situation, it is impossible to identify what the majority prefers. Another difficulty arises when the vote is so divided that no choice receives a majority.
A practical approach to microeconomic policy will need to take a realistic view of the specific strengths and weaknesses of markets as well as government, rather than making the easy but wrong assumption that either the market or government is always beneficial or always harmful.
18.07: Self-Check Questions
1.
Based on the theory of rational ignorance, what should we expect to happen to voter turnout as the internet makes information easier to obtain?
2.
What is the cost of voting in an election?
3.
What is the main factor preventing a large community from influencing policy in the same way as a special interest group?
4.
Why might legislators vote to impose a tariff on Egyptian cotton, when consumers in their districts would benefit from its availability?
5.
True or false: Majority rule can fail to produce a single preferred outcome when there are more than two choices.
6.
Anastasia, Emma, and Greta are deciding what to do on a weekend getaway. They each suggest a first, second, and third choice and then vote on the options. Table 18.2 shows their first, second, and third choice preferences . Explain why they will have a hard time reaching a decision. Does the group prefer mountain biking to canoeing? What about canoeing compared to the beach? What about the beach compared to the original choice of mountain biking?
Anastasia Emma Greta
First Choice Beach Mountain biking Canoeing
Second Choice Mountain biking Canoeing Beach
Third Choice Canoeing Beach Mountain biking
Table 18.2
7.
Suppose there is an election for Soft Drink Commissioner. The field consists of one candidate from the Pepsi party and four from the Coca-Cola party. This would seem to indicate a strong preference for Coca-Cola among the voting population, but the Pepsi candidate ends up winning in a landslide. Why does this happen?
18.08: Review Questions
8.
How does rational ignorance discourage voting?
9.
How can a small special interest group win in a situation of majority voting when the benefits it seeks flow only to a small group?
10.
How can pork-barrel spending occur in a situation of majority voting when it benefits only a small group?
11.
Why do legislators vote for spending projects in districts that are not their own?
12.
Why does a voting cycle make it impossible to decide on a majority-approved choice?
13.
How does a government agency raise revenue differently from a private company, and how does that affect the way government makes decisions compared to business decisions? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/18%3A_Public_Economy/18.05%3A_Key_Terms.txt |
14.
What are some reasons people might find acquiring information about politics and voting rational, in contrast to rational ignorance theory?
15.
What are some possible ways to encourage voter participation and overcome rational ignorance?
16.
Given that rational ignorance discourages some people from becoming informed about elections, is it necessarily a good idea to encourage greater voter turnout? Why or why not?
17.
When Microsoft was founded, the company devoted very few resources to lobbying activities. After a high-profile antitrust case against it, however, the company began to lobby heavily. Why does it make financial sense for companies to invest in lobbyists?
18.
Representatives of competing firms often comprise special interest groups. Why are competitors sometimes willing to cooperate in order to form lobbying associations?
19.
Special interests do not oppose regulations in all cases. The Marketplace Fairness Act of 2013 would require online merchants to collect sales taxes from their customers in other states. Why might a large online retailer like Amazon.com support such a measure?
20.
To ensure safety and efficacy, the Food and Drug Administration regulates the medicines that pharmacies are allowed to sell in the United States. Sometimes this means a company must test a drug for years before it can reach the market. We can easily identify the winners in this system as those who are protected from unsafe drugs that might otherwise harm them. Who are the more anonymous losers who do not benefit from strict medical regulations?
21.
How is it possible to bear a cost without realizing it? What are some examples of policies that affect people in ways of which they may not even be aware?
22.
Is pork-barrel spending always a bad thing? Can you think of some examples of pork-barrel projects, perhaps from your own district, that have had positive results?
23.
The United States currently uses a voting system called “first past the post” in elections, meaning that the candidate with the most votes wins. What are some of the problems with a “first past the post” system?
24.
What are some alternatives to a “first past the post” system that might reduce the problem of voting cycles?
25.
AT&T spent some \$10 million dollars lobbying Congress to block entry of competitors into the telephone market in 1978. Why do you think it efforts failed?
26.
Occupy Wall Street was a national (and later global) organized protest against the greed, bank profits, and financial corruption that led to the 2008–2009 recession. The group popularized slogans like “We are the 99%,” meaning it represented the majority against the wealth of the top 1%. Does the fact that the protests had little to no effect on legislative changes support or contradict the chapter?
18.10: Problems
27.
Say that the government is considering a ban on smoking in restaurants in Tobaccoville. There are 1 million people living there, and each would benefit by \$200 from this smoking ban. However, there are two large tobacco companies in Tobaccoville and the ban would cost them \$5 million each. What are the proposed policy's total costs and benefits? Do you think it will pass? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/18%3A_Public_Economy/18.09%3A_Critical_Thinking_Questions.txt |
Figure 19.1 Apple or Samsung iPhone? While the iPhone is readily recognized as an Apple product, many versions (including recently released offerings) have key components made by rival phone-maker, Samsung. In international trade, there are often “conflicts” like this as each country or company focuses on what it does best. (Credit: modification of “iPhone 4's Retina Display v.s. iPhone 3G” by Yutaka Tsutano/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Absolute and Comparative Advantage
• What Happens When a Country Has an Absolute Advantage in All Goods
• Intra-industry Trade between Similar Economies
• The Benefits of Reducing Barriers to International Trade
Bring It Home
Just Whose iPhone Is It?
The iPhone is a global product. Apple does not manufacture the iPhone components, nor does it assemble them. The assembly is done by Foxconn Corporation, a Taiwanese company, at its factories in China and India. But, Samsung, the electronics firm and competitor to Apple, actually supplies many of the parts that make up an iPhone. In earlier models, Samsung parts made up as much as 26% of the total costs of production. And in more recent versions, Samsung manufactures the displays and cameras. In some ways, then, Samsung is both the biggest supplier and biggest competitor for Apple. Why do these two firms work together to produce the iPhone? To understand the economic logic behind international trade, you have to accept, as these firms do, that trade is about mutually beneficial exchange. Samsung is one of the world’s largest electronics parts suppliers. Apple lets Samsung focus on making the best parts, which allows Apple to concentrate on its strength—designing elegant products that are easy to use. If each company (and by extension each country) focuses on what it does best, there will be gains for all through trade.
We live in a global marketplace. The food on your table might include fresh fruit from Chile, cheese from France, and bottled water from Scotland. Your wireless phone might have been made in Taiwan or Korea. The clothes you wear might be designed in Italy and manufactured in China. The toys you give to a child might have come from India. The car you drive might come from Japan, Germany, or Korea. The gasoline in the tank might be refined from crude oil from Saudi Arabia, Mexico, or Nigeria. As a worker, if your job is involved with farming, machinery, airplanes, cars, scientific instruments, or many other technology-related industries, the odds are good that a hearty proportion of the sales of your employer—and hence the money that pays your salary—comes from export sales. We are all linked by international trade, and the volume of that trade has grown dramatically in the last few decades.
The first wave of globalization started in the nineteenth century and lasted up to the beginning of World War I. Over that time, global exports as a share of global GDP rose from less than 1% of GDP in 1820 to 9% of GDP in 1913. As the Nobel Prize-winning economist Paul Krugman of Princeton University wrote in 1995:
It is a late-twentieth-century conceit that we invented the global economy just yesterday. In fact, world markets achieved an impressive degree of integration during the second half of the nineteenth century. Indeed, if one wants a specific date for the beginning of a truly global economy, one might well choose 1869, the year in which both the Suez Canal and the Union Pacific railroad were completed. By the eve of the First World War steamships and railroads had created markets for standardized commodities, like wheat and wool, that were fully global in their reach. Even the global flow of information was better than modern observers, focused on electronic technology, tend to realize: the first submarine telegraph cable was laid under the Atlantic in 1858, and by 1900 all of the world’s major economic regions could effectively communicate instantaneously.
This first wave of globalization crashed to a halt early in the twentieth century. World War I severed many economic connections. During the Great Depression of the 1930s, many nations misguidedly tried to fix their own economies by reducing foreign trade with others. World War II further hindered international trade. Global flows of goods and financial capital were rebuilt only slowly after World War II. It was not until the early 1980s that global economic forces again became as important, relative to the size of the world economy, as they were before World War I. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/19%3A_International_Trade/19.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Define absolute advantage, comparative advantage, and opportunity costs
• Explain the gains of trade created when a country specializes
The American statesman Benjamin Franklin (1706–1790) once wrote: “No nation was ever ruined by trade.” Many economists would express their attitudes toward international trade in an even more positive manner. The evidence that international trade confers overall benefits on economies is pretty strong. Trade has accompanied economic growth in the United States and around the world. Many of the national economies that have shown the most rapid growth in the last several decades—for example, Japan, South Korea, China, and India—have done so by dramatically orienting their economies toward international trade. There is no modern example of a country that has shut itself off from world trade and yet prospered. To understand the benefits of trade, or why we trade in the first place, we need to understand the concepts of comparative and absolute advantage.
In 1817, David Ricardo, a businessman, economist, and member of the British Parliament, wrote a treatise called On the Principles of Political Economy and Taxation. In this treatise, Ricardo argued that specialization and free trade benefit all trading partners, even those that may be relatively inefficient. To see what he meant, we must be able to distinguish between absolute and comparative advantage.
A country has an absolute advantage over another country in producing a good if it uses fewer resources to produce that good. Absolute advantage can be the result of a country’s natural endowment. For example, extracting oil in Saudi Arabia is pretty much just a matter of “drilling a hole.” Producing oil in other countries can require considerable exploration and costly technologies for drilling and extraction—if they have any oil at all. The United States has some of the richest farmland in the world, making it easier to grow corn and wheat than in many other countries. Guatemala and Colombia have climates especially suited for growing coffee. Chile and Zambia have some of the world’s richest copper mines. As some have argued, “geography is destiny.” Chile will provide copper and Guatemala will produce coffee, and they will trade. When each country has a product others need and it can produce it with fewer resources in one country than in another, then it is easy to imagine all parties benefitting from trade. However, thinking about trade just in terms of geography and absolute advantage is incomplete. Trade really occurs because of comparative advantage.
Recall from the chapter Choice in a World of Scarcity that a country has a comparative advantage when it can produce a good at a lower cost in terms of other goods. The question each country or company should be asking when it trades is this: “What do we give up to produce this good?” It should be no surprise that the concept of comparative advantage is based on this idea of opportunity cost from Choice in a World of Scarcity. For example, if Zambia focuses its resources on producing copper, it cannot use its labor, land and financial resources to produce other goods such as corn. As a result, Zambia gives up the opportunity to produce corn. How do we quantify the cost in terms of other goods? Simplify the problem and assume that Zambia just needs labor to produce copper and corn. The companies that produce either copper or corn tell you that it takes two hours to mine a ton of copper and one hour to harvest a bushel of corn. This means the opportunity cost of producing a ton of copper is two bushels of corn. The next section develops absolute and comparative advantage in greater detail and relates them to trade.
Link It Up
Visit this website for a list of articles and podcasts pertaining to international trade topics.
A Numerical Example of Absolute and Comparative Advantage
Consider a hypothetical world with two countries, Saudi Arabia and the United States, and two products, oil and corn. Further assume that consumers in both countries desire both these goods. These goods are homogeneous, meaning that consumers/producers cannot differentiate between corn or oil from either country. There is only one resource available in both countries, labor hours. Saudi Arabia can produce oil with fewer resources, while the United States can produce corn with fewer resources. Table 19.1 illustrates the advantages of the two countries, expressed in terms of how many hours it takes to produce one unit of each good.
Country Oil (hours per barrel) Corn (hours per bushel)
Saudi Arabia 1 4
United States 2 1
Table 19.1 How Many Hours It Takes to Produce Oil and Corn
In Table 19.1, Saudi Arabia has an absolute advantage in producing oil because it only takes an hour to produce a barrel of oil compared to two hours in the United States. The United States has an absolute advantage in producing corn.
To simplify, let’s say that Saudi Arabia and the United States each have 100 worker hours (see Table 19.2). Figure 19.2 illustrates what each country is capable of producing on its own using a production possibility frontier (PPF) graph. Recall from Choice in a World of Scarcity that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers, and its level of technology.
Country Oil Production using 100 worker hours (barrels) Corn Production using 100 worker hours (bushels)
Saudi Arabia 100 or 25
United States 50 or 100
Table 19.2 Production Possibilities before Trade
Figure 19.2 Production Possibilities Frontiers (a) Saudi Arabia can produce 100 barrels of oil at maximum and zero corn (point A), or 25 bushels of corn and zero oil (point B). It can also produce other combinations of oil and corn if it wants to consume both goods, such as at point C. Here it chooses to produce/consume 60 barrels of oil, leaving 40 work hours that to allocate to produce 10 bushels of corn, using the data in Table 19.1. (b) If the United States produces only oil, it can produce, at maximum, 50 barrels and zero corn (point A'), or at the other extreme, it can produce a maximum of 100 bushels of corn and no oil (point B'). Other combinations of both oil and corn are possible, such as point C'. All points above the frontiers are impossible to produce given the current level of resources and technology.
Arguably Saudi and U.S. consumers desire both oil and corn to live. Let’s say that before trade occurs, both countries produce and consume at point C or C'. Thus, before trade, the Saudi Arabian economy will devote 60 worker hours to produce oil, as Table 19.3 shows. Given the information in Table 19.1, this choice implies that it produces/consumes 60 barrels of oil. With the remaining 40 worker hours, since it needs four hours to produce a bushel of corn, it can produce only 10 bushels. To be at point C', the U.S. economy devotes 40 worker hours to produce 20 barrels of oil and it can allocate the remaining worker hours to produce 60 bushels of corn.
Country Oil Production (barrels) Corn Production (bushels)
Saudi Arabia (C) 60 10
United States (C') 20 60
Total World Production 80 70
Table 19.3 Production before Trade
The slope of the production possibility frontier illustrates the opportunity cost of producing oil in terms of corn. Using all its resources, the United States can produce 50 barrels of oil or 100 bushels of corn; therefore, the opportunity cost of one barrel of oil is two bushels of corn—or the slope is 1/2. Thus, in the U.S. production possibility frontier graph, every increase in oil production of one barrel implies a decrease of two bushels of corn. Saudi Arabia can produce 100 barrels of oil or 25 bushels of corn. The opportunity cost of producing one barrel of oil is the loss of 1/4 of a bushel of corn that Saudi workers could otherwise have produced. In terms of corn, notice that Saudi Arabia gives up the least to produce a barrel of oil. Table 19.4 summarizes these calculations.
Country Opportunity cost of one unit — Oil (in terms of corn) Opportunity cost of one unit — Corn (in terms of oil)
Saudi Arabia ¼ 4
United States 2 ½
Table 19.4 Opportunity Cost and Comparative Advantage
Again recall that we defined comparative advantage as the opportunity cost of producing goods. Since Saudi Arabia gives up the least to produce a barrel of oil, ($14Table 19.4) it has a comparative advantage in oil production. The United States gives up the least to produce a bushel of corn, so it has a comparative advantage in corn production.$
In this example, there is symmetry between absolute and comparative advantage. Saudi Arabia needs fewer worker hours to produce oil (absolute advantage, see Table 19.1), and also gives up the least in terms of other goods to produce oil (comparative advantage, see Table 19.4). Such symmetry is not always the case, as we will show after we have discussed gains from trade fully, but first, read the following Clear It Up feature to make sure you understand why the PPF line in the graphs is straight.
Clear It Up
Can a production possibility frontier be straight?
When you first met the production possibility frontier (PPF) in the chapter on Choice in a World of Scarcity we drew it with an outward-bending shape. This shape illustrated that as we transferred inputs from producing one good to another—like from education to health services—there were increasing opportunity costs. In the examples in this chapter, we draw the PPFs as straight lines, which means that opportunity costs are constant. When we transfer a marginal unit of labor away from growing corn and toward producing oil, the decline in the quantity of corn and the increase in the quantity of oil is always the same. In reality this is possible only if the contribution of additional workers to output did not change as the scale of production changed. The linear production possibilities frontier is a less realistic model, but a straight line simplifies calculations. It also illustrates economic themes like absolute and comparative advantage just as clearly.
Gains from Trade
Consider the trading positions of the United States and Saudi Arabia after they have specialized and traded. Before trade, Saudi Arabia produces/consumes 60 barrels of oil and 10 bushels of corn. The United States produces/consumes 20 barrels of oil and 60 bushels of corn. Given their current production levels, if the United States can trade an amount of corn fewer than 60 bushels and receive in exchange an amount of oil greater than 20 barrels, it will gain from trade. With trade, the United States can consume more of both goods than it did without specialization and trade. (Recall that the chapter Welcome to Economics! defined specialization as it applies to workers and firms. Economists also use specialization to describe the occurrence when a country shifts resources to focus on producing a good that offers comparative advantage.) Similarly, if Saudi Arabia can trade an amount of oil less than 60 barrels and receive in exchange an amount of corn greater than 10 bushels, it will have more of both goods than it did before specialization and trade. Table 19.5 illustrates the range of trades that would benefit both sides.
The U.S. economy, after specialization, will benefit if it: The Saudi Arabian economy, after specialization, will benefit if it:
Exports no more than 60 bushels of corn Imports at least 10 bushels of corn
Imports at least 20 barrels of oil Exports less than 60 barrels of oil
Table 19.5 The Range of Trades That Benefit Both the United States and Saudi Arabia
The underlying reason why trade benefits both sides is rooted in the concept of opportunity cost, as the following Clear It Up feature explains. If Saudi Arabia wishes to expand domestic production of corn in a world without international trade, then based on its opportunity costs it must give up four barrels of oil for every one additional bushel of corn. If Saudi Arabia could find a way to give up less than four barrels of oil for an additional bushel of corn (or equivalently, to receive more than one bushel of corn for four barrels of oil), it would be better off.
Clear It Up
What are the opportunity costs and gains from trade?
The range of trades that will benefit each country is based on the country’s opportunity cost of producing each good. The United States can produce 100 bushels of corn or 50 barrels of oil. For the United States, the opportunity cost of producing one barrel of oil is two bushels of corn. If we divide the numbers above by 50, we get the same ratio: one barrel of oil is equivalent to two bushels of corn, or (100/50 = 2 and 50/50 = 1). In a trade with Saudi Arabia, if the United States is going to give up 100 bushels of corn in exports, it must import at least 50 barrels of oil to be just as well off. Clearly, to gain from trade it needs to be able to gain more than a half barrel of oil for its bushel of corn—or why trade at all?
Recall that David Ricardo argued that if each country specializes in its comparative advantage, it will benefit from trade, and total global output will increase. How can we show gains from trade as a result of comparative advantage and specialization? Table 19.6 shows the output assuming that each country specializes in its comparative advantage and produces no other good. This is 100% specialization. Specialization leads to an increase in total world production. (Compare the total world production in Table 19.3 to that in Table 19.6.)
Country Quantity produced after 100% specialization — Oil (barrels) Quantity produced after 100% specialization — Corn (bushels)
Saudi Arabia 100 0
United States 0 100
Total World Production 100 100
Table 19.6 How Specialization Expands Output
What if we did not have complete specialization, as in Table 19.6? Would there still be gains from trade? Consider another example, such as when the United States and Saudi Arabia start at C and C', respectively, as Figure 19.2 shows. Consider what occurs when trade is allowed and the United States exports 20 bushels of corn to Saudi Arabia in exchange for 20 barrels of oil.
Figure 19.3 Production Possibilities Frontier in Saudi Arabia Trade allows a country to go beyond its domestic production-possibility frontier
Starting at point C, which shows Saudi oil production of 60, reduce Saudi oil domestic oil consumption by 20, since 20 is exported to the United States and exchanged for 20 units of corn. This enables Saudi to reach point D, where oil consumption is now 40 barrels and corn consumption has increased to 30 (see Figure 19.3). Notice that even without 100% specialization, if the “trading price,” in this case 20 barrels of oil for 20 bushels of corn, is greater than the country’s opportunity cost, the Saudis will gain from trade. Since the post-trade consumption point D is beyond its production possibility frontier, Saudi Arabia has gained from trade.
Link It Up
Visit this website for trade-related data visualizations. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/19%3A_International_Trade/19.02%3A_Absolute_and_Comparative_Advantage.txt |
Learning Objectives
By the end of this section, you will be able to:
• Show the relationship between production costs and comparative advantage
• Identify situations of mutually beneficial trade
• Identify trade benefits by considering opportunity costs
What happens to the possibilities for trade if one country has an absolute advantage in everything? This is typical for high-income countries that often have well-educated workers, technologically advanced equipment, and the most up-to-date production processes. These high-income countries can produce all products with fewer resources than a low-income country. If the high-income country is more productive across the board, will there still be gains from trade? Good students of Ricardo understand that trade is about mutually beneficial exchange. Even when one country has an absolute advantage in all products, trade can still benefit both sides. This is because gains from trade come from specializing in one’s comparative advantage.
Production Possibilities and Comparative Advantage
Consider the example of trade between the United States and Mexico described in Table 19.7. In this example, it takes four U.S. workers to produce 1,000 pairs of shoes, but it takes five Mexican workers to do so. It takes one U.S. worker to produce 1,000 refrigerators, but it takes four Mexican workers to do so. The United States has an absolute advantage in productivity with regard to both shoes and refrigerators; that is, it takes fewer workers in the United States than in Mexico to produce both a given number of shoes and a given number of refrigerators.
Country Number of Workers needed to produce 1,000 units — Shoes Number of Workers needed to produce 1,000 units — Refrigerators
United States 4 workers 1 worker
Mexico 5 workers 4 workers
Table 19.7 Resources Needed to Produce Shoes and Refrigerators
Absolute advantage simply compares the productivity of a worker between countries. It answers the question, “How many inputs do I need to produce shoes in Mexico?” Comparative advantage asks this same question slightly differently. Instead of comparing how many workers it takes to produce a good, it asks, “How much am I giving up to produce this good in this country?” Another way of looking at this is that comparative advantage identifies the good for which the producer’s absolute advantage is relatively larger, or where the producer’s absolute productivity disadvantage is relatively smaller. The United States can produce 1,000 shoes with four-fifths as many workers as Mexico (four versus five), but it can produce 1,000 refrigerators with only one-quarter as many workers (one versus four). So, the comparative advantage of the United States, where its absolute productivity advantage is relatively greatest, lies with refrigerators, and Mexico’s comparative advantage, where its absolute productivity disadvantage is least, is in the production of shoes.
Mutually Beneficial Trade with Comparative Advantage
When nations increase production in their area of comparative advantage and trade with each other, both countries can benefit. Again, the production possibility frontier is a useful tool to visualize this benefit.
Consider a situation where the United States and Mexico each have 40 workers. For example, as Table 19.8 shows, if the United States divides its labor so that 40 workers are making shoes, then, since it takes four workers in the United States to make 1,000 shoes, a total of 10,000 shoes will be produced. (If four workers can make 1,000 shoes, then 40 workers will make 10,000 shoes). If the 40 workers in the United States are making refrigerators, and each worker can produce 1,000 refrigerators, then a total of 40,000 refrigerators will be produced.
Country Shoe Production — using 40 workers Refrigerator Production — using 40 workers
United States 10,000 shoes or 40,000 refrigerators
Mexico 8,000 shoes or 10,000 refrigerators
Table 19.8 Production Possibilities before Trade with Complete Specialization
As always, the slope of the production possibility frontier for each country is the opportunity cost of one refrigerator in terms of foregone shoe production–when labor is transferred from producing the latter to producing the former (see Figure 19.4).
Figure 19.4 Production Possibility Frontiers (a) With 40 workers, the United States can produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. All other points on the production possibility line are possible combinations of the two goods that can be produced given current resources. Point A on both graphs is where the countries start producing and consuming before trade. Point B is where they end up after trade.
Let’s say that, in the situation before trade, each nation prefers to produce a combination of shoes and refrigerators that is shown at point A. Table 19.9 shows the output of each good for each country and the total output for the two countries.
Country Current Shoe Production Current Refrigerator Production
United States 5,000 20,000
Mexico 4,000 5,000
Total 9,000 25,000
Table 19.9 Total Production at Point A before Trade
Continuing with this scenario, suppose that each country transfers some amount of labor toward its area of comparative advantage. For example, the United States transfers six workers away from shoes and toward producing refrigerators. As a result, U.S. production of shoes decreases by 1,500 units (6/4 × 1,000), while its production of refrigerators increases by 6,000 (that is, 6/1 × 1,000). Mexico also moves production toward its area of comparative advantage, transferring 10 workers away from refrigerators and toward production of shoes. As a result, production of refrigerators in Mexico falls by 2,500 (10/4 × 1,000), but production of shoes increases by 2,000 pairs (10/5 × 1,000). Notice that when both countries shift production toward each of their comparative advantages (what they are relatively better at), their combined production of both goods rises, as shown in Table 19.10. The reduction of shoe production by 1,500 pairs in the United States is more than offset by the gain of 2,000 pairs of shoes in Mexico, while the reduction of 2,500 refrigerators in Mexico is more than offset by the additional 6,000 refrigerators produced in the United States.
Country Shoe Production Refrigerator Production
United States 3,500 26,000
Mexico 6,000 2,500
Total 9,500 28,500
Table 19.10 Shifting Production Toward Comparative Advantage Raises Total Output
This numerical example illustrates the remarkable insight of comparative advantage: even when one country has an absolute advantage in all goods and another country has an absolute disadvantage in all goods, both countries can still benefit from trade. Even though the United States has an absolute advantage in producing both refrigerators and shoes, it makes economic sense for it to specialize in the good for which it has a comparative advantage. The United States will export refrigerators and in return import shoes.
How Opportunity Cost Sets the Boundaries of Trade
This example shows that both parties can benefit from specializing in their comparative advantages and trading. By using the opportunity costs in this example, it is possible to identify the range of possible trades that would benefit each country.
Mexico started out, before specialization and trade, producing 4,000 pairs of shoes and 5,000 refrigerators (see Figure 19.4 and Table 19.9). Then, in the numerical example given, Mexico shifted production toward its comparative advantage and produced 6,000 pairs of shoes but only 2,500 refrigerators. Thus, if Mexico can export no more than 2,000 pairs of shoes (giving up 2,000 pairs of shoes) in exchange for imports of at least 2,500 refrigerators (a gain of 2,500 refrigerators), it will be able to consume more of both goods than before trade. Mexico will be unambiguously better off. Conversely, the United States started off, before specialization and trade, producing 5,000 pairs of shoes and 20,000 refrigerators. In the example, it then shifted production toward its comparative advantage, producing only 3,500 shoes but 26,000 refrigerators. If the United States can export no more than 6,000 refrigerators in exchange for imports of at least 1,500 pairs of shoes, it will be able to consume more of both goods and will be unambiguously better off.
The range of trades that can benefit both nations is shown in Table 19.11. For example, a trade where the U.S. exports 4,000 refrigerators to Mexico in exchange for 1,800 pairs of shoes would benefit both sides, in the sense that both countries would be able to consume more of both goods than in a world without trade.
The U.S. economy, after specialization, will benefit if it: The Mexican economy, after specialization, will benefit if it:
Exports fewer than 6,000 refrigerators Imports at least 2,500 refrigerators
Imports at least 1,500 pairs of shoes Exports no more than 2,000 pairs of shoes
Table 19.11 The Range of Trades That Benefit Both the United States and Mexico
Trade allows each country to take advantage of lower opportunity costs in the other country. If Mexico wants to produce more refrigerators without trade, it must face its domestic opportunity costs and reduce shoe production. If Mexico, instead, produces more shoes and then trades for refrigerators made in the United States, where the opportunity cost of producing refrigerators is lower, Mexico can in effect take advantage of the lower opportunity cost of refrigerators in the United States. Conversely, when the United States specializes in its comparative advantage of refrigerator production and trades for shoes produced in Mexico, international trade allows the United States to take advantage of the lower opportunity cost of shoe production in Mexico.
The theory of comparative advantage explains why countries trade: they have different comparative advantages. It shows that the gains from international trade result from pursuing comparative advantage and producing at a lower opportunity cost. The following Work It Out feature shows how to calculate absolute and comparative advantage and the way to apply them to a country’s production.
Work It Out
Calculating Absolute and Comparative Advantage
In Canada a worker can produce 20 barrels of oil or 40 tons of lumber. In Venezuela, a worker can produce 60 barrels of oil or 30 tons of lumber.
Country Oil (barrels) Lumber (tons)
Canada 20 or 40
Venezuela 60 or 30
Table 19.12
1. Who has the absolute advantage in the production of oil or lumber? How can you tell?
2. Which country has a comparative advantage in the production of oil?
3. Which country has a comparative advantage in producing lumber?
4. In this example, is absolute advantage the same as comparative advantage, or not?
5. In what product should Canada specialize? In what product should Venezuela specialize?
Step 1. Make a table like Table 19.12.
Step 2. To calculate absolute advantage, look at the larger of the numbers for each product. One worker in Canada can produce more lumber (40 tons versus 30 tons), so Canada has the absolute advantage in lumber. One worker in Venezuela can produce 60 barrels of oil compared to a worker in Canada who can produce only 20.
Step 3. To calculate comparative advantage, find the opportunity cost of producing one barrel of oil in both countries. The country with the lowest opportunity cost has the comparative advantage. With the same labor time, Canada can produce either 20 barrels of oil or 40 tons of lumber. So in effect, 20 barrels of oil is equivalent to 40 tons of lumber: 20 oil = 40 lumber. Divide both sides of the equation by 20 to calculate the opportunity cost of one barrel of oil in Canada. 20/20 oil = 40/20 lumber. 1 oil = 2 lumber. To produce one additional barrel of oil in Canada has an opportunity cost of 2 lumber. Calculate the same way for Venezuela: 60 oil = 30 lumber. Divide both sides of the equation by 60. One oil in Venezuela has an opportunity cost of 1/2 lumber. Because 1/2 lumber < 2 lumber, Venezuela has the comparative advantage in producing oil.
Step 4. Calculate the opportunity cost of one lumber by reversing the numbers, with lumber on the left side of the equation. In Canada, 40 lumber is equivalent in labor time to 20 barrels of oil: 40 lumber = 20 oil. Divide each side of the equation by 40. The opportunity cost of one lumber is 1/2 oil. In Venezuela, the equivalent labor time will produce 30 lumber or 60 oil: 30 lumber = 60 oil. Divide each side by 30. One lumber has an opportunity cost of two oil. Canada has the lower opportunity cost in producing lumber.
Step 5. In this example, absolute advantage is the same as comparative advantage. Canada has the absolute and comparative advantage in lumber; Venezuela has the absolute and comparative advantage in oil.
Step 6. Canada should specialize in the commodity for which it has a relative lower opportunity cost, which is lumber, and Venezuela should specialize in oil. Canada will be exporting lumber and importing oil, and Venezuela will be exporting oil and importing lumber.
Comparative Advantage Goes Camping
To build an intuitive understanding of how comparative advantage can benefit all parties, set aside examples that involve national economies for a moment and consider the situation of a group of friends who decide to go camping together. The six friends have a wide range of skills and experiences, but one person in particular, Jethro, has done lots of camping before and is also a great athlete. Jethro has an absolute advantage in all aspects of camping: he is faster at carrying a backpack, gathering firewood, paddling a canoe, setting up tents, making a meal, and washing up. So here is the question: Because Jethro has an absolute productivity advantage in everything, should he do all the work?
Of course not! Even if Jethro is willing to work like a mule while everyone else sits around, he, like all mortals, only has 24 hours in a day. If everyone sits around and waits for Jethro to do everything, not only will Jethro be an unhappy camper, but there will not be much output for his group of six friends to consume. The theory of comparative advantage suggests that everyone will benefit if they figure out their areas of comparative advantage—that is, the area of camping where their productivity disadvantage is least, compared to Jethro. For example, it may be that Jethro is 80% faster at building fires and cooking meals than anyone else, but only 20% faster at gathering firewood and 10% faster at setting up tents. In that case, Jethro should focus on building fires and making meals, and others should attend to the other tasks, each according to where their productivity disadvantage is smallest. If the campers coordinate their efforts according to comparative advantage, they can all gain. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/19%3A_International_Trade/19.03%3A_What_Happens_When_a_Country_Has_an_Absolute_Advantage_in_All_Goods.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify at least two advantages of intra-industry trading
• Explain the relationship between economies of scale and intra-industry trade
Absolute and comparative advantages explain a great deal about global trading patterns. For example, they help to explain the patterns that we noted at the start of this chapter, like why you may be eating fresh fruit from Chile or Mexico, or why lower productivity regions like Africa and Latin America are able to sell a substantial proportion of their exports to higher productivity regions like the European Union and North America. Comparative advantage, however, at least at first glance, does not seem especially well-suited to explain other common patterns of international trade.
The Prevalence of Intra-Industry Trade between Similar Economies
The theory of comparative advantage suggests that trade should happen between economies with large differences in opportunity costs of production. Roughly half of all U.S. trade involves shipping goods between the fairly similar high-income economies of Japan, Canada, and the United States. Furthermore, the trade has an important geographic component—the biggest trading partners of the United States are Canada and Mexico (see Table 19.13).
Country U.S. Exports Go to ... U.S. Imports Come from ...
China 8.6% 17.7%
Canada 17.6% 12.6%
Japan 4.3% 4.3%
Mexico 15.8% 13.6%
South Korea 3.8% 3.3%
Table 19.13 Top Trading Partners (November 2021)
Moreover, the theory of comparative advantage suggests that each economy should specialize to a degree in certain products, and then exchange those products. A high proportion of trade, however, is intra-industry trade—that is, trade of goods within the same industry from one country to another. For example, the United States produces and exports autos and imports autos. Table 19.14 shows some of the largest categories of U.S. exports and imports. In all of these categories, the United States is both a substantial exporter and a substantial importer of goods from the same industry. In 2021, according to the U.S. Census Bureau, the United States exported \$131 billion worth of autos, and imported \$317 billion worth of autos. About 60% of U.S. trade and 60% of European trade is intra-industry trade.
Some U.S. Exports Quantity of Exports (\$ billions) Quantity of Imports (\$ billions)
Autos \$131 \$317
Food and beverages \$147 \$167
Capital goods \$474 \$695
Consumer goods \$201 \$699
Industrial supplies \$578 \$589
Other transportation \$63 \$113
Table 19.14 Some Intra-Industry U.S. Exports and Imports in 2021
Why do similar high-income economies engage in intra-industry trade? What can be the economic benefit of having workers of fairly similar skills making cars, computers, machinery and other products which are then shipped across the oceans to and from the United States, the European Union, and Japan? There are two reasons: (1) The division of labor leads to learning, innovation, and unique skills; and (2) economies of scale.
Gains from Specialization and Learning
Consider the category of machinery, where the U.S. economy has considerable intra-industry trade. Machinery comes in many varieties, so the United States may be exporting machinery for manufacturing with wood, but importing machinery for photographic processing. The underlying reason why a country like the United States, Japan, or Germany produces one kind of machinery rather than another is usually not related to U.S., German, or Japanese firms and workers having generally higher or lower skills. It is just that, in working on very specific and particular products, firms in certain countries develop unique and different skills.
Specialization in the world economy can be very finely split. In fact, recent years have seen a trend in international trade, which economists call splitting up the value chain. The value chain describes how a good is produced in stages. As indicated in the beginning of the chapter, producing the iPhone involves designing and engineering the phone in the United States, supplying parts from Korea, assembling the parts in China, and advertising and marketing in the United States. Thanks in large part to improvements in communication technology, sharing information, and transportation, it has become easier to split up the value chain. Instead of production in a single large factory, different firms operating in various places and even different countries can divide the value chain. Because firms split up the value chain, international trade often does not involve nations trading whole finished products like automobiles or refrigerators. Instead, it involves shipping more specialized goods like, say, automobile dashboards or the shelving that fits inside refrigerators. Intra-industry trade between similar countries produces economic gains because it allows workers and firms to learn and innovate on particular products—and often to focus on very particular parts of the value chain.
Link It Up
Visit this website for some interesting information about the assembly of the iPhone.
Economies of Scale, Competition, Variety
A second broad reason that intra-industry trade between similar nations produces economic gains involves economies of scale. The concept of economies of scale, as we introduced in Production, Costs and Industry Structure, means that as the scale of output goes up, average costs of production decline—at least up to a point. Figure 19.5 illustrates economies of scale for a plant producing toaster ovens. The horizontal axis of the figure shows the quantity of production by a certain firm or at a certain manufacturing plant. The vertical axis measures the average cost of production. Production plant S produces a small level of output at 30 units and has an average cost of production of \$30 per toaster oven. Plant M produces at a medium level of output at 50 units, and has an average cost of production of \$20 per toaster oven. Plant L produces 150 units of output with an average cost of production of only \$10 per toaster oven. Although plant V can produce 200 units of output, it still has the same unit cost as Plant L.
In this example, a small or medium plant, like S or M, will not be able to compete in the market with a large or a very large plant like L or V, because the firm that operates L or V will be able to produce and sell its output at a lower price. In this example, economies of scale operate up to point L, but beyond point L to V, the additional scale of production does not continue to reduce average costs of production.
Figure 19.5 Economies of Scale Production Plant S, has an average cost of production of \$30 per toaster oven. Production plant M has an average cost of production of \$20 per toaster oven. Production plant L has an average cost of production of only \$10 per toaster oven. Production plant V still has an average cost of production of \$10 per toaster oven. Thus, production plant M can produce toaster ovens more cheaply than plant S because of economies of scale, and plants L or V can produce more cheaply than S or M because of economies of scale. However, the economies of scale end at an output level of 150. Plant V, despite being larger, cannot produce more cheaply on average than plant L.
The concept of economies of scale becomes especially relevant to international trade when it enables one or two large producers to supply the entire country. For example, a single large automobile factory could probably supply all the cars consumers purchase in a smaller economy like the United Kingdom or Belgium in a given year. However, if a country has only one or two large factories producing cars, and no international trade, then consumers in that country would have relatively little choice between kinds of cars (other than the color of the paint and other nonessential options). Little or no competition will exist between different car manufacturers.
International trade provides a way to combine the lower average production costs that come from economies of scale and still have competition and variety for consumers. Large automobile factories in different countries can make and sell their products around the world. If General Motors, Ford, and Chrysler were the only players in the U.S. automobile market, the level of competition and consumer choice would be considerably lower than when U.S. carmakers must face competition from Toyota, Honda, Suzuki, Fiat, Mitsubishi, Nissan, Volkswagen, Kia, Hyundai, BMW, Subaru, and others. Greater competition brings with it innovation and responsiveness to what consumers want. America’s car producers make far better cars now than they did several decades ago, and much of the reason is competitive pressure, especially from East Asian and European carmakers.
Dynamic Comparative Advantage
The sources of gains from intra-industry trade between similar economies—namely, the learning that comes from a high degree of specialization and splitting up the value chain and from economies of scale—do not contradict the earlier theory of comparative advantage. Instead, they help to broaden the concept.
In intra-industry trade, climate or geography do not determine the level of worker productivity. Even the general level of education or skill does not determine it. Instead, how firms engage in specific learning about specialized products, including taking advantage of economies of scale determine the level of worker productivity. In this vision, comparative advantage can be dynamic—that is, it can evolve and change over time as one develops new skills and as manufacturers split the value chain in new ways. This line of thinking also suggests that countries are not destined to have the same comparative advantage forever, but must instead be flexible in response to ongoing changes in comparative advantage. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/19%3A_International_Trade/19.04%3A_Intra-industry_Trade_between_Similar_Economies.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain tariffs as barriers to trade
• Identify at least two benefits of reducing barriers to international trade
Tariffs are taxes that governments place on imported goods for a variety of reasons. Some of these reasons include protecting sensitive industries, for humanitarian reasons, and protecting against dumping. Traditionally, tariffs were used simply as a political tool to protect certain vested economic, social, and cultural interests. The World Trade Organization (WTO) is committed to lowering barriers to trade. The world’s nations meet through the WTO to negotiate how they can reduce barriers to trade, such as tariffs. WTO negotiations happen in “rounds,” where all countries negotiate one agreement to encourage trade, take a year or two off, and then start negotiating a new agreement. The current round of negotiations is called the Doha Round because it was officially launched in Doha, the capital city of Qatar, in November 2001. In 2010, the WTO noted that the Doha Round’s emphasis on market access and reforms of agricultural subsidies could add \$121–\$202 billion to the world economy.
In the context of a global economy that currently produces more than \$80 trillion of goods and services each year, this amount is not large: it is an increase of less than 1%. But before dismissing the gains from trade too quickly, it is worth remembering two points.
• First, a gain of a few hundred billion dollars is enough money to deserve attention! Moreover, remember that this increase is not a one-time event; it would persist each year into the future.
• Second, the estimate of gains may be on the low side because some of the gains from trade are not measured especially well in economic statistics. For example, it is difficult to measure the potential advantages to consumers of having a variety of products available and a greater degree of competition among producers. Perhaps the most important unmeasured factor is that trade between countries, especially when firms are splitting up the value chain of production, often involves a transfer of knowledge that can involve skills in production, technology, management, finance, and law.
Low-income countries benefit more from trade than high-income countries do. In some ways, the giant U.S. economy has less need for international trade, because it can already take advantage of internal trade within its economy. However, many smaller national economies around the world, in regions like Latin America, Africa, the Middle East, and Asia, have much more limited possibilities for trade inside their countries or their immediate regions. Without international trade, they may have little ability to benefit from comparative advantage, slicing up the value chain, or economies of scale. Moreover, smaller economies often have fewer competitive firms making goods within their economy, and thus firms have less pressure from other firms to provide the goods and prices that consumers want.
The economic gains from expanding international trade are measured in hundreds of billions of dollars, and the gains from international trade as a whole probably reach well into the trillions of dollars. The potential for gains from trade may be especially high among the smaller and lower-income countries of the world.
Link It Up
Visit this website for a list of some benefits of trade.
From Interpersonal to International Trade
Most people find it easy to believe that they, personally, would not be better off if they tried to grow and process all of their own food, to make all of their own clothes, to build their own cars and houses from scratch, and so on. Instead, we all benefit from living in economies where people and firms can specialize and trade with each other.
The benefits of trade do not stop at national boundaries, either. Earlier we explained that the division of labor could increase output for three reasons: (1) workers with different characteristics can specialize in the types of production where they have a comparative advantage; (2) firms and workers who specialize in a certain product become more productive with learning and practice; and (3) economies of scale. These three reasons apply from the individual and community level right up to the international level. If it makes sense to you that interpersonal, intercommunity, and interstate trade offer economic gains, it should make sense that international trade offers gains, too.
International trade currently involves about \$20 trillion worth of goods and services moving around the globe. Any economic force of that size, even if it confers overall benefits, is certain to cause disruption and controversy. This chapter has only made the case that trade brings economic benefits. Other chapters discuss, in detail, the public policy arguments over whether to restrict international trade.
Bring It Home
Just Whose iPhone Is It?
Apple Corporation uses a global platform to produce the iPhone. Now that you understand the concept of comparative advantage, you can see why the engineering and design of the iPhone is done in the United States. The United States has built up a comparative advantage over the years in designing and marketing products, and sacrifices fewer resources to design high-tech devices relative to other countries. China has a comparative advantage in assembling the phone due to its large skilled labor force. Korea has a comparative advantage in producing components. Korea focuses its production by increasing its scale, learning better ways to produce screens and computer chips, and uses innovation to lower average costs of production. Apple, in turn, benefits because it can purchase these quality products at lower prices. Put the global assembly line together and you have the device with which we are all so familiar. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/19%3A_International_Trade/19.05%3A_The_Benefits_of_Reducing_Barriers_to_International_Trade.txt |
absolute advantage
when one country can use fewer resources to produce a good compared to another country; when a country is more productive compared to another country
gain from trade
a country that can consume more than it can produce as a result of specialization and trade
intra-industry trade
international trade of goods within the same industry
splitting up the value chain
many of the different stages of producing a good happen in different geographic locations
tariffs
taxes that governments place on imported goods
value chain
how a good is produced in stages
19.07: Key Concepts and Summary
19.1 Absolute and Comparative Advantage
A country has an absolute advantage in those products in which it has a productivity edge over other countries; it takes fewer resources to produce a product. A country has a comparative advantage when it can produce a good at a lower cost in terms of other goods. Countries that specialize based on comparative advantage gain from trade.
19.2 What Happens When a Country Has an Absolute Advantage in All Goods
Even when a country has high levels of productivity in all goods, it can still benefit from trade. Gains from trade come about as a result of comparative advantage. By specializing in a good that it gives up the least to produce, a country can produce more and offer that additional output for sale. If other countries specialize in the area of their comparative advantage as well and trade, the highly productive country is able to benefit from a lower opportunity cost of production in other countries.
19.3 Intra-industry Trade between Similar Economies
A large share of global trade happens between high-income economies that are quite similar in having well-educated workers and advanced technology. These countries practice intra-industry trade, in which they import and export the same products at the same time, like cars, machinery, and computers. In the case of intra-industry trade between economies with similar income levels, the gains from trade come from specialized learning in very particular tasks and from economies of scale. Splitting up the value chain means that several stages of producing a good take place in different countries around the world.
19.4 The Benefits of Reducing Barriers to International Trade
Tariffs are placed on imported goods as a way of protecting sensitive industries, for humanitarian reasons, and for protection against dumping. Traditionally, tariffs were used as a political tool to protect certain vested economic, social, and cultural interests. The WTO has been, and continues to be, a way for nations to meet and negotiate in order to reduce barriers to trade. The gains of international trade are very large, especially for smaller countries, but are beneficial to all.
19.08: Self-Check Questions
1.
True or False: The source of comparative advantage must be natural elements like climate and mineral deposits. Explain.
2.
Brazil can produce 100 pounds of beef or 10 autos. In contrast the United States can produce 40 pounds of beef or 30 autos. Which country has the absolute advantage in beef? Which country has the absolute advantage in producing autos? What is the opportunity cost of producing one pound of beef in Brazil? What is the opportunity cost of producing one pound of beef in the United States?
3.
In France it takes one worker to produce one sweater, and one worker to produce one bottle of wine. In Tunisia it takes two workers to produce one sweater, and three workers to produce one bottle of wine. Who has the absolute advantage in production of sweaters? Who has the absolute advantage in the production of wine? How can you tell?
4.
In Germany it takes three workers to make one television and four workers to make one video camera. In Poland it takes six workers to make one television and 12 workers to make one video camera.
1. Who has the absolute advantage in the production of televisions? Who has the absolute advantage in the production of video cameras? How can you tell?
2. Calculate the opportunity cost of producing one additional television set in Germany and in Poland. (Your calculation may involve fractions, which is fine.) Which country has a comparative advantage in the production of televisions?
3. Calculate the opportunity cost of producing one video camera in Germany and in Poland. Which country has a comparative advantage in the production of video cameras?
4. In this example, is absolute advantage the same as comparative advantage, or not?
5. In what product should Germany specialize? In what product should Poland specialize?
5.
How can there be any economic gains for a country from both importing and exporting the same good, like cars?
6.
Table 19.15 shows how the average costs of production for semiconductors (the “chips” in computer memories) change as the quantity of semiconductors built at that factory increases.
1. Based on these data, sketch a curve with quantity produced on the horizontal axis and average cost of production on the vertical axis. How does the curve illustrate economies of scale?
2. If the equilibrium quantity of semiconductors demanded is 90,000, can this economy take full advantage of economies of scale? What about if quantity demanded is 70,000 semiconductors? 50,000 semiconductors? 30,000 semiconductors?
3. Explain how international trade could make it possible for even a small economy to take full advantage of economies of scale, while also benefiting from competition and the variety offered by several producers.
Quantity of Semiconductors Average Total Cost
10,000 \$8 each
20,000 \$5 each
30,000 \$3 each
40,000 \$2 each
100,000 \$2 each
Table 19.15
7.
If the removal of trade barriers is so beneficial to international economic growth, why would a nation continue to restrict trade on some imported or exported products? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/19%3A_International_Trade/19.06%3A_Key_Terms.txt |
8.
What is absolute advantage? What is comparative advantage?
9.
Under what conditions does comparative advantage lead to gains from trade?
10.
What factors does Paul Krugman identify that supported expanding international trade in the 1800s?
11.
Is it possible to have a comparative advantage in the production of a good but not to have an absolute advantage? Explain.
12.
How does comparative advantage lead to gains from trade?
13.
What is intra-industry trade?
14.
What are the two main sources of economic gains from intra-industry trade?
15.
What is splitting up the value chain?
16.
Are the gains from international trade more likely to be relatively more important to large or small countries?
19.10: Critical Thinking Questions
17.
Are differences in geography behind the differences in absolute advantages?
18.
Why does the United States not have an absolute advantage in coffee?
19.
Look at Exercise 19.2. Compute the opportunity costs of producing sweaters and wine in both France and Tunisia. Who has the lowest opportunity cost of producing sweaters and who has the lowest opportunity cost of producing wine? Explain what it means to have a lower opportunity cost.
20.
You just overheard your friend say the following: “Poor countries like Malawi have no absolute advantages. They have poor soil, low investments in formal education and hence low-skill workers, no capital, and no natural resources to speak of. Because they have no advantage, they cannot benefit from trade.” How would you respond?
21.
Look at Table 19.9. Is there a range of trades for which there will be no gains?
22.
You just got a job in Washington, D.C. You move into an apartment with some acquaintances. All your roommates, however, are slackers and do not clean up after themselves. You, on the other hand, can clean faster than each of them. You determine that you are 70% faster at dishes and 10% faster with vacuuming. All of these tasks have to be done daily. Which jobs should you assign to your roommates to get the most free time overall? Assume you have the same number of hours to devote to cleaning. Now, since you are faster, you seem to get done quicker than your roommate. What sorts of problems may this create? Can you imagine a trade-related analogy to this problem?
23.
Does intra-industry trade contradict the theory of comparative advantage?
24.
Do consumers benefit from intra-industry trade?
25.
Why might intra-industry trade seem surprising from the point of view of comparative advantage?
26.
In World Trade Organization meetings, what do you think low-income countries lobby for?
27.
Why might a low-income country put up barriers to trade, such as tariffs on imports?
28.
Can a nation’s comparative advantage change over time? What factors would make it change?
19.11: Problems
29.
France and Tunisia both have Mediterranean climates that are excellent for producing/harvesting green beans and tomatoes. In France it takes two hours for each worker to harvest green beans and two hours to harvest a tomato. Tunisian workers need only one hour to harvest the tomatoes but four hours to harvest green beans. Assume there are only two workers, one in each country, and each works 40 hours a week.
1. Draw a production possibilities frontier for each country. Hint: Remember the production possibility frontier is the maximum that all workers can produce at a unit of time which, in this problem, is a week.
2. Identify which country has the absolute advantage in green beans and which country has the absolute advantage in tomatoes.
3. Identify which country has the comparative advantage.
4. How much would France have to give up in terms of tomatoes to gain from trade? How much would it have to give up in terms of green beans?
30.
In Japan, one worker can make 5 tons of rubber or 80 radios. In Malaysia, one worker can make 10 tons of rubber or 40 radios.
1. Who has the absolute advantage in the production of rubber or radios? How can you tell?
2. Calculate the opportunity cost of producing 80 additional radios in Japan and in Malaysia. (Your calculation may involve fractions, which is fine.) Which country has a comparative advantage in the production of radios?
3. Calculate the opportunity cost of producing 10 additional tons of rubber in Japan and in Malaysia. Which country has a comparative advantage in producing rubber?
4. In this example, does each country have an absolute advantage and a comparative advantage in the same good?
5. In what product should Japan specialize? In what product should Malaysia specialize?
31.
Review the numbers for Canada and Venezuela from Table 19.12 which describes how many barrels of oil and tons of lumber the workers can produce. Use these numbers to answer the rest of this question.
1. Draw a production possibilities frontier for each country. Assume there are 100 workers in each country. Canadians and Venezuelans desire both oil and lumber. Canadians want at least 2,000 tons of lumber. Mark a point on their production possibilities where they can get at least 3,000 tons.
2. Assume that the Canadians specialize completely because they figured out they have a comparative advantage in lumber. They are willing to give up 1,000 tons of lumber. How much oil should they ask for in return for this lumber to be as well off as they were with no trade? How much should they ask for if they want to gain from trading with Venezuela? Note: We can think of this “ask” as the relative price or trade price of lumber.
3. Is the Canadian “ask” you identified in (b) also beneficial for Venezuelans? Use the production possibilities frontier graph for Venezuela to show that Venezuelans can gain from trade.
32.
In Exercise 19.31, is there an “ask” where Venezuelans may say “no thank you” to trading with Canada?
33.
From earlier chapters you will recall that technological change shifts the average cost curves. Draw a graph showing how technological change could influence intra-industry trade.
34.
Consider two countries: South Korea and Taiwan. Taiwan can produce one million mobile phones per day at the cost of \$10 per phone and South Korea can produce 50 million mobile phones at \$5 per phone. Assume these phones are the same type and quality and there is only one price. What is the minimum price at which both countries will engage in trade?
35.
If trade increases world GDP by 1% per year, what is the global impact of this increase over 10 years? How does this increase compare to the annual GDP of a country like Sri Lanka? Discuss. Hint: To answer this question, here are steps you may want to consider. Go to the World Development Indicators (online) published by the World Bank. Find the current level of World GDP in constant international dollars. Also, find the GDP of Sri Lanka in constant international dollars. Once you have these two numbers, compute the amount the additional increase in global incomes due to trade and compare that number to Sri Lanka’s GDP. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/19%3A_International_Trade/19.09%3A_Review_Questions.txt |
Figure 20.1 Flat Screen Competition The market for flat-panel displays in the United States is huge. The manufacturers of flat screens in the United States must compete against manufacturers from around the world. (Credit: modification of “IMG_4674” by “Jemimus”/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Protectionism: An Indirect Subsidy from Consumers to Producers
• International Trade and Its Effects on Jobs, Wages, and Working Conditions
• Arguments in Support of Restricting Imports
• How Trade Policy Is Enacted: Globally, Regionally, and Nationally
• The Tradeoffs of Trade Policy
Bring It Home
What’s the Downside of Protection?
Governments are motivated to limit and alter market outcomes for political or social ends. While governments can limit the rise in prices of some products, they cannot control how much people want to buy or how much firms are willing to sell. The laws of demand and supply still hold. Trade policy is an example where regulations can redirect economic forces, but it cannot stop them from manifesting themselves elsewhere.
Flat-panel displays, the displays for laptop computers, tablets, and flat screen televisions, are an example of such an enduring principle. In the early 1990s, the vast majority of flat-panel displays used in U.S.-manufactured laptops were imported, primarily from Japan. The small but politically powerful U.S. flat-panel-display industry filed a dumping complaint with the Commerce Department. They argued that Japanese firms were selling displays at “less than fair value,” which made it difficult for U.S. firms to compete. This argument for trade protection is referred to as anti-dumping. Other arguments for protection in this complaint included national security. After a preliminary determination by the Commerce Department that the Japanese firms were dumping, the U.S. International Trade Commission imposed a 63% dumping margin (or tax) on the import of flat-panel displays. Was this a successful exercise of U.S. trade policy? See what you think after reading the chapter.
The world has become more connected on multiple levels, especially economically. In 1970, imports and exports made up 11% of U.S. GDP, while now they make up 32%. However, the United States, due to its size, is less internationally connected than most countries. For example, according to the World Bank, 97% of Botswana’s economic activity is connected to trade. This chapter explores trade policy—the laws and strategies a country uses to regulate international trade. This topic is not without controversy.
As the world has become more globally connected, firms and workers in high-income countries like the United States, Japan, or the nations of the European Union, perceive a competitive threat from firms in medium-income countries like Mexico, China, or South Africa, that have lower costs of living and therefore pay lower wages. Firms and workers in low-income countries fear that they will suffer if they must compete against more productive workers and advanced technology in high-income countries.
On a different tack, some environmentalists worry that multinational firms may evade environmental protection laws by moving their production to countries with loose or nonexistent pollution standards, trading a clean environment for jobs. Some politicians worry that their country may become overly dependent on key imported products, like oil, which in a time of war could threaten national security. All of these fears influence governments to reach the same basic policy conclusion: to protect national interests, whether businesses, jobs, or security, imports of foreign products should be restricted. This chapter analyzes such arguments. First, however, it is essential to learn a few key concepts and understand how the demand and supply model applies to international trade. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/20%3A_Globalization_and_Protectionism/20.01%3A_Introduction.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain protectionism and its three main forms
• Analyze protectionism through concepts of demand and supply, noting its effects on equilibrium
• Calculate the effects of trade barriers
When a government legislates policies to reduce or block international trade it is engaging in protectionism. Protectionist policies often seek to shield domestic producers and domestic workers from foreign competition. Protectionism takes three main forms: tariffs, import quotas, and nontariff barriers.
Recall from International Trade that tariffs are taxes that governments impose on imported goods and services. This makes imports more expensive for consumers, discouraging imports. For example, in 2018, President Trump increased tariffs on Chinese-manufactured goods by 2–25%, including TVs, monitors, desktop PCs, smartwatches, and many other consumer goods. The intention behind the policy was to shelter U.S. manufacturers from competition, helping companies that operate domestically. China responded with tariffs on American goods, launching a trade war. President Biden retained these tariffs and considered additional ones, but as of August 2022, the administration was considering changes designed to reduce inflation.
Another way to control trade is through import quotas, which are numerical limitations on the quantity of products that a country can import. For instance, during the early 1980s, the Reagan Administration imposed a quota on the import of Japanese automobiles. In the 1970s, many developed countries, including the United States, found themselves with declining textile industries. Textile production does not require highly skilled workers, so producers were able to set up lower-cost factories in developing countries. In order to “manage” this loss of jobs and income, the developed countries established an international Multifiber Agreement that essentially divided the market for textile exports between importers and the remaining domestic producers. The agreement, which ran from 1974 to 2004, specified the exact quota of textile imports that each developed country would accept from each low-income country. A similar story exists for sugar imports into the United States, which are still governed by quotas.
Nontariff barriers are all the other ways that a nation can draw up rules, regulations, inspections, and paperwork to make it more costly or difficult to import products. A rule requiring certain safety standards can limit imports just as effectively as high tariffs or low import quotas, for instance. There are also nontariff barriers in the form of “rules-of-origin” regulations; these rules describe the “Made in Country X” label as the one in which the last substantial change in the product took place. A manufacturer wishing to evade import restrictions may try to change the production process so that the last big change in the product happens in their own country. For example, certain textiles are made in the United States, shipped to other countries, combined with textiles made in those other countries to make apparel—and then re-exported back to the United States for a final assembly, to escape paying tariffs or to obtain a “Made in the USA” label.
Despite import quotas, tariffs, and nontariff barriers, the share of apparel sold in the United States that is imported rose from about half in 1999 to about three-quarters today. According to the U.S. Bureau of Labor Statistics (BLS), estimated the number of U.S. jobs in textiles and apparel fell 44% from 2007 to 2014, and will fall by another 25% by 2024. Even more U.S. textile industry jobs would have been lost without tariffs. However, domestic jobs that are saved by import quotas come at a cost. Because textile and apparel protectionism adds to the costs of imports, consumers end up paying billions of dollars more for clothing each year.
When the United States eliminates trade barriers in one area, consumers spend the money they save on that product elsewhere in the economy. Thus, while eliminating trade barriers in one sector of the economy will likely result in some job loss in that sector, consumers will spend the resulting savings in other sectors of the economy and hence increase the number of jobs in those other sectors. Of course, workers in some of the poorest countries of the world who would otherwise have jobs producing textiles, would gain considerably if the United States reduced its barriers to trade in textiles. That said, there are good reasons to be wary about reducing barriers to trade. The 2012 and 2013 Bangladeshi fires in textile factories, which resulted in a horrific loss of life, present complications that our simplified analysis in the chapter will not capture.
Realizing the compromises between nations that come about due to trade policy, many countries came together in 1947 to form the General Agreement on Tariffs and Trade (GATT). (We’ll cover the GATT in more detail later in the chapter.) This agreement has since been superseded by the World Trade Organization (WTO), whose membership includes about 150 nations and most of the world's economies. It is the primary international mechanism through which nations negotiate their trade rules—including rules about tariffs, quotas, and nontariff barriers. The next section examines the results of such protectionism and develops a simple model to show the impact of trade policy.
Demand and Supply Analysis of Protectionism
To the non-economist, restricting imports may appear to be nothing more than taking sales from foreign producers and giving them to domestic producers. Other factors are at work, however, because firms do not operate in a vacuum. Instead, firms sell their products either to consumers or to other firms (if they are business suppliers), who are also affected by the trade barriers. A demand and supply analysis of protectionism shows that it is not just a matter of domestic gains and foreign losses, but a policy that imposes substantial domestic costs as well.
Consider two countries, Brazil and the United States, who produce sugar. Each country has a domestic supply and demand for sugar, as Table 20.1 details and Figure 20.2 illustrates. In Brazil, without trade, the equilibrium price of sugar is 12 cents per pound and the equilibrium output is 30 tons. When there is no trade in the United States, the equilibrium price of sugar is 24 cents per pound and the equilibrium quantity is 80 tons. We label these equilibrium points as point E in each part of the figure.
Figure 20.2 The Sugar Trade between Brazil and the United States Before trade, the equilibrium price of sugar in Brazil is 12 cents a pound and it is 24 cents per pound in the United States. When trade is allowed, businesses will buy cheap sugar in Brazil and sell it in the United States. This will result in higher prices in Brazil and lower prices in the United States. Ignoring transaction costs, prices should converge to 16 cents per pound, with Brazil exporting 15 tons of sugar and the United States importing 15 tons of sugar. If trade is only partly open between the countries, it will lead to an outcome between the free-trade and no-trade possibilities.
Price Brazil: Quantity Supplied (tons) Brazil: Quantity Demanded (tons) U.S.: Quantity Supplied (tons) U.S.: Quantity Demanded (tons)
8 cents 20 35 60 100
12 cents 30 30 66 93
14 cents 35 28 69 90
16 cents 40 25 72 87
20 cents 45 21 76 83
24 cents 50 18 80 80
28 cents 55 15 82 78
Table 20.1 The Sugar Trade between Brazil and the United States
If international trade between Brazil and the United States now becomes possible, profit-seeking firms will spot an opportunity: buy sugar cheaply in Brazil, and sell it at a higher price in the United States. As sugar is shipped from Brazil to the United States, the quantity of sugar produced in Brazil will be greater than Brazilian consumption (with the extra production exported), and the amount produced in the United States will be less than the amount of U.S. consumption (with the extra consumption imported). Exports to the United States will reduce the sugar supply in Brazil, raising its price. Imports into the United States will increase the sugar supply, lowering its price. When the sugar price is the same in both countries, there is no incentive to trade further. As Figure 20.2 shows, the equilibrium with trade occurs at a price of 16 cents per pound. At that price, the sugar farmers of Brazil supply a quantity of 40 tons, while the consumers of Brazil buy only 25 tons.
The extra 15 tons of sugar production, shown by the horizontal gap between the demand curve and the supply curve in Brazil, is exported to the United States. In the United States, at a price of 16 cents, the farmers produce a quantity of 72 tons and consumers demand a quantity of 87 tons. The excess demand of 15 tons by American consumers, shown by the horizontal gap between demand and domestic supply at the price of 16 cents, is supplied by imported sugar. Free trade typically results in income distribution effects, but the key is to recognize the overall gains from trade, as Figure 20.3 shows. Building on the concepts that we outlined in Demand and Supply and Demand, Supply, and Efficiency in terms of consumer and producer surplus, Figure 20.3 (a) shows that producers in Brazil gain by selling more sugar at a higher price, while Figure 20.3 (b) shows consumers in the United States benefit from the lower price and greater availability of sugar. Consumers in Brazil are worse off (compare their no-trade consumer surplus with the free-trade consumer surplus) and U.S. producers of sugar are worse off. There are gains from trade—an increase in social surplus in each country. That is, both the United States and Brazil are better off than they would be without trade. The following Clear It Up feature explains how trade policy can influence low-income countries.
Figure 20.3 Free Trade of Sugar Free trade results in gains from trade. Total surplus increases in both countries, as the two blue-shaded areas show. However, there are clear income distribution effects. Producers gain in the exporting country, while consumers lose; and in the importing country, consumers gain and producers lose.
Link It Up
Visit this website to read more about the global sugar trade.
Clear It Up
Why are there low-income countries?
Why are the poor countries of the world poor? There are a number of reasons, but one of them will surprise you: the trade policies of the high-income countries. Following is a stark review of social priorities which the international aid organization, Oxfam International has widely publicized.
High-income countries of the world—primarily the United States, countries of the European Union, and Japan—subsidize their domestic farmers collectively by about \$200 billion per year. Why does this matter?
It matters because the support of farmers in high-income countries is devastating to the livelihoods of farmers in low-income countries. Even when their climate and land are well-suited to products like cotton, rice, sugar, or milk, farmers in low-income countries find it difficult to compete. Farm subsidies in the high-income countries cause farmers in those countries to increase the amount they produce. This increase in supply drives down world prices of farm products below the costs of production. As Michael Gerson of the Washington Post describes it: “[T]he effects in the cotton-growing regions of West Africa are dramatic . . . keep[ing] millions of Africans on the edge of malnutrition. In some of the poorest countries on Earth, cotton farmers are some of the poorest people, earning about a dollar a day. . . . Who benefits from the current system of subsidies? About 20,000 American cotton producers, with an average annual income of more than \$125,000.”
As if subsidies were not enough, often, the high-income countries block agricultural exports from low-income countries. In some cases, the situation gets even worse when the governments of high-income countries, having bought and paid for an excess supply of farm products, give away those products in poor countries and drive local farmers out of business altogether.
For example, shipments of excess milk from the European Union to Jamaica have caused great hardship for Jamaican dairy farmers. Shipments of excess rice from the United States to Haiti drove thousands of low-income rice farmers in Haiti out of business. The opportunity costs of protectionism are not paid just by domestic consumers, but also by foreign producers—and for many agricultural products, those foreign producers are the world’s poor.
Now, let’s look at what happens with protectionism. U.S. sugar farmers are likely to argue that, if only they could be protected from sugar imported from Brazil, the United States would have higher domestic sugar production, more jobs in the sugar industry, and American sugar farmers would receive a higher price. If the United States government sets a high-enough tariff on imported sugar, or sets an import quota at zero, the result will be that the quantity of sugar traded between countries could be reduced to zero, and the prices in each country will return to the levels before trade was allowed.
Blocking only some trade is also possible. Suppose that the United States passed a sugar import quota of seven tons. The United States will import no more than seven tons of sugar, which means that Brazil can export no more than seven tons of sugar to the United States. As a result, the price of sugar in the United States will be 20 cents, which is the price where the quantity demanded is seven tons greater than the domestic quantity supplied. Conversely, if Brazil can export only seven tons of sugar, then the price of sugar in Brazil will be 14 cents per pound, which is the price where the domestic quantity supplied in Brazil is seven tons greater than domestic demand.
In general, when a country sets a low or medium tariff or import quota, the equilibrium price and quantity will be somewhere between those that prevail with no trade and those with completely free trade. The following Work It Out explores the impact of these trade barriers.
Work It Out
Effects of Trade Barriers
Let’s look carefully at the effects of tariffs or quotas. If the U.S. government imposes a tariff or quota sufficient to eliminate trade with Brazil, two things occur: U.S. consumers pay a higher price and therefore buy a smaller quantity of sugar. U.S. producers obtain a higher price and they sell a larger quantity of sugar. We can measure the effects of a tariff on producers and consumers in the United States using two concepts that we developed in Demand, Supply, and Efficiency: consumer surplus and producer surplus.
Figure 20.4 U.S. Sugar Supply and Demand When there is free trade, the equilibrium is at point A. When there is no trade, the equilibrium is at point E.
Step 1. Look at Figure 20.4, which shows a hypothetical version of the demand and supply of sugar in the United States.
Step 2. Note that when there is free trade the sugar market is in equilibrium at point A where Domestic Quantity Demanded (Qd) = Quantity Supplied (Domestic Qs + Imports from Brazil) at a price of PTrade.
Step 3. Note, also, that imports are equal to the distance between points C and A.
Step 4. Recall that consumer surplus is the value that consumers get beyond what they paid for when they buy a product. Graphically, it is the area under a demand curve but above the price. In this case, the consumer surplus in the United States is the area of the triangle formed by the points PTrade, A, and B.
Step 5. Recall, also, that producer surplus is another name for profit—it is the income producers get above the cost of production, which is shown by the supply curve here. In this case, the producer surplus with trade is the area of the triangle formed by the points Ptrade, C, and D.
Step 6. Suppose that the barriers to trade are imposed, imports are excluded, and the price rises to PNoTrade. Look what happens to producer surplus and consumer surplus. At the higher price, the domestic quantity supplied increases from Qs to Q at point E. Because producers are selling more quantity at a higher price, the producer surplus increases to the area of the triangle PNoTrade, E, and D.
Step 7. Compare the areas of the two triangles and you will see the increase in the producer surplus.
Step 8. Examine the consumer surplus. Consumers are now paying a higher price to get a lower quantity (Q instead of Qd). Their consumer surplus shrinks to the area of the triangle PNoTrade, E, and B.
Step 9. Determine the net effect. The producer surplus increases by the area Ptrade, C, E, PNoTrade. The loss of consumer surplus, however, is larger. It is the area Ptrade, A, E, PNoTrade. In other words, consumers lose more than producers gain as a result of the trade barriers and the United States has a lower social surplus.
Who Benefits and Who Pays?
Using the demand and supply model, consider the impact of protectionism on producers and consumers in each of the two countries. For protected producers like U.S. sugar farmers, restricting imports is clearly positive. Without a need to face imported products, these producers are able to sell more, at a higher price. For consumers in the country with the protected good, in this case U.S. sugar consumers, restricting imports is clearly negative. They end up buying a lower quantity of the good and paying a higher price for what they do buy, compared to the equilibrium price and quantity with trade. The following Clear It Up feature considers why a country might outsource jobs even for a domestic product.
Clear It Up
Why are Life Savers, an American product, not made in America?
In 1912, Clarence Crane invented Life Savers, the hard candy with the hole in the middle, in Cleveland, Ohio. Starting in the late 1960s and for 35 years afterward, a plant in Holland, Michigan produced 46 billion Life Savers a year, in 200 million rolls. However, in 2002, the Kraft Company announced that it would close the Michigan plant and move Life Saver production across the border to Montreal, Canada.
One reason is that Canadian workers are paid slightly less, especially in healthcare and insurance costs that are not linked to employment there. Another main reason is that the United States government keeps the sugar price high for the benefit of sugar farmers, with a combination of a government price floor program and strict quotas on imported sugar. In recent years, the price of U.S. sugar has been about double the price of sugar produced by the rest of the world. Life Saver production uses over 100 tons of sugar each day, because the candies are 95% sugar.
A number of other candy companies have also reduced U.S. production and expanded foreign production. Sugar-using industries have eliminated over 100,000 jobs over the last 20 years, more than seven times the total employment in sugar production. While the candy industry is especially affected by the cost of sugar, the costs are spread more broadly. U.S. consumers pay roughly \$1 billion per year in higher food prices because of elevated sugar costs. Meanwhile, sugar producers in low-income countries are driven out of business. Because of the sugar subsidies to domestic producers and the quotas on imports, they cannot sell their output profitably, or at all, in the United States market.
The fact that protectionism pushes up prices for consumers in the country enacting such protectionism is not always acknowledged openly, but it is not disputed. After all, if protectionism did not benefit domestic producers, there would not be much point in enacting such policies in the first place. Protectionism is simply a method of requiring consumers to subsidize producers. The subsidy is indirect, since consumers pay for it through higher prices, rather than a direct government subsidy paid with money collected from taxpayers. However, protectionism works like a subsidy, nonetheless. The American satirist Ambrose Bierce defined “tariff” this way in his 1911 book, The Devil’s Dictionary: “Tariff, n. A scale of taxes on imports, designed to protect the domestic producer against the greed of his consumer.”
The effect of protectionism on producers and consumers in the foreign country is complex. When a government uses an import quota to impose partial protectionism, Brazilian sugar producers receive a lower price for the sugar they sell in Brazil—but a higher price for the sugar they are allowed to export to the United States. Notice that some of the burden of protectionism, paid by domestic consumers, ends up in the hands of foreign producers in this case. Brazilian sugar consumers seem to benefit from U.S. protectionism, because it reduces the price of sugar that they pay (compared to the free-trade situation). On the other hand, at least some of these Brazilian sugar consumers also work as sugar farmers, so protectionism reduces their incomes and jobs. Moreover, if trade between the countries vanishes, Brazilian consumers would miss out on better prices for imported goods—which do not appear in our single-market example of sugar protectionism.
The effects of protectionism on foreign countries notwithstanding, protectionism requires domestic consumers of a product (consumers may include either households or other firms) to pay higher prices to benefit domestic producers of that product. In addition, when a country enacts protectionism, it loses the economic gains it would have been able to achieve through a combination of comparative advantage, specialized learning, and economies of scale, concepts that we discuss in International Trade. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/20%3A_Globalization_and_Protectionism/20.02%3A_Protectionism-_An_Indirect_Subsidy_from_Consumers_to_Producers.txt |
Learning Objectives
By the end of this section, you will be able to:
• Discuss how international trade influences the job market
• Analyze the opportunity cost of protectionism
• Explain how international trade impacts wages, labor standards, and working conditions
In theory at least, imports might injure workers in several different ways: fewer jobs, lower wages, or poor working conditions. Let’s consider these in turn.
Fewer Jobs?
In the early 1990s, the United States was negotiating the North American Free Trade Agreement (NAFTA)1 with Mexico, an agreement that reduced tariffs, import quotas, and nontariff barriers to trade between the United States, Mexico, and Canada. H. Ross Perot, a 1992 candidate for U.S. president, claimed, in prominent campaign arguments, that if the United States expanded trade with Mexico, there would be a “giant sucking sound” as U.S. employers relocated to Mexico to take advantage of lower wages. After all, average wages in Mexico were, at that time, about one-eighth of those in the United States. NAFTA passed Congress, President Bill Clinton signed it into law, and it took effect in 1995. For the next six years, the United States economy had some of the most rapid job growth and low unemployment in its history. Those who feared that open trade with Mexico would lead to a dramatic decrease in jobs were proven wrong.
This result was no surprise to economists. After all, the trend toward globalization has been going on for decades, not just since NAFTA. If trade reduced the number of available jobs, then the United States should have been seeing a steady loss of jobs for decades. While the United States economy does experience rises and falls in unemployment rates, the number of jobs is not falling over extended periods of time. The number of U.S. jobs rose from 71 million in 1970 to 150 million in 2021.
Protectionism certainly saves jobs in the specific industry being protected but, for two reasons, it costs jobs in other unprotected industries. First, if consumers are paying higher prices to the protected industry, they inevitably have less money to spend on goods from other industries, and so jobs are lost in those other industries. Second, if a firm sells the protected product to other firms, so that other firms must now pay a higher price for a key input, then those firms will lose sales to foreign producers who do not need to pay the higher price. Lost sales translate into lost jobs. The hidden opportunity cost of using protectionism to save jobs in one industry is jobs sacrificed in other industries. This is why the United States International Trade Commission, in its study of barriers to trade, predicts that reducing trade barriers would not lead to an overall loss of jobs. Protectionism reshuffles jobs from industries without import protections to industries that are protected from imports, but it does not create more jobs.
Moreover, the costs of saving jobs through protectionism can be very high. A number of different studies have attempted to estimate the cost to consumers in higher prices per job saved through protectionism. Table 20.2 shows a sample of results, compiled by economists at the Federal Reserve Bank of Dallas. Saving a job through protectionism typically costs much more than the actual worker’s salary. For example, a study published in 2002 compiled evidence that using protectionism to save an average job in the textile and apparel industry would cost \$199,000 per job saved. In other words, those workers could have been paid \$100,000 per year to be unemployed and the cost would only be half of what it is to keep them working in the textile and apparel industry. This result is not unique to textiles and apparel.
Industry Protected with Import Tariffs or Quotas Annual Cost per Job Saved
Sugar \$826,000
Polyethylene resins \$812,000
Dairy products \$685,000
Frozen concentrated orange juice \$635,000
Ball bearings \$603,000
Machine tools \$479,000
Women’s handbags \$263,000
Glassware \$247,000
Apparel and textiles \$199,000
Rubber footwear \$168,000
Women’s nonathletic footwear \$139,000
Table 20.2 Cost to U.S. Consumers of Saving a Job through Protectionism (Source: Federal Reserve Bank of Dallas)
Why does it cost so much to save jobs through protectionism? The basic reason is that not all of the extra money that consumers pay because of tariffs or quotas goes to save jobs. For example, if the government imposes tariffs on steel imports so that steel buyers pay a higher price, U.S. steel companies earn greater profits, buy more equipment, pay bigger bonuses to managers, give pay raises to existing employees—and also avoid firing some additional workers. Only part of the higher price of protected steel goes toward saving jobs. Also, when an industry is protected, the economy as a whole loses the benefits of playing to its comparative advantage—in other words, producing what it is best at. Therefore, part of the higher price that consumers pay for protected goods is lost economic efficiency, which we can measure as another deadweight loss, like what we discussed in Labor and Financial Markets.
There’s a bumper sticker that speaks to the threat some U.S. workers feel from imported products: “Buy American—Save U.S. Jobs.” If an economist were driving the car, the sticker might declare: “Block Imports—Save Jobs for Some Americans, Lose Jobs for Other Americans, and Also Pay High Prices.”
Trade and Wages
Even if trade does not reduce the number of jobs, it could affect wages. Here, it is important to separate issues about the average level of wages from issues about whether the wages of certain workers may be helped or hurt by trade.
Because trade raises the amount that an economy can produce by letting firms and workers play to their comparative advantage, trade will also cause the average level of wages in an economy to rise. Workers who can produce more will be more desirable to employers, which will shift the demand for their labor out to the right, and increase wages in the labor market. By contrast, barriers to trade will reduce the average level of wages in an economy.
However, even if trade increases the overall wage level, it will still benefit some workers and hurt others. Workers in industries that are confronted by competition from imported products may find that demand for their labor decreases and shifts back to the left, so that their wages decline with a rise in international trade. Conversely, workers in industries that benefit from selling in global markets may find that demand for their labor shifts out to the right, so that trade raises their wages.
Link It Up
View this website to read an article on the issues surrounding fair trade coffee.
One concern is that while globalization may be benefiting high-skilled, high-wage workers in the United States, it may also impose costs on low-skilled, low-wage workers. After all, high-skilled U.S. workers presumably benefit from increased sales of sophisticated products like computers, machinery, and pharmaceuticals in which the United States has a comparative advantage. Meanwhile, low-skilled U.S. workers must now compete against extremely low-wage workers worldwide for making simpler products like toys and clothing. As a result, the wages of low-skilled U.S. workers are likely to fall. There are, however, a number of reasons to believe that while globalization has helped some U.S. industries and hurt others, it has not focused its negative impact on the wages of low-skilled Americans. First, about half of U.S. trade is intra-industry trade. That means the U.S. trades similar goods with other high-wage economies like Canada, Japan, Germany, and the United Kingdom. For instance, in 2014 the U.S. exported over 2 million cars, from all the major automakers, and also imported several million cars from other countries.
Most U.S. workers in these industries have above-average skills and wages—and many of them do quite well in the world of globalization. Some evidence suggested that intra-industry trade between similar countries had a small impact on domestic workers but later evidence indicates that it all depends on how flexible the labor market is. In other words, the key is how flexible workers are in finding jobs in different industries. The effect of trade on low-wage workers depends considerably on the structure of labor markets and indirect effects felt in other parts of the economy. For example, in the United States and the United Kingdom, because labor market frictions are low, the impact of trade on low income workers is small.
Second, many low-skilled U.S. workers hold service jobs that imports from low-wage countries cannot replace. For example, we cannot import lawn care services or moving and hauling services or hotel maids from countries long distances away like China or Bangladesh. Competition from imported products is not the primary determinant of their wages.
Finally, while the focus of the discussion here is on wages, it is worth pointing out that low-wage U.S. workers suffer due to protectionism in all the industries—even those in which they do not work. For example, food and clothing are protected industries. These low-wage workers therefore pay higher prices for these basic necessities and as such their dollar stretches over fewer goods.
The benefits and costs of increased trade in terms of its effect on wages are not distributed evenly across the economy. However, the growth of international trade has helped to raise the productivity of U.S. workers as a whole—and thus helped to raise the average level of wages.
Labor Standards and Working Conditions
Workers in many low-income countries around the world labor under conditions that would be illegal for a worker in the United States. Workers in countries like China, Thailand, Brazil, South Africa, and Poland are often paid less than the United States minimum wage. For example, in the United States, the national minimum wage is \$7.25 per hour. A typical wage in many low-income countries might be more like \$7.25 per day, or often much less. Moreover, working conditions in low-income countries may be extremely unpleasant, or even unsafe. In the worst cases, production may involve the child labor or even workers who are mistreated, abused, or entrapped in their jobs. These concerns over foreign labor standards do not affect most of U.S. trade, which is intra-industry and carried out with other high-income countries that have labor standards similar to the United States, but it is, nonetheless, morally and economically important.
In thinking about labor standards in other countries, it is important to draw some distinctions between what is truly unacceptable and what is painful to think about. Most people, economists included, have little difficulty with the idea that production by six-year-olds confined in factories, by people who are abused or mistreated, or by slave labor is morally unacceptable. They would support aggressive efforts to eliminate such practices—including shutting out imported products made with such labor. Many cases, however, are less clear-cut. An opinion article in the New York Times several years ago described the case of Ahmed Zia, a 14-year-old boy from Pakistan. He earned \$2 per day working in a carpet factory. He dropped out of school in second grade. Should the United States and other countries refuse to purchase rugs made by Ahmed and his co-workers? If the carpet factories were to close, the likely alternative job for Ahmed is farm work, and as Ahmed says of his carpet-weaving job: “This makes much more money and is more comfortable.”
Other workers may have even less attractive alternative jobs, perhaps scavenging garbage or prostitution. The real problem for Ahmed and many others in low-income countries is not that globalization has made their lives worse, but rather that they have so few good life alternatives. The United States went through similar situations during the nineteenth and early twentieth centuries.
In closing, there is some irony when the United States government or U.S. citizens take issue with labor standards in low-income countries, because the United States is not a world leader in government laws to protect employees. According to a recent study by the Organization for Economic Cooperation and Development (OECD), the U.S. is the only one of 41 countries that does not provide mandated paid leave for new parents, and among the 40 countries that do mandate paid leave, the minimum duration is about two months. Many European workers receive six weeks or more of paid vacation per year. In the United States, vacations are often one to three weeks per year. If European countries accused the United States of using unfair labor standards to make U.S. products cheaply, and announced that they would shut out all U.S. imports until the United States adopted paid parental leave, added more national holidays, and doubled vacation time, Americans would be outraged. Yet when U.S. protectionists start talking about restricting imports from poor countries because of low wage levels and poor working conditions, they are making a very similar argument. This is not to say that labor conditions in low-income countries are not an important issue. They are. However, linking labor conditions in low-income countries to trade deflects the emphasis from the real question to ask: “What are acceptable and enforceable minimum labor standards and protections to have the world over?”
Footnotes
• 1As of July 1, 2020, NAFTA was officially replaced with the United States-Mexico-Canada (USMCA) free trade agreement. It is broadly similar to the original NAFTA. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/20%3A_Globalization_and_Protectionism/20.03%3A_International_Trade_and_Its_Effects_on_Jobs_Wages_and_Working_Conditions.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain and analyze various arguments that are in support of restricting imports, including the infant industry argument, the anti-dumping argument, the environmental protection argument, the unsafe consumer products argument, and the national interest argument
• Explain dumping and race to the bottom
• Evaluate the significance of countries’ perceptions on the benefits of growing trade
As we previously noted, protectionism requires domestic consumers of a product to pay higher prices to benefit domestic producers of that product. Countries that institute protectionist policies lose the economic gains achieved through a combination of comparative advantage, specialized learning, and economies of scale. With these overall costs in mind, let us now consider, one by one, a number of arguments that support restricting imports.
The Infant Industry Argument
Imagine Bhutan wants to start its own computer industry, but it has no computer firms that can produce at a low enough price and high enough quality to compete in world markets. However, Bhutanese politicians, business leaders, and workers hope that if the local industry had a chance to get established, before it needed to face international competition, then a domestic company or group of companies could develop the skills, management, technology, and economies of scale that it needs to become a successful profit-earning domestic industry. Thus, the infant industry argument for protectionism is to block imports for a limited time, to give the infant industry time to mature, before it starts competing on equal terms in the global economy. (Revisit Macroeconomic Policy Around the World for more information on the infant industry argument.)
The infant industry argument is theoretically possible, even sensible: give an industry a short-term indirect subsidy through protection, and then reap the long-term economic benefits of having a vibrant, healthy industry. Implementation, however, is tricky. In many countries, infant industries have gone from babyhood to senility and obsolescence without ever having reached the profitable maturity stage. Meanwhile, the protectionism that was supposed to be short-term often took a very long time to be repealed.
As one example, Brazil treated its computer industry as an infant industry from the late 1970s until about 1990. In an attempt to establish its computer industry in the global economy, Brazil largely barred imports of computer products for several decades. This policy guaranteed increased sales for Brazilian computers. However, by the mid-1980s, due to lack of international competition, Brazil had a backward and out-of-date industry, typically lagging behind world standards for price and performance by three to five years—a long time in this fast-moving industry. After more than a decade, during which Brazilian consumers and industries that would have benefited from up-to-date computers paid the costs and Brazil’s computer industry never competed effectively on world markets, Brazil phased out its infant industry policy for the computer industry.
Protectionism for infant industries always imposes costs on domestic users of the product, and typically has provided little benefit in the form of stronger, competitive industries. However, several countries in East Asia offer an exception. Japan, Korea, Thailand, and other countries in this region have sometimes provided a package of indirect and direct subsidies targeted at certain industries, including protection from foreign competition and government loans at interest rates below the market equilibrium. In Japan and Korea, for example, subsidies helped get their domestic steel and auto industries up and running.
Why did the infant industry policy of protectionism and other subsidies work fairly well in East Asia? An early 1990 World Bank study offered three guidelines to countries thinking about infant industry protection:
1. Do not hand out protectionism and other subsidies to all industries, but focus on a few industries where your country has a realistic chance to be a world-class producer.
2. Be very hesitant about using protectionism in areas like computers, where many other industries rely on having the best products available, because it is not useful to help one industry by imposing high costs on many other industries.
3. Have clear guidelines for when the infant industry policy will end.
In Korea in the 1970s and 1980s, a common practice was to link protectionism and subsidies to export sales in global markets. If export sales rose, then the infant industry had succeeded and the government could phase out protectionism. If export sales did not rise, then the infant industry policy had failed and the government could phase out protectionism. Either way, the protectionism would be temporary.
Following these rules is easier said than done. Politics often intrudes, both in choosing which industries will receive the benefits of treatment as “infants” and when to phase out import restrictions and other subsidies. Also, if the country's government wishes to impose costs on its citizens so that it can provide subsidies to a few key industries, it has many tools for doing such as direct government payments, loans, targeted tax reductions, and government support of research and development of new technologies. In other words, protectionism is not the only or even the best way to support key industries.
Link It Up
Visit this website to view a presentation by Pankaj Ghemawat questioning how integrated the world really is.
The Anti-Dumping Argument
Dumping refers to selling goods below their cost of production. Anti-dumping laws block imports that are sold below the cost of production by imposing tariffs that increase the price of these imports to reflect their cost of production. Since dumping is not allowed under World Trade Organization (WTO) rules, nations that believe they are on the receiving end of dumped goods can file a complaint with the WTO. According to the WTO, between 1995 and 2020, it oversaw 137 anti-dumping disputes. Note that dumping cases are countercyclical. During recessions, case filings increase. During economic booms, case filings go down. Individual countries have also frequently started their own anti-dumping investigations. The U.S. government has dozens of anti-dumping orders in place from past investigations. In 2022, for example, some U.S. imports that were under anti-dumping orders included olives from Spain, steel from South Korea, coated paper from Indonesia, light commercial vehicles from Germany and Italy, fish fillets from Vietnam, and cellulose pulp from Canada.
Why Might Dumping Occur?
Why would foreign firms export a product at less than its cost of production—which presumably means taking a loss? This question has two possible answers, one innocent and one more sinister.
The innocent explanation is that demand and supply set market prices, not the cost of production. Perhaps demand for a product shifts back to the left or supply shifts out to the right, which drives the market price to low levels—even below the cost of production. When a local store has a going-out-of-business sale, for example, it may sell goods at below the cost of production. If international companies find that there is excess supply of steel or computer chips or machine tools that is driving the market price down below their cost of production—this may be the market in action.
The sinister explanation is that dumping is part of a long-term strategy. Foreign firms sell goods at prices below the cost of production for a short period of time, and when they have driven out the domestic U.S. competition, they then raise prices. Economists sometimes call this scenario predatory pricing, which we discuss in the Monopoly chapter.
Should Anti-Dumping Cases Be Limited?
Anti-dumping cases pose two questions. How much sense do they make in economic theory? How much sense do they make as practical policy?
In terms of economic theory, the case for anti-dumping laws is weak. In a market governed by demand and supply, the government does not guarantee that firms will be able to make a profit. After all, low prices are difficult for producers, but benefit consumers. Moreover, although there are plenty of cases in which foreign producers have driven out domestic firms, there are zero documented cases in which the foreign producers then jacked up prices. Instead, foreign producers typically continue competing hard against each other and providing low prices to consumers. In short, it is difficult to find evidence of predatory pricing by foreign firms exporting to the United States.
Even if one could make a case that the government should sometimes enact anti-dumping rules in the short term, and then allow free trade to resume shortly thereafter, there is a growing concern that anti-dumping investigations often involve more politics than careful analysis. The U.S. Commerce Department is charged with calculating the appropriate “cost of production,” which can be as much an art as a science.
For example, if a company built a new factory two years ago, should it count part of the factory’s cost in this year’s cost of production? When a company is in a country where the government controls prices, like China for example, how can one measure the true cost of production? When a domestic industry complains loudly enough, government regulators seem very likely to find that unfair dumping has occurred. A common pattern has arisen where a domestic industry files an anti-dumping complaint, the governments meet and negotiate a reduction in imports, and then the domestic producers drop the anti-dumping suit. In such cases, anti-dumping cases often appear to be little more than a cover story for imposing tariffs or import quotas.
In the 1980s, the United States, Canada, the European Union, Australia, and New Zealand implemented almost all the anti-dumping cases. By the 2000s, countries like Argentina, Brazil, South Korea, South Africa, Mexico, and India were filing the majority of the anti-dumping cases before the WTO. As the number of anti-dumping cases has increased, and as countries such as the United States and the European Union feel targeted by the anti-dumping actions of others, the WTO may well propose some additional guidelines to limit the reach of anti-dumping laws.
The Environmental Protection Argument
The potential for global trade to affect the environment has become controversial. A president of the Sierra Club, an environmental lobbying organization, once wrote: “The consequences of globalization for the environment are not good. … Globalization, if we are lucky, will raise average incomes enough to pay for cleaning up some of the mess that we have made. But before we get there, globalization could also destroy enough of the planet’s basic biological and physical systems that prospects for life itself will be radically compromised.”
If free trade meant the destruction of life itself, then even economists would convert to protectionism! While globalization—and economic activity of all kinds—can pose environmental dangers, it seems quite possible that, with the appropriate safeguards in place, we can minimize the environmental impacts of trade. In some cases, trade may even bring environmental benefits.
In general, high-income countries such as the United States, Canada, Japan, the United Kingdom, and the nations of the European Union have relatively strict environmental standards. In contrast, middle- and low-income countries like Brazil, Nigeria, India, and China have lower environmental standards. The general view of the governments of such countries is that environmental protection is a luxury: as soon as their people have enough to eat, decent healthcare, and longer life expectancies, then they will spend more money on items such as sewage treatment plants, scrubbers to reduce air pollution from factory smokestacks, and national parks to protect wildlife.
This gap in environmental standards between high-income and low-income countries raises two worrisome possibilities in a world of increasing global trade: the “race to the bottom” scenario and the question of how quickly environmental standards will improve in low-income countries.
The Race to the Bottom Scenario
The race to the bottom scenario of global environmental degradation runs like this. Profit-seeking multinational companies shift their production from countries with strong environmental standards to countries with weak standards, thus reducing their costs and increasing their profits. Faced with such behavior, countries reduce their environmental standards to attract multinational firms, which, after all, provide jobs and economic clout. As a result, global production becomes concentrated in countries where firms can pollute the most and environmental laws everywhere “race to the bottom.”
Although the race-to-the-bottom scenario sounds plausible, it does not appear to describe reality. In fact, the financial incentive for firms to shift production to poor countries to take advantage of their weaker environmental rules does not seem especially powerful. When firms decide where to locate a new factory, they look at many different factors: the costs of labor and financial capital; whether the location is close to a reliable suppliers of the inputs that they need; whether the location is close to customers; the quality of transportation, communications, and electrical power networks; the level of taxes; and the competence and honesty of the local government. The cost of environmental regulations is a factor, too, but typically environmental costs are no more than 1 to 2% of the costs that a large industrial plant faces. The other factors that determine location are much more important to these companies than trying to skimp on environmental protection costs.
When an international company does choose to build a plant in a low-income country with lax environmental laws, it typically builds a plant similar to those that it operates in high-income countries with stricter environmental standards. Part of the reason for this decision is that designing an industrial plant is a complex and costly task, and so if a plant works well in a high-income country, companies prefer to use the same design everywhere. Also, companies realize that if they create an environmental disaster in a low-income country, it is likely to cost them a substantial amount of money in paying for damages, lost trust, and reduced sales—by building up-to-date plants everywhere they minimize such risks. As a result of these factors, foreign-owned plants in low-income countries often have a better record of compliance with environmental laws than do locally-owned plants.
Pressuring Low-Income Countries for Higher Environmental Standards
In some cases, the issue is not so much whether globalization will pressure low-income countries to reduce their environmental standards, but instead whether the threat of blocking international trade can pressure these countries into adopting stronger standards. For example, restrictions on ivory imports in high-income countries, along with stronger government efforts to catch elephant poachers, have been credited with helping to reduce the illegal poaching of elephants in certain African countries.
However, it would be highly undemocratic for the well-fed citizens of high-income countries to attempt to dictate to the ill-fed citizens of low-income countries what domestic policies and priorities they must adopt, or how they should balance environmental goals against other priorities for their citizens. Furthermore, if high-income countries want stronger environmental standards in low-income countries, they have many options other than the threat of protectionism. For example, high-income countries could pay for anti-pollution equipment in low-income countries, or could help to pay for national parks. High-income countries could help pay for and carry out the scientific and economic studies that would help environmentalists in low-income countries to make a more persuasive case for the economic benefits of protecting the environment.
After all, environmental protection is vital to two industries of key importance in many low-income countries—agriculture and tourism. Environmental advocates can set up standards for labeling products, like “this tuna caught in a net that kept dolphins safe” or “this product made only with wood not taken from rainforests,” so that consumer pressure can reinforce environmentalist values. The United Nations also reinforces these values, by sponsoring treaties to address issues such as climate change and global warming, the preservation of biodiversity, the spread of deserts, and the environmental health of the seabed. Countries that share a national border or are within a region often sign environmental agreements about air and water rights, too. The WTO is also becoming more aware of environmental issues and more careful about ensuring that increases in trade do not inflict environmental damage.
Finally, note that these concerns about the race to the bottom or pressuring low-income countries for more strict environmental standards do not apply very well to the roughly half of all U.S. trade that occurs with other high-income countries. Many European countries have stricter environmental standards in certain industries than the United States.
The Unsafe Consumer Products Argument
One argument for shutting out certain imported products is that they are unsafe for consumers. Consumer rights groups have sometimes warned that the World Trade Organization would require nations to reduce their health and safety standards for imported products. However, the WTO explains its current agreement on the subject in this way: “It allows countries to set their own standards.” It also says “regulations must be based on science. . . . And they should not arbitrarily or unjustifiably discriminate between countries where identical or similar conditions prevail.” Thus, for example, under WTO rules it is perfectly legitimate for the United States to pass laws requiring that all food products or cars sold in the United States meet certain safety standards approved by the United States government, whether or not other countries choose to pass similar standards. However, such standards must have some scientific basis. It is improper to impose one set of health and safety standards for domestically produced goods but a different set of standards for imports, or one set of standards for imports from Europe and a different set of standards for imports from Latin America.
In 2007, Mattel recalled nearly two million toys imported from China due to concerns about high levels of lead in the paint, as well as some loose parts. It is unclear if other toys were subject to similar standards. In 2013, Japan blocked imports of U.S. wheat because of concerns that genetically modified (GMO) wheat might be included in the shipments. The science on the impact of GMOs on health is still developing.
The National Interest Argument
Some argue that a nation should not depend too heavily on other countries for supplies of certain key products, such as oil, or for special materials or technologies that might have national security applications. On closer consideration, this argument for protectionism proves rather weak.
As an example, in the United States, oil provides about 36% of all the energy and 21% of the oil used in the United States economy is imported. Several times in the last few decades, when disruptions in the Middle East have shifted the supply curve of oil back to the left and sharply raised the price, the effects have been felt across the United States economy. This is not, however, a very convincing argument for restricting oil imports. If the United States needs to be protected from a possible cutoff of foreign oil, then a more reasonable strategy would be to import 100% of the petroleum supply now, and save U.S. domestic oil resources for when or if the foreign supply is cut off. It might also be useful to import extra oil and put it into a stockpile for use in an emergency, as the United States government did by starting a Strategic Petroleum Reserve in 1977. Moreover, it may be necessary to discourage people from using oil, and to start a high-powered program to seek out alternatives to oil. A straightforward way to do this would be to raise taxes on oil. Additionally, it makes no sense to argue that because oil is highly important to the United States economy, then the United States should shut out oil imports and use up its domestic supplies more quickly. U.S. domestic oil production is increasing. Shale oil is adding to domestic supply using fracking extraction techniques.
Whether or not to limit certain kinds of imports of key technologies or materials that might be important to national security and weapons systems is a slightly different issue. If weapons’ builders are not confident that they can continue to obtain a key product in wartime, they might decide to avoid designing weapons that use this key product, or they can go ahead and design the weapons and stockpile enough of the key high-tech components or materials to last through an armed conflict. There is a U.S. Defense National Stockpile Center that has built up reserves of many materials, from aluminum oxides, antimony, and bauxite to tungsten, vegetable tannin extracts, and zinc (although many of these stockpiles have been reduced and sold in recent years). Think every country is pro-trade? How about the U.S.? The following Clear It Up might surprise you.
Clear It Up
How does the United States really feel about expanding trade?
How do people around the world feel about expanding trade between nations? In summer 2007, the Pew Foundation surveyed 45,000 people in 47 countries. One of the questions asked about opinions on growing trade ties between countries. Table 20.3 shows the percentages who answered either “very good” or “somewhat good” for some of countries surveyed.
For those who think of the United States as the world’s leading supporter of expanding trade, the survey results may be perplexing. When adding up the shares of those who say that growing trade ties between countries is “very good” or “somewhat good,” Americans had the least favorable attitude toward increasing globalization, while the Chinese and South Africans ranked highest. In fact, among the 47 countries surveyed, the United States ranked by far the lowest on this measure, followed by Egypt, Italy, and Argentina.
Country Very Good Somewhat Good Total
China 38% 53% 91%
South Africa 42% 43% 87%
South Korea 24% 62% 86%
Germany 30% 55% 85%
Canada 29% 53% 82%
United Kingdom 28% 50% 78%
Mexico 22% 55% 77%
Brazil 13% 59% 72%
Japan 17% 55% 72%
United States 14% 45% 59%
Table 20.3 The Status of Growing Trade Ties between Countries (Source: www.pewglobal.org/files/pdf/258.pdf)
One final reason why economists often treat the national interest argument skeptically is that lobbyists and politicians can tout almost any product as vital to national security. In 1954, the United States became worried that it was importing half of the wool required for military uniforms, so it declared wool and mohair to be “strategic materials” and began to give subsidies to wool and mohair farmers. Although the government removed wool from the official list of “strategic” materials in 1960, the subsidies for mohair continued for almost 40 years until the government repealed them in 1993, and then reinstated them in 2002. All too often, the national interest argument has become an excuse for handing out the indirect subsidy of protectionism to certain industries or companies. After all, politicians, not nonpartisan analysts make decisions about what constitutes a key strategic material. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/20%3A_Globalization_and_Protectionism/20.04%3A_Arguments_in_Support_of_Restricting_Imports.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the origin and role of the World Trade Organization (WTO) and General Agreement on Tariffs and Trade (GATT)
• Discuss the significance and provide examples of regional trading agreements
• Analyze trade policy at the national level
• Evaluate long-term trends in barriers to trade
These public policy arguments about how nations should react to globalization and trade are fought out at several levels: at the global level through the World Trade Organization and through regional trade agreements between pairs or groups of countries.
The World Trade Organization
The World Trade Organization (WTO) was officially born in 1995, but its history is much longer. In the years after the Great Depression and World War II, there was a worldwide push to build institutions that would tie the nations of the world together. The United Nations officially came into existence in 1945. The World Bank, which assists the poorest people in the world, and the International Monetary Fund, which addresses issues raised by international financial transactions, were both created in 1946. The third planned organization was to be an International Trade Organization, which would manage international trade. The United Nations was unable to agree to this. Instead, 27 nations signed the General Agreement on Tariffs and Trade (GATT) in Geneva, Switzerland on October 30, 1947 to provide a forum in which nations could come together to negotiate reductions in tariffs and other barriers to trade. In 1995, the GATT transformed into the WTO.
The GATT process was to negotiate an agreement to reduce barriers to trade, sign that agreement, pause for a while, and then start negotiating the next agreement. Table 20.4 shows rounds of talks in the GATT, and now the WTO. Notice that the early rounds of GATT talks took a relatively short time, included a small number of countries, and focused almost entirely on reducing tariffs. Since the mid-1960s, however, rounds of trade talks have taken years, included a large number of countries, and have included an ever-broadening range of issues.
Year Place or Name of Round Main Subjects Number of Countries Involved
1947 Geneva Tariff reduction 23
1949 Annecy Tariff reduction 13
1951 Torquay Tariff reduction 38
1956 Geneva Tariff reduction 26
1960–61 Dillon round Tariff reduction 26
1964–67 Kennedy round Tariffs, anti-dumping measures 62
1973–79 Tokyo round Tariffs, nontariff barriers 102
1986–94 Uruguay round Tariffs, nontariff barriers, services, intellectual property, dispute settlement, textiles, agriculture, creation of WTO 123
2001– Doha round Agriculture, services, intellectual property, competition, investment, environment, dispute settlement 147
Table 20.4 The Negotiating Rounds of GATT and the World Trade Organization
The sluggish pace of GATT negotiations led to an old joke that GATT really stood for Gentleman’s Agreement to Talk and Talk. The slow pace of international trade talks, however, is understandable, even sensible. Having dozens of nations agree to any treaty is a lengthy process. GATT often set up separate trading rules for certain industries, like agriculture, and separate trading rules for certain countries, like the low-income countries. There were rules, exceptions to rules, opportunities to opt out of rules, and precise wording to be fought over in every case. Like the GATT before it, the WTO is not a world government, with power to impose its decisions on others. The total staff of the WTO Secretariat in 2021 is 625 people and its annual budget (as of 2020) is \$197 million, which makes it smaller in size than many large universities.
Regional Trading Agreements
There are different types of economic integration across the globe, ranging from free trade agreements, in which participants allow each other’s imports without tariffs or quotas, to common markets, in which participants have a common external trade policy as well as free trade within the group, to full economic unions, in which, in addition to a common market, monetary and fiscal policies are coordinated. Many nations belong both to the World Trade Organization and to regional trading agreements.
The best known of these regional trading agreements is the European Union. In the years after World War II, leaders of several European nations reasoned that if they could tie their economies together more closely, they might be more likely to avoid another devastating war. Their efforts began with a free trade association, evolved into a common market, and then transformed into what is now a full economic union, known as the European Union. The EU, as it is often called, has a number of goals. For example, in the early 2000s it introduced a common currency for Europe, the euro, and phased out most of the former national forms of money like the German mark and the French franc, though a few have retained their own currency. Another key element of the union is to eliminate barriers to the mobility of goods, labor, and capital across Europe. In 2016, Britain voted to leave the European Union—a move that was completed in January 2020.
For the United States, perhaps the best-known regional trading agreement is the North American Free Trade Agreement (NAFTA). 2 The United States also participates in some less-prominent regional trading agreements, like the Caribbean Basin Initiative, which offers reduced tariffs for imports from these countries, and a free trade agreement with Israel.
The world has seen a flood of regional trading agreements in recent years. About 100 such agreements are now in place. Table 20.5 lists a few of the more prominent ones. Some are just agreements to continue talking. Others set specific goals for reducing tariffs, import quotas, and nontariff barriers. One economist described the current trade treaties as a “spaghetti bowl,” which is what a map with lines connecting all the countries with trade treaties looks like.
There is concern among economists who favor free trade that some of these regional agreements may promise free trade, but actually act as a way for the countries within the regional agreement to try to limit trade from anywhere else. In some cases, the regional trade agreements may even conflict with the broader agreements of the World Trade Organization.
Trade Agreements Participating Countries
Asia Pacific Economic Cooperation (APEC) Australia, Brunei, Canada, Chile, People’s Republic of China, Hong Kong, China, Indonesia, Japan, Republic of Korea, Malaysia, Mexico, New Zealand, Papua New Guinea, Peru, Philippines, Russia, Singapore, Chinese Taipei, Thailand, United States, Vietnam
European Union (EU) Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, United Kingdom*
North America Free Trade Agreement (NAFTA) Canada, Mexico, United States
Latin American Integration Association (LAIA) Argentina, Bolivia, Brazil, Chile, Columbia, Ecuador, Mexico, Paraguay, Peru, Uruguay, Venezuela, Panama
Association of Southeast Asian Nations (ASEAN) Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam
Southern African Development Community (SADC) Angola, Botswana, Comoros, Congo, Lesotho, Madagascar, Malawi, Mauritius, Mozambique, Namibia, Seychelles, South Africa, Swaziland, Tanzania, Zambia, Zimbabwe
Table 20.5 Some Regional Trade Agreements * Following the 2016 referendum vote to leave the European Union, the UK government triggered the withdrawal process on March 29, 2017, setting the date for the UK to leave by April 2019. In January 2020, the withdrawal was complete and the United Kingdom is now no longer part of the EU trading bloc. Also, as of 2020, NAFTA has been replaced by the United States-Mexico-Canada (USMCA) free trade agreement.
Trade Policy at the National Level
Yet another dimension of trade policy, along with international and regional trade agreements, happens at the national level. The United States, for example, imposes import quotas on sugar, because of a fear that such imports would drive down the price of sugar and thus injure domestic sugar producers. One of the jobs of the United States Department of Commerce is to determine if there is import dumping from other countries. The United States International Trade Commission—a government agency—determines whether the dumping has substantially injured domestic industries, and if so, the president can impose tariffs that are intended to offset the unfairly low price.
In the arena of trade policy, the battle often seems to be between national laws that increase protectionism and international agreements that try to reduce protectionism, like the WTO. Why would a country pass laws or negotiate agreements to shut out certain foreign products, like sugar or textiles, while simultaneously negotiating to reduce trade barriers in general? One plausible answer is that international trade agreements offer a method for countries to restrain their own special interests. A member of Congress can say to an industry lobbying for tariffs or quotas on imports: “Sure would like to help you, but that pesky WTO agreement just won’t let me.”
Link It Up
If consumers are the biggest losers from trade, why do they not fight back? The quick answer is because it is easier to organize a small group of people around a narrow interest (producers) versus a large group that has diffuse interests (consumers). This is a question about trade policy theory. Visit this website and read the article by Jonathan Rauch.
Long-Term Trends in Barriers to Trade
In newspaper headlines, trade policy appears mostly as disputes and acrimony. Countries are almost constantly threatening to challenge other nations' “unfair” trading practices. Cases are brought to the dispute settlement procedures of the WTO, the European Union, NAFTA, and other regional trading agreements. Politicians in national legislatures, goaded on by lobbyists, often threaten to pass bills that will “establish a fair playing field” or “prevent unfair trade”—although most such bills seek to accomplish these high-sounding goals by placing more restrictions on trade. Protesters in the streets may object to specific trade rules or to the entire practice of international trade.
Through all the controversy, the general trend in the last 60 years is clearly toward lower barriers to trade. The average level of tariffs on imported products charged by industrialized countries was 40% in 1946. By 1990, after decades of GATT negotiations, it was down to less than 5%. One of the reasons that GATT negotiations shifted from focusing on tariff reduction in the early rounds to a broader agenda was that tariffs had been reduced so dramatically there was not much more to do in that area. U.S. tariffs have followed this general pattern: After rising sharply during the Great Depression, tariffs dropped off to less than 2% by the end of the century. Although measures of import quotas and nontariff barriers are less exact than those for tariffs, they generally appear to be at lower levels than they had been previously, too.
Thus, the last half-century has seen both a dramatic reduction in government-created barriers to trade, such as tariffs, import quotas, and nontariff barriers, and also a number of technological developments that have made international trade easier, like advances in transportation, communication, and information management. The result has been the powerful surge of international trade.
These trends were altered by two important events in 2016: the UK vote to leave the EU and the election of President Trump in the United States, whose administration pursued a policy of raising trade barriers. In 2018, tariffs on a broad range of imports from China were raised by around 25%. As of 2022, the UK has been out of the EU for two years, and it remains unclear if President Biden’s administration will adjust or remove President Trump’s trade barriers.
Footnotes
• 2As of July 1, 2020, NAFTA was officially replaced with the United States-Mexico-Canada (USMCA) free trade agreement. It is broadly similar to the original NAFTA. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/20%3A_Globalization_and_Protectionism/20.05%3A_How_Governments_Enact_Trade_Policy-_Globally_Regionally_and_Nationally.txt |
Learning Objectives
By the end of this section, you will be able to:
• Asses the complexity of international trade
• Discuss why a market-oriented economy is so affected by international trade
• Explain disruptive market change
Economists readily acknowledge that international trade is not all sunshine, roses, and happy endings. Over time, the average person gains from international trade, both as a worker who has greater productivity and higher wages because of the benefits of specialization and comparative advantage, and as a consumer who can benefit from shopping all over the world for a greater variety of quality products at attractive prices. The “average person,” however, is hypothetical, not real—representing a mix of those who have done very well, those who have done all right, and those who have done poorly. It is a legitimate concern of public policy to focus not just on the average or on the success stories, but also on those who have not been so fortunate. Workers in other countries, the environment, and prospects for new industries and materials that might be of key importance to the national economy are also all legitimate issues.
The common belief among economists is that it is better to embrace the gains from trade, and then deal with the costs and tradeoffs with other policy tools, than it is to cut off trade to avoid the costs and tradeoffs.
To gain a better intuitive understanding for this argument, consider a hypothetical American company called Technotron. Technotron invents a new scientific technology that allows the firm to increase the output and quality of its goods with a smaller number of workers at a lower cost. As a result of this technology, other U.S. firms in this industry will lose money and will also have to lay off workers—and some of the competing firms will even go bankrupt. Should the United States government protect the existing firms and their employees by making it illegal for Technotron to use its new technology? Most people who live in market-oriented economies would oppose trying to block better products that lower the cost of services. Certainly, there is a case for society providing temporary support and assistance for those who find themselves without work. Many would argue for government support of programs that encourage retraining and acquiring additional skills. Government might also support research and development efforts, so that other firms may find ways of outdoing Technotron. Blocking the new technology altogether, however, seems like a mistake. After all, few people would advocate giving up electricity because it caused so much disruption to the kerosene and candle business. Few would suggest holding back on improvements in medical technology because they might cause companies selling leeches and snake oil to lose money. In short, most people view disruptions due to technological change as a necessary cost that is worth bearing.
Now, imagine that Technotron’s new “technology” is as simple as this: the company imports what it sells from another country. In other words, think of foreign trade as a type of innovative technology. The objective situation is now exactly the same as before. Because of Technotron’s new technology—which in this case is importing goods from another county—other firms in this industry will lose money and lay off workers. Just as it would have been inappropriate and ultimately foolish to respond to the disruptions of new scientific technology by trying to shut it down, it would be inappropriate and ultimately foolish to respond to the disruptions of international trade by trying to restrict trade.
Some workers and firms will suffer because of international trade. In a living, breathing market-oriented economy, some workers and firms will always be experiencing disruptions, for a wide variety of reasons. Corporate management can be better or worse. Workers for a certain firm can be more or less productive. Tough domestic competitors can create just as much disruption as tough foreign competitors. Sometimes a new product is a hit with consumers; sometimes it is a flop. Sometimes a company is blessed by a run of good luck or stricken with a run of bad luck. For some firms, international trade will offer great opportunities for expanding productivity and jobs; for other firms, trade will impose stress and pain. The disruption caused by international trade is not fundamentally different from all the other disruptions caused by the other workings of a market economy.
In other words, the economic analysis of free trade does not rely on a belief that foreign trade is not disruptive or does not pose tradeoffs; indeed, the story of Technotron begins with a particular disruptive market change—a new technology—that causes real tradeoffs. In thinking about the disruptions of foreign trade, or any of the other possible costs and tradeoffs of foreign trade discussed in this chapter, the best public policy solutions typically do not involve protectionism, but instead involve finding ways for public policy to address the particular issues resulting from these disruptions, costs, and tradeoffs, while still allowing the benefits of international trade to occur.
Bring It Home
What’s the Downside of Protection?
The domestic flat-panel display industry employed many workers before the ITC imposed the dumping margin tax. Flat-panel displays make up a significant portion of the cost of producing laptop computers—as much as 50%. Therefore, the antidumping tax would substantially increase the cost, and thus the price, of U.S.-manufactured laptops. As a result of the ITC’s decision, Apple moved its domestic manufacturing plant for Macintosh computers to Ireland (where it had an existing plant). Toshiba shut down its U.S. manufacturing plant for laptops. And IBM cancelled plans to open a laptop manufacturing plant in North Carolina, instead deciding to expand production at its plant in Japan. In this case, rather than having the desired effect of protecting U.S. interests and giving domestic manufacturing an advantage over items manufactured elsewhere, it had the unintended effect of driving the manufacturing completely out of the country. Many people lost their jobs and most flat-panel display production now occurs in countries other than the United States. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/20%3A_Globalization_and_Protectionism/20.06%3A_The_Tradeoffs_of_Trade_Policy.txt |
anti-dumping laws
laws that block imports sold below the cost of production and impose tariffs that would increase the price of these imports to reflect their cost of production
common market
economic agreement between countries to allow free trade in goods, services, labor, and financial capital between members while having a common external trade policy
disruptive market change
innovative new product or production technology which disrupts the status quo in a market, leading the innovators to earn more income and profits and the other firms to lose income and profits, unless they can come up with their own innovations
dumping
selling internationally traded goods below their cost of production
economic union
economic agreement between countries to allow free trade between members, a common external trade policy, and coordinated monetary and fiscal policies
free trade agreement
economic agreement between countries to allow free trade between members
General Agreement on Tariffs and Trade (GATT)
forum in which nations could come together to negotiate reductions in tariffs and other barriers to trade; the precursor to the World Trade Organization
import quotas
numerical limits on the quantity of products that a country can import
national interest argument
the argument that there are compelling national interests against depending on key imports from other nations
nontariff barriers
ways a nation can draw up rules, regulations, inspections, and paperwork to make it more costly or difficult to import products
protectionism
government policies to reduce or block imports
race to the bottom
when production locates in countries with the lowest environmental (or other) standards, putting pressure on all countries to reduce their environmental standards
World Trade Organization (WTO)
organization that seeks to negotiate reductions in barriers to trade and to adjudicate complaints about violations of international trade policy; successor to the General Agreement on Tariffs and Trade (GATT)
20.08: Key Concepts and Summary
20.1 Protectionism: An Indirect Subsidy from Consumers to Producers
There are three tools for restricting the flow of trade: tariffs, import quotas, and nontariff barriers. When a country places limitations on imports from abroad, regardless of whether it uses tariffs, quotas, or nontariff barriers, it is said to be practicing protectionism. Protectionism will raise the price of the protected good in the domestic market, which causes domestic consumers to pay more, but domestic producers to earn more.
20.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions
As international trade increases, it contributes to a shift in jobs away from industries where that economy does not have a comparative advantage and toward industries where it does have a comparative advantage. The degree to which trade affects labor markets has much to do with the structure of the labor market in that country and the adjustment process in other industries. Global trade should raise the average level of wages by increasing productivity. However, this increase in average wages may include both gains to workers in certain jobs and industries and losses to others.
In thinking about labor practices in low-income countries, it is useful to draw a line between what is unpleasant to think about and what is morally objectionable. For example, low wages and long working hours in poor countries are unpleasant to think about, but for people in low-income parts of the world, it may well be the best option open to them. Practices like child labor and forced labor are morally objectionable and many countries refuse to import products made using these practices.
20.3 Arguments in Support of Restricting Imports
There are a number of arguments that support restricting imports. These arguments are based around industry and competition, environmental concerns, and issues of safety and security.
The infant industry argument for protectionism is that small domestic industries need to be temporarily nurtured and protected from foreign competition for a time so that they can grow into strong competitors. In some cases, notably in East Asia, this approach has worked. Often, however, the infant industries never grow up. On the other hand, arguments against dumping (which is setting prices below the cost of production to drive competitors out of the market), often simply seem to be a convenient excuse for imposing protectionism.
Low-income countries typically have lower environmental standards than high-income countries because they are more worried about immediate basics such as food, education, and healthcare. However, except for a small number of extreme cases, shutting off trade seems unlikely to be an effective method of pursuing a cleaner environment.
Finally, there are arguments involving safety and security. Under the rules of the World Trade Organization, countries are allowed to set whatever standards for product safety they wish, but the standards must be the same for domestic products as for imported products and there must be a scientific basis for the standard. The national interest argument for protectionism holds that it is unwise to import certain key products because if the nation becomes dependent on key imported supplies, it could be vulnerable to a cutoff. However, it is often wiser to stockpile resources and to use foreign supplies when available, rather than preemptively restricting foreign supplies so as not to become dependent on them.
20.4 How Governments Enact Trade Policy: Globally, Regionally, and Nationally
Governments determine trade policy at many different levels: administrative agencies within government, laws passed by the legislature, regional negotiations between a small group of nations (sometimes just two), and global negotiations through the World Trade Organization. During the second half of the twentieth century, trade barriers have, in general, declined quite substantially in the United States economy and in the global economy. One reason why countries sign international trade agreements to commit themselves to free trade is to give themselves protection against their own special interests. When an industry lobbies for protection from foreign producers, politicians can point out that, because of the trade treaty, their hands are tied.
20.5 The Tradeoffs of Trade Policy
International trade certainly has income distribution effects. This is hardly surprising. All domestic or international competitive market forces are disruptive. They cause companies and industries to rise and fall. Government has a role to play in cushioning workers against the disruptions of the market. However, just as it would be unwise in the long term to clamp down on new technology and other causes of disruption in domestic markets, it would be unwise to clamp down on foreign trade. In both cases, the disruption brings with it economic benefits. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/20%3A_Globalization_and_Protectionism/20.07%3A_Key_Terms.txt |
1.
Explain how a tariff reduction causes an increase in the equilibrium quantity of imports and a decrease in the equilibrium price. Hint: Consider the Work It Out "Effects of Trade Barriers."
2.
Explain how a subsidy on agricultural goods like sugar adversely affects the income of foreign producers of imported sugar.
3.
Explain how trade barriers save jobs in protected industries, but only by costing jobs in other industries.
4.
Explain how trade barriers raise wages in protected industries by reducing average wages economy-wide.
5.
How does international trade affect working conditions of low-income countries?
6.
Do the jobs for workers in low-income countries that involve making products for export to high-income countries typically pay these workers more or less than their next-best alternative?
7.
How do trade barriers affect the average income level in an economy?
8.
How does the cost of “saving” jobs in protected industries compare to the workers’ wages and salaries?
9.
Explain how predatory pricing could be a motivation for dumping.
10.
Why do low-income countries like Brazil, Egypt, or Vietnam have lower environmental standards than high-income countries like the Germany, Japan, or the United States?
11.
Explain the logic behind the “race to the bottom” argument and the likely reason it has not occurred.
12.
What are the conditions under which a country may use the unsafe products argument to block imports?
13.
Why is the national security argument not convincing?
14.
Assume a perfectly competitive market and the exporting country is small. Using a demand and supply diagram, show the impact of increasing standards on a low-income exporter of toys. Show the tariff's impact. Is the effect on toy prices the same or different? Why is a standards policy preferred to tariffs?
15.
What is the difference between a free trade association, a common market, and an economic union?
16.
Why would countries promote protectionist laws, while also negotiate for freer trade internationally?
17.
What might account for the dramatic increase in international trade over the past 50 years?
18.
How does competition, whether domestic or foreign, harm businesses?
19.
What are the gains from competition?
20.10: Review Questions
20.
Who does protectionism protect? From what does it protect them?
21.
Name and define three policy tools for enacting protectionism.
22.
How does protectionism affect the price of the protected good in the domestic market?
23.
Does international trade, taken as a whole, increase the total number of jobs, decrease the total number of jobs, or leave the total number of jobs about the same?
24.
Is international trade likely to have roughly the same effect on the number of jobs in each individual industry?
25.
How is international trade, taken as a whole, likely to affect the average level of wages?
26.
Is international trade likely to have about the same effect on everyone’s wages?
27.
What are main reasons for protecting “infant industries”? Why is it difficult to stop protecting them?
28.
What is dumping? Why does prohibiting it often work better in theory than in practice?
29.
What is the “race to the bottom” scenario?
30.
Do the rules of international trade require that all nations impose the same consumer safety standards?
31.
What is the national interest argument for protectionism with regard to certain products?
32.
Name several of the international treaties where countries negotiate with each other over trade policy.
33.
What is the general trend of trade barriers over recent decades: higher, lower, or about the same?
34.
If opening up to free trade would benefit a nation, then why do nations not just eliminate their trade barriers, and not bother with international trade negotiations?
35.
Who gains and who loses from trade?
36.
Why is trade a good thing if some people lose?
37.
What are some ways that governments can help people who lose from trade? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/20%3A_Globalization_and_Protectionism/20.09%3A_Self-Check_Questions.txt |
38.
Show graphically that for any tariff, there is an equivalent quota that would give the same result. What would be the difference, then, between the two types of trade barriers? Hint: It is not something you can see from the graph.
39.
From the Work It Out "Effects of Trade Barriers," you can see that a tariff raises the price of imports. What is interesting is that the price rises by less than the amount of the tariff. Who pays the rest of the tariff amount? Can you show this graphically?
40.
If trade barriers hurt the average worker in an economy (due to lower wages), why does government create trade barriers?
41.
Why do you think labor standards and working conditions are lower in the low-income countries of the world than in countries like the United States?
42.
How would direct subsidies to key industries be preferable to tariffs or quotas?
43.
How can governments identify good candidates for infant industry protection? Can you suggest some key characteristics of good candidates? Why are industries like computers not good candidates for infant industry protection?
44.
Microeconomic theory argues that it is economically rationale (and profitable) to sell additional output as long as the price covers the variable costs of production. How is this relevant to the determination of whether dumping has occurred?
45.
How do you think Americans would feel if other countries began to urge the United States to increase environmental standards?
46.
Is it legitimate to impose higher safety standards on imported goods that exist in the foreign country where the goods were produced?
47.
Why might the unsafe consumer products argument be a more effective strategy (from the perspective of the importing country) than using tariffs or quotas to restrict imports?
48.
Why might a tax on domestic consumption of resources critical for national security be a more efficient approach than barriers to imports?
49.
Why do you think that the GATT rounds and, more recently, WTO negotiations have become longer and more difficult to resolve?
50.
An economic union requires giving up some political autonomy to succeed. What are some examples of political power countries must give up to be members of an economic union?
51.
What are some examples of innovative products that have disrupted their industries for the better?
52.
In principle, the benefits of international trade to a country exceed the costs, no matter whether the country is importing or exporting. In practice, it is not always possible to compensate the losers in a country, for example, workers who lose their jobs due to foreign imports. In your opinion, does that mean that trade should be inhibited to prevent the losses?
53.
Economists sometimes say that protectionism is the “second-best” choice for dealing with any particular problem. What they mean is that there is often a policy choice that is more direct or effective for dealing with the problem—a choice that would still allow the benefits of trade to occur. Explain why protectionism is a “second-best” choice for:
1. helping workers as a group
2. helping industries stay strong
3. protecting the environment
4. advancing national defense
54.
Trade has income distribution effects. For example, suppose that because of a government-negotiated reduction in trade barriers, trade between Germany and the Czech Republic increases. Germany sells house paint to the Czech Republic. The Czech Republic sells alarm clocks to Germany. Would you expect this pattern of trade to increase or decrease jobs and wages in the paint industry in Germany? The alarm clock industry in Germany? The paint industry in Czech Republic? The alarm clock industry in Czech Republic? What has to happen for there to be no increase in total unemployment in both countries?
20.12: Problems
55.
Assume two countries, Thailand (T) and Japan (J), have one good: cameras. The demand (d) and supply (s) for cameras in Thailand and Japan is described by the following functions:
$QdT = 60 – PQdT = 60 – P$ $QsT = –5 + 14PQsT = –5 + 14P$ $QdJ = 80 – PQdJ = 80 – P$ $QsJ = –10 + 12PQsJ = –10 + 12P$
P is the price measured in a common currency used in both countries, such as the Thai Baht.
1. Compute the equilibrium price (P) and quantities (Q) in each country without trade.
2. Now assume that free trade occurs. The free-trade price goes to 56.36 Baht. Who exports and imports cameras and in what quantities?
56.
You have just been put in charge of trade policy for Malawi. Coffee is a recent crop that is growing well and the Malawian export market is developing. As such, Malawi coffee is an infant industry. Malawi coffee producers come to you and ask for tariff protection from cheap Tanzanian coffee. What sorts of policies will you enact? Explain.
57.
The country of Pepperland exports steel to the Land of Submarines. Information for the quantity demanded (Qd) and quantity supplied (Qs) in each country, in a world without trade, are given in Table 20.6 and Table 20.7.
Price (\$) Qd Qs
60 230 180
70 200 200
80 170 220
90 150 240
100 140 250
Table 20.6 Pepperland
Price (\$) Qd Qs
60 430 310
70 420 330
80 410 360
90 400 400
100 390 440
Table 20.7 Land of Submarines
1. What would be the equilibrium price and quantity in each country in a world without trade? How can you tell?
2. What would be the equilibrium price and quantity in each country if trade is allowed to occur? How can you tell?
3. Sketch two supply and demand diagrams, one for each country, in the situation before trade.
4. On those diagrams, show the equilibrium price and the levels of exports and imports in the world after trade.
5. If the Land of Submarines imposes an anti-dumping import quota of 30, explain in general terms whether it will benefit or injure consumers and producers in each country.
6. Does your general answer change if the Land of Submarines imposes an import quota of 70? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/20%3A_Globalization_and_Protectionism/20.11%3A_Critical_Thinking_Questions.txt |
(This appendix should be consulted after first reading Welcome to Economics!) Economics is not math. There is no important concept in this course that cannot be explained without mathematics. That said, math is a tool that can be used to illustrate economic concepts. Remember the saying a picture is worth a thousand words? Instead of a picture, think of a graph. It is the same thing. Economists use models as the primary tool to derive insights about economic issues and problems. Math is one way of working with (or manipulating) economic models.
There are other ways of representing models, such as text or narrative. But why would you use your fist to bang a nail, if you had a hammer? Math has certain advantages over text. It disciplines your thinking by making you specify exactly what you mean. You can get away with fuzzy thinking in your head, but you cannot when you reduce a model to algebraic equations. At the same time, math also has disadvantages. Mathematical models are necessarily based on simplifying assumptions, so they are not likely to be perfectly realistic. Mathematical models also lack the nuances which can be found in narrative models. The point is that math is one tool, but it is not the only tool or even always the best tool economists can use. So what math will you need for this book? The answer is: little more than high school algebra and graphs. You will need to know:
• What a function is
• How to interpret the equation of a line (i.e., slope and intercept)
• How to manipulate a line (i.e., changing the slope or the intercept)
• How to compute and interpret a growth rate (i.e., percentage change)
• How to read and manipulate a graph
In this text, we will use the easiest math possible, and we will introduce it in this appendix. So if you find some math in the book that you cannot follow, come back to this appendix to review. Like most things, math has diminishing returns. A little math ability goes a long way; the more advanced math you bring in, the less additional knowledge that will get you. That said, if you are going to major in economics, you should consider learning a little calculus. It will be worth your while in terms of helping you learn advanced economics more quickly.
Algebraic Models
Often economic models (or parts of models) are expressed in terms of mathematical functions. What is a function? A function describes a relationship. Sometimes the relationship is a definition. For example (using words), your professor is Adam Smith. This could be expressed as Professor = Adam Smith. Or Friends = Bob + Shawn + Margaret.
Often in economics, functions describe cause and effect. The variable on the left-hand side is what is being explained (“the effect”). On the right-hand side is what is doing the explaining (“the causes”). For example, suppose your GPA was determined as follows:
$GPA = 0.25 × combined_SAT + 0.25 × class_attendance + 0.50 × hours_spent_studyingGPA = 0.25 × combined_SAT + 0.25 × class_attendance + 0.50 × hours_spent_studying$
This equation states that your GPA depends on three things: your combined SAT score, your class attendance, and the number of hours you spend studying. It also says that study time is twice as important (0.50) as either combined_SAT score (0.25) or class_attendance (0.25). If this relationship is true, how could you raise your GPA? By not skipping class and studying more. Note that you cannot do anything about your SAT score, since if you are in college, you have (presumably) already taken the SATs.
Of course, economic models express relationships using economic variables, like Budget = money_spent_on_econ_books + money_spent_on_music, assuming that the only things you buy are economics books and music.
Most of the relationships we use in this course are expressed as linear equations of the form:
$y = b + mxy = b + mx$
Expressing Equations Graphically
Graphs are useful for two purposes. The first is to express equations visually, and the second is to display statistics or data. This section will discuss expressing equations visually.
To a mathematician or an economist, a variable is the name given to a quantity that may assume a range of values. In the equation of a line presented above, x and y are the variables, with x on the horizontal axis and y on the vertical axis, and b and m representing factors that determine the shape of the line. To see how this equation works, consider a numerical example:
$y = 9 + 3xy = 9 + 3x$
In this equation for a specific line, the b term has been set equal to 9 and the m term has been set equal to 3. Table A1 shows the values of x and y for this given equation. Figure A1 shows this equation, and these values, in a graph. To construct the table, just plug in a series of different values for x, and then calculate what value of y results. In the figure, these points are plotted and a line is drawn through them.
x y
0 9
1 12
2 15
3 18
4 21
5 24
6 27
Table A1 Values for the Slope Intercept Equation
Figure A1 Slope and the Algebra of Straight Lines This line graph has x on the horizontal axis and y on the vertical axis. The y-intercept—that is, the point where the line intersects the y-axis—is 9. The slope of the line is 3; that is, there is a rise of 3 on the vertical axis for every increase of 1 on the horizontal axis. The slope is the same all along a straight line.
This example illustrates how the b and m terms in an equation for a straight line determine the shape of the line. The b term is called the y-intercept. The reason for this name is that, if x = 0, then the b term will reveal where the line intercepts, or crosses, the y-axis. In this example, the line hits the vertical axis at 9. The m term in the equation for the line is the slope. Remember that slope is defined as rise over run; more specifically, the slope of a line from one point to another is the change in the vertical axis divided by the change in the horizontal axis. In this example, each time the x term increases by one (the run), the y term rises by three. Thus, the slope of this line is three. Specifying a y-intercept and a slope—that is, specifying b and m in the equation for a line—will identify a specific line. Although it is rare for real-world data points to arrange themselves as an exact straight line, it often turns out that a straight line can offer a reasonable approximation of actual data.
Interpreting the Slope
The concept of slope is very useful in economics, because it measures the relationship between two variables. A positive slope means that two variables are positively related; that is, when x increases, so does y, or when x decreases, y decreases also. Graphically, a positive slope means that as a line on the line graph moves from left to right, the line rises. The length-weight relationship, shown in Figure A3 later in this Appendix, has a positive slope. We will learn in other chapters that price and quantity supplied have a positive relationship; that is, firms will supply more when the price is higher.
A negative slope means that two variables are negatively related; that is, when x increases, y decreases, or when x decreases, y increases. Graphically, a negative slope means that, as the line on the line graph moves from left to right, the line falls. The altitude-air density relationship, shown in Figure A4 later in this appendix, has a negative slope. We will learn that price and quantity demanded have a negative relationship; that is, consumers will purchase less when the price is higher.
A slope of zero means that there is no relationship between x and y. Graphically, the line is flat; that is, zero rise over the run. Figure A5 of the unemployment rate, shown later in this appendix, illustrates a common pattern of many line graphs: some segments where the slope is positive, other segments where the slope is negative, and still other segments where the slope is close to zero.
The slope of a straight line between two points can be calculated in numerical terms. To calculate slope, begin by designating one point as the “starting point” and the other point as the “end point” and then calculating the rise over run between these two points. As an example, consider the slope of the air density graph between the points representing an altitude of 4,000 meters and an altitude of 6,000 meters:
Rise: Change in variable on vertical axis (end point minus original point)
$= 0.100 – 0.307 = –0.207 = 0.100 – 0.307 = –0.207$
Run: Change in variable on horizontal axis (end point minus original point)
$= 6,000 – 4,000= 2,000= 6,000 – 4,000= 2,000$
Thus, the slope of a straight line between these two points would be that from the altitude of 4,000 meters up to 6,000 meters, the density of the air decreases by approximately 0.1 kilograms/cubic meter for each of the next 1,000 meters.
Suppose the slope of a line were to increase. Graphically, that means it would get steeper. Suppose the slope of a line were to decrease. Then it would get flatter. These conditions are true whether or not the slope was positive or negative to begin with. A higher positive slope means a steeper upward tilt to the line, while a smaller positive slope means a flatter upward tilt to the line. A negative slope that is larger in absolute value (that is, more negative) means a steeper downward tilt to the line. A slope of zero is a horizontal flat line. A vertical line has an infinite slope.
Suppose a line has a larger intercept. Graphically, that means it would shift out (or up) from the old origin, parallel to the old line. If a line has a smaller intercept, it would shift in (or down), parallel to the old line.
Solving Models with Algebra
Economists often use models to answer a specific question, like: What will the unemployment rate be if the economy grows at 3% per year? Answering specific questions requires solving the “system” of equations that represent the model.
Suppose the demand for personal pizzas is given by the following equation:
$Qd = 16 – 2PQd = 16 – 2P$
where Qd is the amount of personal pizzas consumers want to buy (i.e., quantity demanded), and P is the price of pizzas. Suppose the supply of personal pizzas is:
$Qs = 2 + 5PQs = 2 + 5P$
where Qs is the amount of pizza producers will supply (i.e., quantity supplied).
Finally, suppose that the personal pizza market operates where supply equals demand, or
$Qd = QsQd = Qs$
We now have a system of three equations and three unknowns (Qd, Qs, and P), which we can solve with algebra:
Since Qd = Qs, we can set the demand and supply equation equal to each other:
$Qd = Qs16 – 2P = 2 + 5PQd = Qs16 – 2P = 2 + 5P$
Subtracting 2 from both sides and adding 2P to both sides yields:
$16 – 2P – 2 = 2 + 5P – 214 – 2P = 5P14 – 2P + 2P = 5P + 2P14 = 7P147 = 7P72 = P16 – 2P – 2 = 2 + 5P – 214 – 2P = 5P14 – 2P + 2P = 5P + 2P14 = 7P147 = 7P72 = P$
In other words, the price of each personal pizza will be \$2. How much will consumers buy?
Taking the price of \$2, and plugging it into the demand equation, we get:
$Qd = 16 – 2P = 16 – 2(2) = 16 – 4 = 12Qd = 16 – 2P = 16 – 2(2) = 16 – 4 = 12$
So if the price is \$2 each, consumers will purchase 12. How much will producers supply? Taking the price of \$2, and plugging it into the supply equation, we get:
$Qs = 2 + 5P = 2 + 5(2) = 2 + 10 = 12Qs = 2 + 5P = 2 + 5(2) = 2 + 10 = 12$
So if the price is \$2 each, producers will supply 12 personal pizzas. This means we did our math correctly, since Qd = Qs.
Solving Models with Graphs
If algebra is not your forte, you can get the same answer by using graphs. Take the equations for Qd and Qs and graph them on the same set of axes as shown in Figure A2. Since P is on the vertical axis, it is easiest if you solve each equation for P. The demand curve is then P = 8 – 0.5Qd and the supply curve is P = –0.4 + 0.2Qs. Note that the vertical intercepts are 8 and –0.4, and the slopes are –0.5 for demand and 0.2 for supply. If you draw the graphs carefully, you will see that where they cross (Qs = Qd), the price is \$2 and the quantity is 12, just like the algebra predicted.
Figure A2 Supply and Demand Graph The equations for Qd and Qs are displayed graphically by the sloped lines.
We will use graphs more frequently in this book than algebra, but now you know the math behind the graphs.
Growth Rates
Growth rates are frequently encountered in real world economics. A growth rate is simply the percentage change in some quantity. It could be your income. It could be a business’s sales. It could be a nation’s GDP. The formula for computing a growth rate is straightforward:
$Percentage change = Change in quantityQuantityPercentage change = Change in quantityQuantity$
Suppose your job pays \$10 per hour. Your boss, however, is so impressed with your work that he gives you a \$2 per hour raise. The percentage change (or growth rate) in your pay is \$2/\$10 = 0.20 or 20%.
To compute the growth rate for data over an extended period of time, for example, the average annual growth in GDP over a decade or more, the denominator is commonly defined a little differently. In the previous example, we defined the quantity as the initial quantity—or the quantity when we started. This is fine for a one-time calculation, but when we compute the growth over and over, it makes more sense to define the quantity as the average quantity over the period in question, which is defined as the quantity halfway between the initial quantity and the next quantity. This is harder to explain in words than to show with an example. Suppose a nation’s GDP was \$1 trillion in 2005 and \$1.03 trillion in 2006. The growth rate between 2005 and 2006 would be the change in GDP (\$1.03 trillion – \$1.00 trillion) divided by the average GDP between 2005 and 2006 (\$1.03 trillion + \$1.00 trillion)/2. In other words:
$= 1.03 trillion – 1.00 trillion(1.03 trillion + 1.00 trillion) / 2 = 0.031.015 = 0.0296 = 2.96% growth = 1.03 trillion – 1.00 trillion(1.03 trillion + 1.00 trillion) / 2 = 0.031.015 = 0.0296 = 2.96% growth$
Note that if we used the first method, the calculation would be (\$1.03 trillion – \$1.00 trillion) / \$1.00 trillion = 3% growth, which is approximately the same as the second, more complicated method. If you need a rough approximation, use the first method. If you need accuracy, use the second method.
A few things to remember: A positive growth rate means the quantity is growing. A smaller growth rate means the quantity is growing more slowly. A larger growth rate means the quantity is growing more quickly. A negative growth rate means the quantity is decreasing.
The same change over times yields a smaller growth rate. If you got a \$2 raise each year, in the first year the growth rate would be \$2/\$10 = 20%, as shown above. But in the second year, the growth rate would be \$2/\$12 = 0.167 or 16.7% growth. In the third year, the same \$2 raise would correspond to a \$2/\$14 = 14.2%. The moral of the story is this: To keep the growth rate the same, the change must increase each period.
Displaying Data Graphically and Interpreting the Graph
Graphs are also used to display data or evidence. Graphs are a method of presenting numerical patterns. They condense detailed numerical information into a visual form in which relationships and numerical patterns can be seen more easily. For example, which countries have larger or smaller populations? A careful reader could examine a long list of numbers representing the populations of many countries, but with over 200 nations in the world, searching through such a list would take concentration and time. Putting these same numbers on a graph can quickly reveal population patterns. Economists use graphs both for a compact and readable presentation of groups of numbers and for building an intuitive grasp of relationships and connections.
Three types of graphs are used in this book: line graphs, pie graphs, and bar graphs. Each is discussed below. We also provide warnings about how graphs can be manipulated to alter viewers’ perceptions of the relationships in the data.
Line Graphs
The graphs we have discussed so far are called line graphs, because they show a relationship between two variables: one measured on the horizontal axis and the other measured on the vertical axis.
Sometimes it is useful to show more than one set of data on the same axes. The data in Table A2 is displayed in Figure A3 which shows the relationship between two variables: length and median weight for American baby boys and girls during the first three years of life. (The median means that half of all babies weigh more than this and half weigh less.) The line graph measures length in inches on the horizontal axis and weight in pounds on the vertical axis. For example, point A on the figure shows that a boy who is 28 inches long will have a median weight of about 19 pounds. One line on the graph shows the length-weight relationship for boys and the other line shows the relationship for girls. This kind of graph is widely used by healthcare providers to check whether a child’s physical development is roughly on track.
Figure A3 The Length-Weight Relationship for American Boys and Girls The line graph shows the relationship between height and weight for boys and girls from birth to 3 years. Point A, for example, shows that a boy of 28 inches in height (measured on the horizontal axis) is typically 19 pounds in weight (measured on the vertical axis). These data apply only to children in the first three years of life.
Boys from Birth to 36 Months Girls from Birth to 36 Months
Length (inches) Weight (pounds) Length (inches) Weight (pounds)
20.0 8.0 20.0 7.9
22.0 10.5 22.0 10.5
24.0 13.5 24.0 13.2
26.0 16.4 26.0 16.0
28.0 19.0 28.0 18.8
30.0 21.8 30.0 21.2
32.0 24.3 32.0 24.0
34.0 27.0 34.0 26.2
36.0 29.3 36.0 28.9
38.0 32.0 38.0 31.3
Table A2 Length to Weight Relationship for American Boys and Girls
Not all relationships in economics are linear. Sometimes they are curves. Figure A4 presents another example of a line graph, representing the data from Table A3. In this case, the line graph shows how thin the air becomes when you climb a mountain. The horizontal axis of the figure shows altitude, measured in meters above sea level. The vertical axis measures the density of the air at each altitude. Air density is measured by the weight of the air in a cubic meter of space (that is, a box measuring one meter in height, width, and depth). As the graph shows, air pressure is heaviest at ground level and becomes lighter as you climb. Figure A4 shows that a cubic meter of air at an altitude of 500 meters weighs approximately one kilogram (about 2.2 pounds). However, as the altitude increases, air density decreases. A cubic meter of air at the top of Mount Everest, at about 8,828 meters, would weigh only 0.023 kilograms. The thin air at high altitudes explains why many mountain climbers need to use oxygen tanks as they reach the top of a mountain.
Figure A4 Altitude-Air Density Relationship This line graph shows the relationship between altitude, measured in meters above sea level, and air density, measured in kilograms of air per cubic meter. As altitude rises, air density declines. The point at the top of Mount Everest has an altitude of approximately 8,828 meters above sea level (the horizontal axis) and air density of 0.023 kilograms per cubic meter (the vertical axis).
Altitude (meters) Air Density (kg/cubic meters)
0 1.200
500 1.093
1,000 0.831
1,500 0.678
2,000 0.569
2,500 0.484
3,000 0.415
3,500 0.357
4,000 0.307
4,500 0.231
5,000 0.182
5,500 0.142
6,000 0.100
6,500 0.085
7,000 0.066
7,500 0.051
8,000 0.041
8,500 0.025
9,000 0.022
9,500 0.019
10,000 0.014
Table A3 Altitude to Air Density Relationship
The length-weight relationship and the altitude-air density relationships in these two figures represent averages. If you were to collect actual data on air pressure at different altitudes, the same altitude in different geographic locations will have slightly different air density, depending on factors like how far you are from the equator, local weather conditions, and the humidity in the air. Similarly, in measuring the height and weight of children for the previous line graph, children of a particular height would have a range of different weights, some above average and some below. In the real world, this sort of variation in data is common. The task of a researcher is to organize that data in a way that helps to understand typical patterns. The study of statistics, especially when combined with computer statistics and spreadsheet programs, is a great help in organizing this kind of data, plotting line graphs, and looking for typical underlying relationships. For most economics and social science majors, a statistics course will be required at some point.
One common line graph is called a time series, in which the horizontal axis shows time and the vertical axis displays another variable. Thus, a time series graph shows how a variable changes over time. Figure A5 shows the unemployment rate in the United States since 1975, where unemployment is defined as the percentage of adults who want jobs and are looking for a job, but cannot find one. The points for the unemployment rate in each year are plotted on the graph, and a line then connects the points, showing how the unemployment rate has moved up and down since 1975. The line graph makes it easy to see, for example, that the highest unemployment rate during this time period was slightly less than 10% in the early 1980s and 2010, while the unemployment rate declined from the early 1990s to the end of the 1990s, before rising and then falling back in the early 2000s, and then rising sharply during the recession from 2008–2009.
Figure A5 U.S. Unemployment Rate, 1975–2014 This graph provides a quick visual summary of unemployment data. With a graph like this, it is easy to spot the times of high unemployment and of low unemployment.
Pie Graphs
A pie graph (sometimes called a pie chart) is used to show how an overall total is divided into parts. A circle represents a group as a whole. The slices of this circular “pie” show the relative sizes of subgroups.
Figure A6 shows how the U.S. population was divided among children, working age adults, and the elderly in 1970, 2000, and what is projected for 2030. The information is first conveyed with numbers in Table A4, and then in three pie charts. The first column of Table A4 shows the total U.S. population for each of the three years. Columns 2–4 categorize the total in terms of age groups—from birth to 18 years, from 19 to 64 years, and 65 years and above. In columns 2–4, the first number shows the actual number of people in each age category, while the number in parentheses shows the percentage of the total population comprised by that age group.
Year Total Population 19 and Under 20–64 years Over 65
1970 205.0 million 77.2 (37.6%) 107.7 (52.5%) 20.1 (9.8%)
2000 275.4 million 78.4 (28.5%) 162.2 (58.9%) 34.8 (12.6%)
2030 351.1 million 92.6 (26.4%) 188.2 (53.6%) 70.3 (20.0%)
Table A4 U.S. Age Distribution, 1970, 2000, and 2030 (projected)
Figure A6 Pie Graphs of the U.S. Age Distribution (numbers in millions) The three pie graphs illustrate the division of total population into three age groups for the three different years.
In a pie graph, each slice of the pie represents a share of the total, or a percentage. For example, 50% would be half of the pie and 20% would be one-fifth of the pie. The three pie graphs in Figure A6 show that the share of the U.S. population 65 and over is growing. The pie graphs allow you to get a feel for the relative size of the different age groups from 1970 to 2000 to 2030, without requiring you to slog through the specific numbers and percentages in the table. Some common examples of how pie graphs are used include dividing the population into groups by age, income level, ethnicity, religion, occupation; dividing different firms into categories by size, industry, number of employees; and dividing up government spending or taxes into its main categories.
Bar Graphs
A bar graph uses the height of different bars to compare quantities. Table A5 lists the 12 most populous countries in the world. Figure A7 provides this same data in a bar graph. The height of the bars corresponds to the population of each country. Although you may know that China and India are the most populous countries in the world, seeing how the bars on the graph tower over the other countries helps illustrate the magnitude of the difference between the sizes of national populations.
Figure A7 Leading Countries of the World by Population, 2015 (in millions) The graph shows the 12 countries of the world with the largest populations. The height of the bars in the bar graph shows the size of the population for each country.
Country Population
China 1,369
India 1,270
United States 321
Indonesia 255
Brazil 204
Pakistan 190
Nigeria 184
Bangladesh 158
Russia 146
Japan 127
Mexico 121
Philippines 101
Table A5 Leading 12 Countries of the World by Population
Bar graphs can be subdivided in a way that reveals information similar to that we can get from pie charts. Figure A8 offers three bar graphs based on the information from Figure A6 about the U.S. age distribution in 1970, 2000, and 2030. Figure A8 (a) shows three bars for each year, representing the total number of persons in each age bracket for each year. Figure A8 (b) shows just one bar for each year, but the different age groups are now shaded inside the bar. In Figure A8 (c), still based on the same data, the vertical axis measures percentages rather than the number of persons. In this case, all three bar graphs are the same height, representing 100% of the population, with each bar divided according to the percentage of population in each age group. It is sometimes easier for a reader to run their eyes across several bar graphs, comparing the shaded areas, rather than trying to compare several pie graphs.
Figure A8 U.S. Population with Bar Graphs Population data can be represented in different ways. (a) Shows three bars for each year, representing the total number of persons in each age bracket for each year. (b) Shows just one bar for each year, but the different age groups are now shaded inside the bar. (c) Sets the vertical axis as a measure of percentages rather than the number of persons. All three bar graphs are the same height and each bar is divided according to the percentage of population in each age group.
Figure A7 and Figure A8 show how the bars can represent countries or years, and how the vertical axis can represent a numerical or a percentage value. Bar graphs can also compare size, quantity, rates, distances, and other quantitative categories.
Comparing Line Graphs with Pie Charts and Bar Graphs
Now that you are familiar with pie graphs, bar graphs, and line graphs, how do you know which graph to use for your data? Pie graphs are often better than line graphs at showing how an overall group is divided. However, if a pie graph has too many slices, it can become difficult to interpret.
Bar graphs are especially useful when comparing quantities. For example, if you are studying the populations of different countries, as in Figure A7, bar graphs can show the relationships between the population sizes of multiple countries. Not only can it show these relationships, but it can also show breakdowns of different groups within the population.
A line graph is often the most effective format for illustrating a relationship between two variables that are both changing. For example, time series graphs can show patterns as time changes, like the unemployment rate over time. Line graphs are widely used in economics to present continuous data about prices, wages, quantities bought and sold, the size of the economy.
How Graphs Can Be Misleading
Graphs not only reveal patterns; they can also alter how patterns are perceived. To see some of the ways this can be done, consider the line graphs of Figure A9, Figure A10, and Figure A11. These graphs all illustrate the unemployment rate—but from different perspectives.
Figure A9
Figure A10 Presenting Unemployment Rates in Different Ways, All of Them Accurate Simply changing the width and height of the area in which data is displayed can alter the perception of the data.
Figure A11 Presenting Unemployment Rates in Different Ways, All of Them Accurate Simply changing the width and height of the area in which data is displayed can alter the perception of the data.
Suppose you wanted a graph which gives the impression that the rise in unemployment in 2009 was not all that large, or all that extraordinary by historical standards. You might choose to present your data as in Figure A9 (a). Figure A9 (a) includes much of the same data presented earlier in Figure A5, but stretches the horizontal axis out longer relative to the vertical axis. By spreading the graph wide and flat, the visual appearance is that the rise in unemployment is not so large, and is similar to some past rises in unemployment. Now imagine you wanted to emphasize how unemployment spiked substantially higher in 2009. In this case, using the same data, you can stretch the vertical axis out relative to the horizontal axis, as in Figure A9 (b), which makes all rises and falls in unemployment appear larger.
A similar effect can be accomplished without changing the length of the axes, but by changing the scale on the vertical axis. In Figure A10 (c), the scale on the vertical axis runs from 0% to 30%, while in Figure A10 (d), the vertical axis runs from 3% to 10%. Compared to Figure A5, where the vertical scale runs from 0% to 12%, Figure A10 (c) makes the fluctuation in unemployment look smaller, while Figure A10 (d) makes it look larger.
Another way to alter the perception of the graph is to reduce the amount of variation by changing the number of points plotted on the graph. Figure A10 (e) shows the unemployment rate according to five-year averages. By averaging out some of the year-to-year changes, the line appears smoother and with fewer highs and lows. In reality, the unemployment rate is reported monthly, and Figure A11 (f) shows the monthly figures since 1960, which fluctuate more than the five-year average. Figure A11 (f) is also a vivid illustration of how graphs can compress lots of data. The graph includes monthly data since 1960, which over almost 50 years, works out to nearly 600 data points. Reading that list of 600 data points in numerical form would be hypnotic. You can, however, get a good intuitive sense of these 600 data points very quickly from the graph.
A final trick in manipulating the perception of graphical information is that, by choosing the starting and ending points carefully, you can influence the perception of whether the variable is rising or falling. The original data show a general pattern with unemployment low in the 1960s, but spiking up in the mid-1970s, early 1980s, early 1990s, early 2000s, and late 2000s. Figure A11 (g), however, shows a graph that goes back only to 1975, which gives an impression that unemployment was more-or-less gradually falling over time until the 2009 recession pushed it back up to its “original” level—which is a plausible interpretation if one starts at the high point around 1975.
These kinds of tricks—or shall we just call them “presentation choices”— are not limited to line graphs. In a pie chart with many small slices and one large slice, someone must decide what categories should be used to produce these slices in the first place, thus making some slices appear bigger than others. If you are making a bar graph, you can make the vertical axis either taller or shorter, which will tend to make variations in the height of the bars appear more or less.
Being able to read graphs is an essential skill, both in economics and in life. A graph is just one perspective or point of view, shaped by choices such as those discussed in this section. Do not always believe the first quick impression from a graph. View with caution.
Key Concepts and Summary
Math is a tool for understanding economics and economic relationships can be expressed mathematically using algebra or graphs. The algebraic equation for a line is y = b + mx, where x is the variable on the horizontal axis and y is the variable on the vertical axis, the b term is the y-intercept and the m term is the slope. The slope of a line is the same at any point on the line and it indicates the relationship (positive, negative, or zero) between two economic variables.
Economic models can be solved algebraically or graphically. Graphs allow you to illustrate data visually. They can illustrate patterns, comparisons, trends, and apportionment by condensing the numerical data and providing an intuitive sense of relationships in the data. A line graph shows the relationship between two variables: one is shown on the horizontal axis and one on the vertical axis. A pie graph shows how something is allotted, such as a sum of money or a group of people. The size of each slice of the pie is drawn to represent the corresponding percentage of the whole. A bar graph uses the height of bars to show a relationship, where each bar represents a certain entity, like a country or a group of people. The bars on a bar graph can also be divided into segments to show subgroups.
Any graph is a single visual perspective on a subject. The impression it leaves will be based on many choices, such as what data or time frame is included, how data or groups are divided up, the relative size of vertical and horizontal axes, whether the scale used on a vertical starts at zero. Thus, any graph should be regarded somewhat skeptically, remembering that the underlying relationship can be open to different interpretations.
Review Questions
Exercise A1
Name three kinds of graphs and briefly state when is most appropriate to use each type of graph.
Exercise A2
What is slope on a line graph?
Exercise A3
What do the slices of a pie chart represent?
Exercise A4
Why is a bar chart the best way to illustrate comparisons?
Exercise A5
How does the appearance of positive slope differ from negative slope and from zero slope? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.01%3A_Appendix_A-_The_Use_of_Mathematics_in_Principles_of_Economics.txt |
Economists use a vocabulary of maximizing utility to describe people’s preferences. In Consumer Choices, the level of utility that a person receives is described in numerical terms. This appendix presents an alternative approach to describing personal preferences, called indifference curves, which avoids any need for using numbers to measure utility. By setting aside the assumption of putting a numerical valuation on utility—an assumption that many students and economists find uncomfortably unrealistic—the indifference curve framework helps to clarify the logic of the underlying model.
What Is an Indifference Curve?
People cannot really put a numerical value on their level of satisfaction. However, they can, and do, identify what choices would give them more, or less, or the same amount of satisfaction. An indifference curve shows combinations of goods that provide an equal level of utility or satisfaction. For example, Figure B1 presents three indifference curves that represent Lilly’s preferences for the tradeoffs that she faces in her two main relaxation activities: eating doughnuts and reading paperback books. Each indifference curve (Ul, Um, and Uh) represents one level of utility. First we will explore the meaning of one particular indifference curve and then we will look at the indifference curves as a group.
Figure B1 Lilly’s Indifference Curves Lilly would receive equal utility from all points on a given indifference curve. Any points on the highest indifference curve Uh, like F, provide greater utility than any points like A, B, C, and D on the middle indifference curve Um. Similarly, any points on the middle indifference curve Um provide greater utility than any points on the lowest indifference curve Ul.
The Shape of an Indifference Curve
The indifference curve Um has four points labeled on it: A, B, C, and D. Since an indifference curve represents a set of choices that have the same level of utility, Lilly must receive an equal amount of utility, judged according to her personal preferences, from two books and 120 doughnuts (point A), from three books and 84 doughnuts (point B) from 11 books and 40 doughnuts (point C) or from 12 books and 35 doughnuts (point D). She would also receive the same utility from any of the unlabeled intermediate points along this indifference curve.
Indifference curves have a roughly similar shape in two ways: 1) they are downward sloping from left to right; 2) they are convex with respect to the origin. In other words, they are steeper on the left and flatter on the right. The downward slope of the indifference curve means that Lilly must trade off less of one good to get more of the other, while holding utility constant. For example, points A and B sit on the same indifference curve Um, which means that they provide Lilly with the same level of utility. Thus, the marginal utility that Lilly would gain from, say, increasing her consumption of books from two to three must be equal to the marginal utility that she would lose if her consumption of doughnuts was cut from 120 to 84—so that her overall utility remains unchanged between points A and B. Indeed, the slope along an indifference curve as the marginal rate of substitution, which is the rate at which a person is willing to trade one good for another so that utility will remain the same.
Indifference curves like Um are steeper on the left and flatter on the right. The reason behind this shape involves diminishing marginal utility—the notion that as a person consumes more of a good, the marginal utility from each additional unit becomes lower. Compare two different choices between points that all provide Lilly an equal amount of utility along the indifference curve Um: the choice between A and B, and between C and D. In both choices, Lilly consumes one more book, but between A and B her consumption of doughnuts falls by 36 (from 120 to 84) and between C and D it falls by only five (from 40 to 35). The reason for this difference is that points A and C are different starting points, and thus have different implications for marginal utility. At point A, Lilly has few books and many doughnuts. Thus, her marginal utility from an extra book will be relatively high while the marginal utility of additional doughnuts is relatively low—so on the margin, it will take a relatively large number of doughnuts to offset the utility from the marginal book. At point C, however, Lilly has many books and few doughnuts. From this starting point, her marginal utility gained from extra books will be relatively low, while the marginal utility lost from additional doughnuts would be relatively high—so on the margin, it will take a relatively smaller number of doughnuts to offset the change of one marginal book. In short, the slope of the indifference curve changes because the marginal rate of substitution—that is, the quantity of one good that would be traded for the other good to keep utility constant—also changes, as a result of diminishing marginal utility of both goods.
The Field of Indifference Curves
Each indifference curve represents the choices that provide a single level of utility. Every level of utility will have its own indifference curve. Thus, Lilly’s preferences will include an infinite number of indifference curves lying nestled together on the diagram—even though only three of the indifference curves, representing three levels of utility, appear on Figure B1. In other words, an infinite number of indifference curves are not drawn on this diagram—but you should remember that they exist.
Higher indifference curves represent a greater level of utility than lower ones. In Figure B1, indifference curve Ul can be thought of as a “low” level of utility, while Um is a “medium” level of utility and Uh is a “high” level of utility. All of the choices on indifference curve Uh are preferred to all of the choices on indifference curve Um, which in turn are preferred to all of the choices on Ul.
To understand why higher indifference curves are preferred to lower ones, compare point B on indifference curve Um to point F on indifference curve Uh. Point F has greater consumption of both books (five to three) and doughnuts (100 to 84), so point F is clearly preferable to point B. Given the definition of an indifference curve—that all the points on the curve have the same level of utility—if point F on indifference curve Uh is preferred to point B on indifference curve Um, then it must be true that all points on indifference curve Uh have a higher level of utility than all points on Um. More generally, for any point on a lower indifference curve, like Ul, you can identify a point on a higher indifference curve like Um or Uh that has a higher consumption of both goods. Since one point on the higher indifference curve is preferred to one point on the lower curve, and since all the points on a given indifference curve have the same level of utility, it must be true that all points on higher indifference curves have greater utility than all points on lower indifference curves.
These arguments about the shapes of indifference curves and about higher or lower levels of utility do not require any numerical estimates of utility, either by the individual or by anyone else. They are only based on the assumptions that when people have less of one good they need more of another good to make up for it, if they are keeping the same level of utility, and that as people have more of a good, the marginal utility they receive from additional units of that good will diminish. Given these gentle assumptions, a field of indifference curves can be mapped out to describe the preferences of any individual.
The Individuality of Indifference Curves
Each person determines their own preferences and utility. Thus, while indifference curves have the same general shape—they slope down, and the slope is steeper on the left and flatter on the right—the specific shape of indifference curves can be different for every person. Figure B1, for example, applies only to Lilly’s preferences. Indifference curves for other people would probably travel through different points.
Utility-Maximizing with Indifference Curves
People seek the highest level of utility, which means that they wish to be on the highest possible indifference curve. However, people are limited by their budget constraints, which show what tradeoffs are actually possible.
Maximizing Utility at the Highest Indifference Curve
Return to the situation of Lilly’s choice between paperback books and doughnuts. Say that books cost \$6, doughnuts are 50 cents each, and that Lilly has \$60 to spend. This information provides the basis for the budget line shown in Figure B2. Along with the budget line are shown the three indifference curves from Figure B1. What is Lilly’s utility-maximizing choice? Several possibilities are identified in the diagram.
Figure B2 Indifference Curves and a Budget Constraint Lilly’s preferences are shown by the indifference curves. Lilly’s budget constraint, given the prices of books and doughnuts and her income, is shown by the straight line. Lilly’s optimal choice will be point B, where the budget line is tangent to the indifference curve Um. Lilly would have more utility at a point like F on the higher indifference curve Uh, but the budget line does not touch the higher indifference curve Uh at any point, so she cannot afford this choice. A choice like G is affordable to Lilly, but it lies on indifference curve Ul and thus provides less utility than choice B, which is on indifference curve Um.
The choice of F with five books and 100 doughnuts is highly desirable, since it is on the highest indifference curve Uh of those shown in the diagram. However, it is not affordable given Lilly’s budget constraint. The choice of H with three books and 70 doughnuts on indifference curve Ul is a wasteful choice, since it is inside Lilly’s budget set, and as a utility-maximizer, Lilly will always prefer a choice on the budget constraint itself. Choices B and G are both on the opportunity set. However, choice G of six books and 48 doughnuts is on lower indifference curve Ul than choice B of three books and 84 doughnuts, which is on the indifference curve Um. If Lilly were to start at choice G, and then thought about whether the marginal utility she was deriving from doughnuts and books, she would decide that some additional doughnuts and fewer books would make her happier—which would cause her to move toward her preferred choice B. Given the combination of Lilly’s personal preferences, as identified by her indifference curves, and Lilly’s opportunity set, which is determined by prices and income, B will be her utility-maximizing choice.
The highest achievable indifference curve touches the opportunity set at a single point of tangency. Since an infinite number of indifference curves exist, even if only a few of them are drawn on any given diagram, there will always exist one indifference curve that touches the budget line at a single point of tangency. All higher indifference curves, like Uh, will be completely above the budget line and, although the choices on that indifference curve would provide higher utility, they are not affordable given the budget set. All lower indifference curves, like Ul, will cross the budget line in two separate places. When one indifference curve crosses the budget line in two places, however, there will be another, higher, attainable indifference curve sitting above it that touches the budget line at only one point of tangency.
Changes in Income
A rise in income causes the budget constraint to shift to the right. In graphical terms, the new budget constraint will now be tangent to a higher indifference curve, representing a higher level of utility. A reduction in income will cause the budget constraint to shift to the left, which will cause it to be tangent to a lower indifference curve, representing a reduced level of utility. If income rises by, for example, 50%, exactly how much will a person alter consumption of books and doughnuts? Will consumption of both goods rise by 50%, or will the quantity of one good rise substantially, while the quantity of the other good rises only a little, or even declines?
Since personal preferences and the shape of indifference curves are different for each individual, the response to changes in income will be different, too. For example, consider the preferences of Manuel and Natasha in Figure B3 (a) and Figure B3 (b). They each start with an identical income of \$40, which they spend on yogurts that cost \$1 and rental movies that cost \$4. Thus, they face identical budget constraints. However, based on Manuel’s preferences, as revealed by his indifference curves, his utility-maximizing choice on the original budget set occurs where his opportunity set is tangent to the highest possible indifference curve at W, with three movies and 28 yogurts, while Natasha’s utility-maximizing choice on the original budget set at Y will be seven movies and 12 yogurts.
Figure B3 Manuel and Natasha’s Indifference Curves Manuel and Natasha originally face the same budget constraints; that is, same prices and same income. However, the indifference curves that illustrate their preferences are not the same. (a) Manuel’s original choice at W involves more yogurt and more movies, and he reacts to the higher income by mainly increasing consumption of movies at X. (b) Conversely, Natasha’s original choice (Y) involves relatively more movies, but she reacts to the higher income by choosing relatively more yogurts. Even when budget constraints are the same, personal preferences lead to different original choices and to different reactions in response to a change in income.
Now, say that income rises to \$60 for both Manuel and Natasha, so their budget constraints shift to the right. As shown in Figure B3 (a), Manuel’s new utility maximizing choice at X will be seven movies and 32 yogurts—that is, Manuel will choose to spend most of the extra income on movies. Natasha’s new utility maximizing choice at Z will be eight movies and 28 yogurts—that is, she will choose to spend most of the extra income on yogurt. In this way, the indifference curve approach allows for a range of possible responses. However, if both goods are normal goods, then the typical response to a higher level of income will be to purchase more of them—although exactly how much more is a matter of personal preference. If one of the goods is an inferior good, the response to a higher level of income will be to purchase less of it.
Responses to Price Changes: Substitution and Income Effects
A higher price for a good will cause the budget constraint to shift to the left, so that it is tangent to a lower indifference curve representing a reduced level of utility. Conversely, a lower price for a good will cause the opportunity set to shift to the right, so that it is tangent to a higher indifference curve representing an increased level of utility. Exactly how much a change in price will lead to the quantity demanded of each good will depend on personal preferences.
Anyone who faces a change in price will experience two interlinked motivations: a substitution effect and an income effect. The substitution effect is that when a good becomes more expensive, people seek out substitutes. If oranges become more expensive, fruit-lovers scale back on oranges and eat more apples, grapefruit, or raisins. Conversely, when a good becomes cheaper, people substitute toward consuming more. If oranges get cheaper, people fire up their juicing machines and ease off on other fruits and foods. The income effect refers to how a change in the price of a good alters the effective buying power of one’s income. If the price of a good that you have been buying falls, then in effect your buying power has risen—you are able to purchase more goods. Conversely, if the price of a good that you have been buying rises, then the buying power of a given amount of income is diminished. (One common source of confusion is that the “income effect” does not refer to a change in actual income. Instead, it refers to the situation in which the price of a good changes, and thus the quantities of goods that can be purchased with a fixed amount of income change. It might be more accurate to call the “income effect” a “buying power effect,” but the “income effect” terminology has been used for decades, and it is not going to change during this economics course.) Whenever a price changes, consumers feel the pull of both substitution and income effects at the same time.
Using indifference curves, you can illustrate the substitution and income effects on a graph. In Figure B4, Ogden faces a choice between two goods: haircuts or personal pizzas. Haircuts cost \$20, personal pizzas cost \$6, and he has \$120 to spend.
Figure B4 Substitution and Income Effects The original choice is A, the point of tangency between the original budget constraint and indifference curve. The new choice is B, the point of tangency between the new budget constraint and the lower indifference curve. Point C is the tangency between the dashed line, where the slope shows the new higher price of haircuts, and the original indifference curve. The substitution effect is the shift from A to C, which means getting fewer haircuts and more pizza. The income effect is the shift from C to B; that is, the reduction in buying power that causes a shift from the higher indifference curve to the lower indifference curve, with relative prices remaining unchanged. The income effect results in less consumed of both goods. Both substitution and income effects cause fewer haircuts to be consumed. For pizza, in this case, the substitution effect and income effect cancel out, leading to the same amount of pizza consumed.
The price of haircuts rises to \$30. Ogden starts at choice A on the higher opportunity set and the higher indifference curve. After the price of haircuts increases, he chooses B on the lower opportunity set and the lower indifference curve. Point B with two haircuts and 10 personal pizzas is immediately below point A with three haircuts and 10 personal pizzas, showing that Ogden reacted to a higher price of haircuts by cutting back only on haircuts, while leaving his consumption of pizza unchanged.
The dashed line in the diagram, and point C, are used to separate the substitution effect and the income effect. To understand their function, start by thinking about the substitution effect with this question: How would Ogden change his consumption if the relative prices of the two goods changed, but this change in relative prices did not affect his utility? The slope of the budget constraint is determined by the relative price of the two goods; thus, the slope of the original budget line is determined by the original relative prices, while the slope of the new budget line is determined by the new relative prices. With this thought in mind, the dashed line is a graphical tool inserted in a specific way: It is inserted so that it is parallel with the new budget constraint, so it reflects the new relative prices, but it is tangent to the original indifference curve, so it reflects the original level of utility or buying power.
Thus, the movement from the original choice (A) to point C is a substitution effect; it shows the choice that Ogden would make if relative prices shifted (as shown by the different slope between the original budget set and the dashed line) but if buying power did not shift (as shown by being tangent to the original indifference curve). The substitution effect will encourage people to shift away from the good which has become relatively more expensive—in Ogden’s case, the haircuts on the vertical axis—and toward the good which has become relatively less expensive—in this case, the pizza on the vertical axis. The two arrows labeled with “s” for “substitution effect,” one on each axis, show the direction of this movement.
The income effect is the movement from point C to B, which shows how Ogden reacts to a reduction in his buying power from the higher indifference curve to the lower indifference curve, but holding constant the relative prices (because the dashed line has the same slope as the new budget constraint). In this case, where the price of one good increases, buying power is reduced, so the income effect means that consumption of both goods should fall (if they are both normal goods, which it is reasonable to assume unless there is reason to believe otherwise). The two arrows labeled with “i” for “income effect,” one on each axis, show the direction of this income effect movement.
Now, put the substitution and income effects together. When the price of pizza increased, Ogden consumed less of it, for two reasons shown in the exhibit: the substitution effect of the higher price led him to consume less and the income effect of the higher price also led him to consume less. However, when the price of pizza increased, Ogden consumed the same quantity of haircuts. The substitution effect of a higher price for pizza meant that haircuts became relatively less expensive (compared to pizza), and this factor, taken alone, would have encouraged Ogden to consume more haircuts. However, the income effect of a higher price for pizza meant that he wished to consume less of both goods, and this factor, taken alone, would have encouraged Ogden to consume fewer haircuts. As shown in Figure B4, in this particular example the substitution effect and income effect on Ogden’s consumption of haircuts are offsetting—so he ends up consuming the same quantity of haircuts after the price increase for pizza as before.
The size of these income and substitution effects will differ from person to person, depending on individual preferences. For example, if Ogden’s substitution effect away from pizza and toward haircuts is especially strong, and outweighs the income effect, then a higher price for pizza might lead to increased consumption of haircuts. This case would be drawn on the graph so that the point of tangency between the new budget constraint and the relevant indifference curve occurred below point B and to the right. Conversely, if the substitution effect away from pizza and toward haircuts is not as strong, and the income effect on is relatively stronger, then Ogden will be more likely to react to the higher price of pizza by consuming less of both goods. In this case, his optimal choice after the price change will be above and to the left of choice B on the new budget constraint.
Although the substitution and income effects are often discussed as a sequence of events, it should be remembered that they are twin components of a single cause—a change in price. Although you can analyze them separately, the two effects are always proceeding hand in hand, happening at the same time.
Indifference Curves with Labor-Leisure and Intertemporal Choices
The concept of an indifference curve applies to tradeoffs in any household choice, including the labor-leisure choice or the intertemporal choice between present and future consumption. In the labor-leisure choice, each indifference curve shows the combinations of leisure and income that provide a certain level of utility. In an intertemporal choice, each indifference curve shows the combinations of present and future consumption that provide a certain level of utility. The general shapes of the indifference curves—downward sloping, steeper on the left and flatter on the right—also remain the same.
A Labor-Leisure Example
Petunia is working at a job that pays \$12 per hour but she gets a raise to \$20 per hour. After family responsibilities and sleep, she has 80 hours per week available for work or leisure. As shown in Figure B5, the highest level of utility for Petunia, on her original budget constraint, is at choice A, where it is tangent to the lower indifference curve (Ul). Point A has 30 hours of leisure and thus 50 hours per week of work, with income of \$600 per week (that is, 50 hours of work at \$12 per hour). Petunia then gets a raise to \$20 per hour, which shifts her budget constraint to the right. Her new utility-maximizing choice occurs where the new budget constraint is tangent to the higher indifference curve Uh. At B, Petunia has 40 hours of leisure per week and works 40 hours, with income of \$800 per week (that is, 40 hours of work at \$20 per hour).
Figure B5 Effects of a Change in Petunia’s Wage Petunia starts at choice A, the tangency between her original budget constraint and the lower indifference curve Ul. The wage increase shifts her budget constraint to the right, so that she can now choose B on indifference curve Uh. The substitution effect is the movement from A to C. In this case, the substitution effect would lead Petunia to choose less leisure, which is relatively more expensive, and more income, which is relatively cheaper to earn. The income effect is the movement from C to B. The income effect in this example leads to greater consumption of both goods. Overall, in this example, income rises because of both substitution and income effects. However, leisure declines because of the substitution effect but increases because of the income effect—leading, in Petunia’s case, to an overall increase in the quantity of leisure consumed.
Substitution and income effects provide a vocabulary for discussing how Petunia reacts to a higher hourly wage. The dashed line serves as the tool for separating the two effects on the graph.
The substitution effect tells how Petunia would have changed her hours of work if her wage had risen, so that income was relatively cheaper to earn and leisure was relatively more expensive, but if she had remained at the same level of utility. The slope of the budget constraint in a labor-leisure diagram is determined by the wage rate. Thus, the dashed line is carefully inserted with the slope of the new opportunity set, reflecting the labor-leisure tradeoff of the new wage rate, but tangent to the original indifference curve, showing the same level of utility or “buying power.” The shift from original choice A to point C, which is the point of tangency between the original indifference curve and the dashed line, shows that because of the higher wage, Petunia will want to consume less leisure and more income. The “s” arrows on the horizontal and vertical axes of Figure B5 show the substitution effect on leisure and on income.
The income effect is that the higher wage, by shifting the labor-leisure budget constraint to the right, makes it possible for Petunia to reach a higher level of utility. The income effect is the movement from point C to point B; that is, it shows how Petunia’s behavior would change in response to a higher level of utility or “buying power,” with the wage rate remaining the same (as shown by the dashed line being parallel to the new budget constraint). The income effect, encouraging Petunia to consume both more leisure and more income, is drawn with arrows on the horizontal and vertical axis of Figure B5.
Putting these effects together, Petunia responds to the higher wage by moving from choice A to choice B. This movement involves choosing more income, both because the substitution effect of higher wages has made income relatively cheaper or easier to earn, and because the income effect of higher wages has made it possible to have more income and more leisure. Her movement from A to B also involves choosing more leisure because, according to Petunia’s preferences, the income effect that encourages choosing more leisure is stronger than the substitution effect that encourages choosing less leisure.
Figure B5 represents only Petunia’s preferences. Other people might make other choices. For example, a person whose substitution and income effects on leisure exactly counterbalanced each other might react to a higher wage with a choice like D, exactly above the original choice A, which means taking all of the benefit of the higher wages in the form of income while working the same number of hours. Yet another person, whose substitution effect on leisure outweighed the income effect, might react to a higher wage by making a choice like F, where the response to higher wages is to work more hours and earn much more income. To represent these different preferences, you could easily draw the indifference curve Uh to be tangent to the new budget constraint at D or F, rather than at B.
An Intertemporal Choice Example
Quentin has saved up \$10,000. He is thinking about spending some or all of it on a vacation in the present, and then will save the rest for another big vacation five years from now. Over those five years, he expects to earn a total 80% rate of return. Figure B6 shows Quentin’s budget constraint and his indifference curves between present consumption and future consumption. The highest level of utility that Quentin can achieve at his original intertemporal budget constraint occurs at point A, where he is consuming \$6,000, saving \$4,000 for the future, and expecting with the accumulated interest to have \$7,200 for future consumption (that is, \$4,000 in current financial savings plus the 80% rate of return).
However, Quentin has just realized that his expected rate of return was unrealistically high. A more realistic expectation is that over five years he can earn a total return of 30%. In effect, his intertemporal budget constraint has pivoted to the left, so that his original utility-maximizing choice is no longer available. Will Quentin react to the lower rate of return by saving more, or less, or the same amount? Again, the language of substitution and income effects provides a framework for thinking about the motivations behind various choices. The dashed line, which is a graphical tool to separate the substitution and income effect, is carefully inserted with the same slope as the new opportunity set, so that it reflects the changed rate of return, but it is tangent to the original indifference curve, so that it shows no change in utility or “buying power.”
The substitution effect tells how Quentin would have altered his consumption because the lower rate of return makes future consumption relatively more expensive and present consumption relatively cheaper. The movement from the original choice A to point C shows how Quentin substitutes toward more present consumption and less future consumption in response to the lower interest rate, with no change in utility. The substitution arrows on the horizontal and vertical axes of Figure B6 show the direction of the substitution effect motivation. The substitution effect suggests that, because of the lower interest rate, Quentin should consume more in the present and less in the future.
Quentin also has an income effect motivation. The lower rate of return shifts the budget constraint to the left, which means that Quentin’s utility or “buying power” is reduced. The income effect (assuming normal goods) encourages less of both present and future consumption. The impact of the income effect on reducing present and future consumption in this example is shown with “i” arrows on the horizontal and vertical axis of Figure B6.
Figure B6 Indifference Curve and an Intertemporal Budget Constraint The original choice is A, at the tangency between the original budget constraint and the original indifference curve Uh. The dashed line is drawn parallel to the new budget set, so that its slope reflects the lower rate of return, but is tangent to the original indifference curve. The movement from A to C is the substitution effect: in this case, future consumption has become relatively more expensive, and present consumption has become relatively cheaper. The income effect is the shift from C to B; that is, the reduction in utility or “buying power” that causes a move to a lower indifference curve Ul, but with the relative price the same. It means less present and less future consumption. In the move from A to B, the substitution effect on present consumption is greater than the income effect, so the overall result is more present consumption. Notice that the lower indifference curve could have been drawn tangent to the lower budget constraint point D or point F, depending on personal preferences.
Taking both effects together, the substitution effect is encouraging Quentin toward more present and less future consumption, because present consumption is relatively cheaper, while the income effect is encouraging him to less present and less future consumption, because the lower interest rate is pushing him to a lower level of utility. For Quentin’s personal preferences, the substitution effect is stronger so that, overall, he reacts to the lower rate of return with more present consumption and less savings at choice B. However, other people might have different preferences. They might react to a lower rate of return by choosing the same level of present consumption and savings at choice D, or by choosing less present consumption and more savings at a point like F. For these other sets of preferences, the income effect of a lower rate of return on present consumption would be relatively stronger, while the substitution effect would be relatively weaker.
Sketching Substitution and Income Effects
Indifference curves provide an analytical tool for looking at all the choices that provide a single level of utility. They eliminate any need for placing numerical values on utility and help to illuminate the process of making utility-maximizing decisions. They also provide the basis for a more detailed investigation of the complementary motivations that arise in response to a change in a price, wage or rate of return—namely, the substitution and income effects.
If you are finding it a little tricky to sketch diagrams that show substitution and income effects so that the points of tangency all come out correctly, it may be useful to follow this procedure.
Step 1. Begin with a budget constraint showing the choice between two goods, which this example will call “candy” and “movies.” Choose a point A which will be the optimal choice, where the indifference curve will be tangent—but it is often easier not to draw in the indifference curve just yet. See Figure B7.
Figure B7
Step 2. Now the price of movies changes: let’s say that it rises. That shifts the budget set inward. You know that the higher price will push the decision-maker down to a lower level of utility, represented by a lower indifference curve. But at this stage, draw only the new budget set. See Figure B8.
Figure B8
Step 3. The key tool in distinguishing between substitution and income effects is to insert a dashed line, parallel to the new budget line. This line is a graphical tool that allows you to distinguish between the two changes: (1) the effect on consumption of the two goods of the shift in prices—with the level of utility remaining unchanged—which is the substitution effect; and (2) the effect on consumption of the two goods of shifting from one indifference curve to the other—with relative prices staying unchanged—which is the income effect. The dashed line is inserted in this step. The trick is to have the dashed line travel close to the original choice A, but not directly through point A. See Figure B9.
Figure B9
Step 4. Now, draw the original indifference curve, so that it is tangent to both point A on the original budget line and to a point C on the dashed line. Many students find it easiest to first select the tangency point C where the original indifference curve touches the dashed line, and then to draw the original indifference curve through A and C. The substitution effect is illustrated by the movement along the original indifference curve as prices change but the level of utility holds constant, from A to C. As expected, the substitution effect leads to less consumed of the good that is relatively more expensive, as shown by the “s” (substitution) arrow on the vertical axis, and more consumed of the good that is relatively less expensive, as shown by the “s” arrow on the horizontal axis. See Figure B10.
Figure B10
Step 5. With the substitution effect in place, now choose utility-maximizing point B on the new opportunity set. When you choose point B, think about whether you wish the substitution or the income effect to have a larger impact on the good (in this case, candy) on the horizontal axis. If you choose point B to be directly in a vertical line with point A (as is illustrated here), then the income effect will be exactly offsetting the substitution effect on the horizontal axis. If you insert point B so that it lies a little to right of the original point A, then the substitution effect will exceed the income effect. If you insert point B so that it lies a little to the left of point A, then the income effect will exceed the substitution effect. The income effect is the movement from C to B, showing how choices shifted as a result of the decline in buying power and the movement between two levels of utility, with relative prices remaining the same. With normal goods, the negative income effect means less consumed of each good, as shown by the direction of the “i” (income effect) arrows on the vertical and horizontal axes. See Figure B11.
Figure B11
In sketching substitution and income effect diagrams, you may wish to practice some of the following variations: (1) Price falls instead of a rising; (2) The price change affects the good on either the vertical or the horizontal axis; (3) Sketch these diagrams so that the substitution effect exceeds the income effect; the income effect exceeds the substitution effect; and the two effects are equal.
One final note: The helpful dashed line can be drawn tangent to the new indifference curve, and parallel to the original budget line, rather than tangent to the original indifference curve and parallel to the new budget line. Some students find this approach more intuitively clear. The answers you get about the direction and relative sizes of the substitution and income effects, however, should be the same.
Key Concepts and Summary
An indifference curve is drawn on a budget constraint diagram that shows the tradeoffs between two goods. All points along a single indifference curve provide the same level of utility. Higher indifference curves represent higher levels of utility. Indifference curves slope downward because, if utility is to remain the same at all points along the curve, a reduction in the quantity of the good on the vertical axis must be counterbalanced by an increase in the quantity of the good on the horizontal axis (or vice versa). Indifference curves are steeper on the far left and flatter on the far right, because of diminishing marginal utility.
The utility-maximizing choice along a budget constraint will be the point of tangency where the budget constraint touches an indifference curve at a single point. A change in the price of any good has two effects: a substitution effect and an income effect. The substitution effect motivation encourages a utility-maximizer to buy less of what is relatively more expensive and more of what is relatively cheaper. The income effect motivation encourages a utility-maximizer to buy more of both goods if utility rises or less of both goods if utility falls (if they are both normal goods).
In a labor-leisure choice, every wage change has a substitution and an income effect. The substitution effect of a wage increase is to choose more income, since it is cheaper to earn, and less leisure, since its opportunity cost has increased. The income effect of a wage increase is to choose more of leisure and income, since they are both normal goods. The substitution and income effects of a wage decrease would reverse these directions.
In an intertemporal consumption choice, every interest rate change has a substitution and an income effect. The substitution effect of an interest rate increase is to choose more future consumption, since it is now cheaper to earn future consumption and less present consumption (more savings), since the opportunity cost of present consumption in terms of what is being given up in the future has increased. The income effect of an interest rate increase is to choose more of both present and future consumption, since they are both normal goods. The substitution and income effects of an interest rate decrease would reverse these directions.
Review Questions
Exercise B1
What point is preferred along an indifference curve?
Exercise B2
Why do indifference curves slope down?
Exercise B3
Why are indifference curves steep on the left and flatter on the right?
Exercise B4
How many indifference curves does a person have?
Exercise B5
How can you tell which indifference curves represent higher or lower levels of utility?
Exercise B6
What is a substitution effect?
Exercise B7
What is an income effect?
Exercise B8
Does the “income effect” involve a change in income? Explain.
Exercise B9
Does a change in price have both an income effect and a substitution effect? Does a change in income have both an income effect and a substitution effect?
Exercise B10
Would you expect, in some cases, to see only an income effect or only a substitution effect? Explain.
Exercise B11
Which is larger, the income effect or the substitution effect? | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.02%3A_Appendix_B-_Indifference_Curves.txt |
As explained in Financial Markets, the prices of stocks and bonds depend on future events. The price of a bond depends on the future payments that the bond is expected to make, including both payments of interest and the repayment of the face value of the bond. The price of a stock depends on the expected future profits earned by the firm. The concept of a present discounted value (PDV), which is defined as the amount you should be willing to pay in the present for a stream of expected future payments, can be used to calculate appropriate prices for stocks and bonds. To place a present discounted value on a future payment, think about what amount of money you would need to have in the present to equal a certain amount in the future. This calculation will require an interest rate. For example, if the interest rate is 10%, then a payment of \$110 a year from now will have a present discounted value of \$100—that is, you could take \$100 in the present and have \$110 in the future. We will first shows how to apply the idea of present discounted value to a stock and then we will show how to apply it to a bond.
Applying Present Discounted Value to a Stock
Consider the case of Babble, Inc., a company that offers speaking lessons. For the sake of simplicity, say that the founder of Babble is 63 years old and plans to retire in two years, at which point the company will be disbanded. The company is selling 200 shares of stock and profits are expected to be \$15 million right away, in the present, \$20 million one year from now, and \$25 million two years from now. All profits will be paid out as dividends to shareholders as they occur. Given this information, what will an investor pay for a share of stock in this company?
A financial investor, thinking about what future payments are worth in the present, will need to choose an interest rate. This interest rate will reflect the rate of return on other available financial investment opportunities, which is the opportunity cost of investing financial capital, and also a risk premium (that is, using a higher interest rate than the rates available elsewhere if this investment appears especially risky). In this example, say that the financial investor decides that appropriate interest rate to value these future payments is 15%.
Table C1 shows how to calculate the present discounted value of the future profits. For each time period, when a benefit is going to be received, apply the formula:
$Present discounted value = Future value received years in the future(1 + Interest rate)numbers of years tPresent discounted value = Future value received years in the future(1 + Interest rate)numbers of years t$
Payments from Firm Present Value
\$15 million in present \$15 million
\$20 million in one year \$20 million/(1 + 0.15)1 = \$17.4 million
\$25 million in two years \$25 million/(1 + 0.15)2 = \$18.9 million
Total \$51.3 million
Table C1 Calculating Present Discounted Value of a Stock
Next, add up all the present values for the different time periods to get a final answer. The present value calculations ask what the amount in the future is worth in the present, given the 15% interest rate. Notice that a different PDV calculation needs to be done separately for amounts received at different times. Then, divide the PDV of total profits by the number of shares, 200 in this case: 51.3 million/200 = 0.2565 million. The price per share should be about \$256,500 per share.
Of course, in the real world expected profits are a best guess, not a hard piece of data. Deciding which interest rate to apply for discounting to the present can be tricky. One needs to take into account both potential capital gains from the future sale of the stock and also dividends that might be paid. Differences of opinion on these issues are exactly why some financial investors want to buy a stock that other people want to sell: they are more optimistic about its future prospects. Conceptually, however, it all comes down to what you are willing to pay in the present for a stream of benefits to be received in the future.
Applying Present Discounted Value to a Bond
A similar calculation works in the case of bonds. Financial Markets explains that if the interest rate falls after a bond is issued, so that the investor has locked in a higher rate, then that bond will sell for more than its face value. Conversely, if the interest rate rises after a bond is issued, then the investor is locked into a lower rate, and the bond will sell for less than its face value. The present value calculation sharpens this intuition.
Think about a simple two-year bond. It was issued for \$3,000 at an interest rate of 8%. Thus, after the first year, the bond pays interest of 240 (which is 3,000 × 8%). At the end of the second year, the bond pays \$240 in interest, plus the \$3,000 in principle. Calculate how much this bond is worth in the present if the discount rate is 8%. Then, recalculate if interest rates rise and the applicable discount rate is 11%. To carry out these calculations, look at the stream of payments being received from the bond in the future and figure out what they are worth in present discounted value terms. The calculations applying the present value formula are shown in Table C2.
Stream of Payments (for the 8% interest rate) Present Value (for the 8% interest rate) Stream of Payments (for the 11% interest rate) Present Value (for the 11% interest rate)
\$240 payment after one year \$240/(1 + 0.08)1 = \$222.20 \$240 payment after one year \$240/(1 + 0.11)1 = \$216.20
\$3,240 payment after second year \$3,240/(1 + 0.08)2 = \$2,777.80 \$3,240 payment after second year \$3,240/(1 + 0.11)2 = \$2,629.60
Total \$3,000 Total \$2,845.80
Table C2 Computing the Present Discounted Value of a Bond
The first calculation shows that the present value of a \$3,000 bond, issued at 8%, is just \$3,000. After all, that is how much money the borrower is receiving. The calculation confirms that the present value is the same for the lender. The bond is moving money around in time, from those willing to save in the present to those who want to borrow in the present, but the present value of what is received by the borrower is identical to the present value of what will be repaid to the lender.
The second calculation shows what happens if the interest rate rises from 8% to 11%. The actual dollar payments in the first column, as determined by the 8% interest rate, do not change. However, the present value of those payments, now discounted at a higher interest rate, is lower. Even though the future dollar payments that the bond is receiving have not changed, a person who tries to sell the bond will find that the investment’s value has fallen.
Again, real-world calculations are often more complex, in part because, not only the interest rate prevailing in the market, but also the riskiness of whether the borrower will repay the loan, will change. In any case, the price of a bond is always the present value of a stream of future expected payments.
Other Applications
Present discounted value is a widely used analytical tool outside the world of finance. Every time a business thinks about making a physical capital investment, it must compare a set of present costs of making that investment to the present discounted value of future benefits. When government thinks about a proposal to, for example, add safety features to a highway, it must compare costs incurred in the present to benefits received in the future. Some academic disputes over environmental policies, like how much to reduce carbon dioxide emissions because of the risk that they will lead to a warming of global temperatures several decades in the future, turn on how one compares present costs of pollution control with long-run future benefits. Someone who wins the lottery and is scheduled to receive a string of payments over 30 years might be interested in knowing what the present discounted value is of those payments. Whenever a string of costs and benefits stretches from the present into different times in the future, present discounted value becomes an indispensable tool of analysis. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.03%3A_Appendix_C-_Present_Discounted_Value.txt |
1.
Scarcity means human wants for goods and services exceed the available supply. Supply is limited because resources are limited. Demand, however, is virtually unlimited. Whatever the supply, it seems human nature to want more.
2.
100 people / 10 people per ham = a maximum of 10 hams per month if all residents produce ham. Since consumption is limited by production, the maximum number of hams residents could consume per month is 10.
3.
She is very productive at her consulting job, but not very productive growing vegetables. Time spent consulting would produce far more income than it what she could save growing her vegetables using the same amount of time. So on purely economic grounds, it makes more sense for her to maximize her income by applying her labor to what she does best (i.e. specialization of labor).
4.
The engineer is better at computer science than at painting. Thus, his time is better spent working for pay at his job and paying a painter to paint his house. Of course, this assumes he does not paint his house for fun!
5.
There are many physical systems that would work, for example, the study of planets (micro) in the solar system (macro), or solar systems (micro) in the galaxy (macro).
6.
Draw a box outside the original circular flow to represent the foreign country. Draw an arrow from the foreign country to firms, to represents imports. Draw an arrow in the reverse direction representing payments for imports. Draw an arrow from firms to the foreign country to represent exports. Draw an arrow in the reverse direction to represent payments for imports.
7.
There are many such problems. Consider the AIDS epidemic. Why are so few AIDS patients in Africa and Southeast Asia treated with the same drugs that are effective in the United States and Europe? It is because neither those patients nor the countries in which they live have the resources to purchase the same drugs.
8.
Public enterprise means the factors of production (resources and businesses) are owned and operated by the government.
9.
The United States is a large country economically speaking, so it has less need to trade internationally than the other countries mentioned. (This is the same reason that France and Italy have lower ratios than Belgium or Sweden.) One additional reason is that each of the other countries is a member of the European Union, where trade between members occurs without barriers to trade, like tariffs and quotas.
21.4.02: Chapter 2
1.
The opportunity cost of bus tickets is the number of burgers that must be given up to obtain one more bus ticket. Originally, when the price of bus tickets was 50 cents per trip, this opportunity cost was 0.50/2 = .25 burgers. The reason for this is that at the original prices, one burger (\$2) costs the same as four bus tickets (\$0.50), so the opportunity cost of a burger is four bus tickets, and the opportunity cost of a bus ticket is .25 burgers (the inverse of the opportunity cost of a burger). With the new, higher price of bus tickets, the opportunity cost rises to \$1/\$2 or 0.50 burgers. You can see this graphically since the slope of the new budget constraint is steeper than the original one. If Alphonso spends all of his budget on burgers, the higher price of bus tickets has no impact so the vertical intercept of the budget constraint is the same. If he spends his entire budget on bus tickets, he can now afford only half as many, so the horizontal intercept is half as much. In short, the budget constraint rotates clockwise around the vertical intercept, steepening as it goes and the opportunity cost of bus tickets increases.
2.
Because of the improvement in technology, the vertical intercept of the PPF would be at a higher level of healthcare. In other words, the PPF would rotate clockwise around the horizontal intercept. This would make the PPF steeper, corresponding to an increase in the opportunity cost of education, since resources devoted to education would now mean forgoing a greater quantity of healthcare.
3.
No. Allocative efficiency requires productive efficiency, because it pertains to choices along the production possibilities frontier.
4.
Both the budget constraint and the PPF show the constraint that each operates under. Both show a tradeoff between having more of one good but less of the other. Both show the opportunity cost graphically as the slope of the constraint (budget or PPF).
5.
When individuals compare cost per unit in the grocery store, or characteristics of one product versus another, they are behaving approximately like the model describes.
6.
Since an op-ed makes a case for what should be, it is considered normative.
7.
Assuming that the study is not taking an explicit position about whether soft drink consumption is good or bad, but just reporting the science, it would be considered positive. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.01%3A_Chapter_1.txt |
1.
Since \$1.60 per gallon is above the equilibrium price, the quantity demanded would be lower at 550 gallons and the quantity supplied would be higher at 640 gallons. (These results are due to the laws of demand and supply, respectively.) The outcome of lower Qd and higher Qs would be a surplus in the gasoline market of 640 – 550 = 90 gallons.
2.
To make it easier to analyze complex problems. Ceteris paribus allows you to look at the effect of one factor at a time on what it is you are trying to analyze. When you have analyzed all the factors individually, you add the results together to get the final answer.
3.
1. An improvement in technology that reduces the cost of production will cause an increase in supply. Alternatively, you can think of this as a reduction in price necessary for firms to supply any quantity. Either way, this can be shown as a rightward (or downward) shift in the supply curve.
2. An improvement in product quality is treated as an increase in tastes or preferences, meaning consumers demand more paint at any price level, so demand increases or shifts to the right. If this seems counterintuitive, note that demand in the future for the longer-lasting paint will fall, since consumers are essentially shifting demand from the future to the present.
3. An increase in need causes an increase in demand or a rightward shift in the demand curve.
4. Factory damage means that firms are unable to supply as much in the present. Technically, this is an increase in the cost of production. Either way you look at it, the supply curve shifts to the left.
4.
1. More fuel-efficient cars means there is less need for gasoline. This causes a leftward shift in the demand for gasoline and thus oil. Since the demand curve is shifting down the supply curve, the equilibrium price and quantity both fall.
2. Cold weather increases the need for heating oil. This causes a rightward shift in the demand for heating oil and thus oil. Since the demand curve is shifting up the supply curve, the equilibrium price and quantity both rise.
3. A discovery of new oil will make oil more abundant. This can be shown as a rightward shift in the supply curve, which will cause a decrease in the equilibrium price along with an increase in the equilibrium quantity. (The supply curve shifts down the demand curve so price and quantity follow the law of demand. If price goes down, then the quantity goes up.)
4. When an economy slows down, it produces less output and demands less input, including energy, which is used in the production of virtually everything. A decrease in demand for energy will be reflected as a decrease in the demand for oil, or a leftward shift in demand for oil. Since the demand curve is shifting down the supply curve, both the equilibrium price and quantity of oil will fall.
5. Disruption of oil pumping will reduce the supply of oil. This leftward shift in the supply curve will show a movement up the demand curve, resulting in an increase in the equilibrium price of oil and a decrease in the equilibrium quantity.
6. Increased insulation will decrease the demand for heating. This leftward shift in the demand for oil causes a movement down the supply curve, resulting in a decrease in the equilibrium price and quantity of oil.
7. Solar energy is a substitute for oil-based energy. So if solar energy becomes cheaper, the demand for oil will decrease as consumers switch from oil to solar. The decrease in demand for oil will be shown as a leftward shift in the demand curve. As the demand curve shifts down the supply curve, both equilibrium price and quantity for oil will fall.
8. A new, popular kind of plastic will increase the demand for oil. The increase in demand will be shown as a rightward shift in demand, raising the equilibrium price and quantity of oil.
5.
Step 1. Draw the graph with the initial supply and demand curves. Label the initial equilibrium price and quantity.
Step 2. Did the economic event affect supply or demand? Jet fuel is a cost of producing air travel, so an increase in jet fuel price affects supply.
Step 3. An increase in the price of jet fuel caused an increase in the cost of air travel. We show this as an upward or leftward shift in supply.
Step 4. A leftward shift in supply causes a movement up the demand curve, increasing the equilibrium price of air travel and decreasing the equilibrium quantity.
6.
Step 1. Draw the graph with the initial supply and demand curves. Label the initial equilibrium price and quantity.
Step 2. Did the economic event affect supply or demand? A tariff is treated like a cost of production, so this affects supply.
Step 3. A tariff reduction is equivalent to a decrease in the cost of production, which we can show as a rightward (or downward) shift in supply.
Step 4. A rightward shift in supply causes a movement down the demand curve, lowering the equilibrium price and raising the equilibrium quantity.
7.
A price ceiling (which is below the equilibrium price) will cause the quantity demanded to rise and the quantity supplied to fall. This is why a price ceiling creates a shortage.
8.
A price ceiling is just a legal restriction. Equilibrium is an economic condition. People may or may not obey the price ceiling, so the actual price may be at or above the price ceiling, but the price ceiling does not change the equilibrium price.
9.
A price ceiling is a legal maximum price, but a price floor is a legal minimum price and, consequently, it would leave room for the price to rise to its equilibrium level. In other words, a price floor below equilibrium will not be binding and will have no effect.
10.
Assuming that people obey the price ceiling, the market price will be below equilibrium, which means that Qd will be more than Qs. Buyers can only buy what is offered for sale, so the number of transactions will fall to Qs. This is easy to see graphically. By analogous reasoning, with a price floor the market price will be above the equilibrium price, so Qd will be less than Qs. Since the limit on transactions here is demand, the number of transactions will fall to Qd. Note that because both price floors and price ceilings reduce the number of transactions, social surplus is less.
11.
Because the losses to consumers are greater than the benefits to producers, so the net effect is negative. Since the lost consumer surplus is greater than the additional producer surplus, social surplus falls. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.03%3A_Chapter_3.txt |
1.
Changes in the wage rate (the price of labor) cause a movement along the demand curve. A change in anything else that affects demand for labor (e.g., changes in output, changes in the production process that use more or less labor, government regulation) causes a shift in the demand curve.
2.
Changes in the wage rate (the price of labor) cause a movement along the supply curve. A change in anything else that affects supply of labor (e.g., changes in how desirable the job is perceived to be, government policy to promote training in the field) causes a shift in the supply curve.
3.
Since a living wage is a suggested minimum wage, it acts like a price floor (assuming, of course, that it is followed). If the living wage is binding, it will cause an excess supply of labor at that wage rate.
4.
Changes in the interest rate (i.e., the price of financial capital) cause a movement along the demand curve. A change in anything else (non-price variable) that affects demand for financial capital (e.g., changes in confidence about the future, changes in needs for borrowing) would shift the demand curve.
5.
Changes in the interest rate (i.e., the price of financial capital) cause a movement along the supply curve. A change in anything else that affects the supply of financial capital (a non-price variable) such as income or future needs would shift the supply curve.
6.
If market interest rates stay in their normal range, an interest rate limit of 35% would not be binding. If the equilibrium interest rate rose above 35%, the interest rate would be capped at that rate, and the quantity of loans would be lower than the equilibrium quantity, causing a shortage of loans.
7.
b and c will lead to a fall in interest rates. At a lower demand, lenders will not be able to charge as much, and with more available lenders, competition for borrowers will drive rates down.
8.
a and c will increase the quantity of loans. More people who want to borrow will result in more loans being given, as will more people who want to lend.
9.
A price floor prevents a price from falling below a certain level, but has no effect on prices above that level. It will have its biggest effect in creating excess supply (as measured by the entire area inside the dotted lines on the graph, from D to S) if it is substantially above the equilibrium price. This is illustrated in the following figure.
It will have a lesser effect if it is slightly above the equilibrium price. This is illustrated in the next figure.
It will have no effect if it is set either slightly or substantially below the equilibrium price, since an equilibrium price above a price floor will not be affected by that price floor. The following figure illustrates these situations.
10.
A price ceiling prevents a price from rising above a certain level, but has no effect on prices below that level. It will have its biggest effect in creating excess demand if it is substantially below the equilibrium price. The following figure illustrates these situations.
When the price ceiling is set substantially or slightly above the equilibrium price, it will have no effect on creating excess demand. The following figure illustrates these situations.
11.
Neither. A shift in demand or supply means that at every price, either a greater or a lower quantity is demanded or supplied. A price floor does not shift a demand curve or a supply curve. However, if the price floor is set above the equilibrium, it will cause the quantity supplied on the supply curve to be greater than the quantity demanded on the demand curve, leading to excess supply.
12.
Neither. A shift in demand or supply means that at every price, either a greater or a lower quantity is demanded or supplied. A price ceiling does not shift a demand curve or a supply curve. However, if the price ceiling is set below the equilibrium, it will cause the quantity demanded on the demand curve to be greater than the quantity supplied on the supply curve, leading to excess demand. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.04%3A_Chapter_4.txt |
1.
From point B to point C, price rises from \$70 to \$80, and Qd decreases from 2,800 to 2,600. So:
$% change in quantity = 2600 – 2800 2600 + 2800 ÷ 2 × 100 = –200 2700 × 100 = –7.41 % change in price = 80 – 70 80 + 70 ÷ 2 × 100 = 10 75 × 100 = 13.33 Elasticity of Demand = –7.41% 13.33% = 0.56 % change in quantity = 2600 – 2800 2600 + 2800 ÷ 2 × 100 = –200 2700 × 100 = –7.41 % change in price = 80 – 70 80 + 70 ÷ 2 × 100 = 10 75 × 100 = 13.33 Elasticity of Demand = –7.41% 13.33% = 0.56$
The demand curve is inelastic in this area; that is, its elasticity value is less than one.
Answer from Point D to point E:
$% change in quantity = 2200 – 2400 2200 + 2400 ÷ 2 × 100 = –200 2300 × 100 = –8.7 % change in price = 100 – 90 100 + 90 ÷ 2 × 100 = 10 95 × 100 = 10.53 Elasticity of Demand = –8.7% 10.53% = 0.83 % change in quantity = 2200 – 2400 2200 + 2400 ÷ 2 × 100 = –200 2300 × 100 = –8.7 % change in price = 100 – 90 100 + 90 ÷ 2 × 100 = 10 95 × 100 = 10.53 Elasticity of Demand = –8.7% 10.53% = 0.83$
The demand curve is inelastic in this area; that is, its elasticity value is less than one.
Answer from Point G to point H:
$% change in quantity=1600–1800 1700 × 100 =–2001700 × 100 =–11.76% change in price=130–120 125 × 100 =10125 × 100 =8.00Elasticity of Demand=–11.76% 8.00% =–1.47 % change in quantity=1600–1800 1700 × 100 =–2001700 × 100 =–11.76% change in price=130–120 125 × 100 =10125 × 100 =8.00Elasticity of Demand=–11.76% 8.00% =–1.47$
The demand curve is elastic in this interval.
2.
From point J to point K, price rises from \$8 to \$9, and quantity rises from 50 to 70. So:
$% change in quantity = 70 – 50 70 + 50 ÷ 2 × 100 = 20 60 × 100 = 33.33 % change in price = 9 – 8 9 + 8 ÷ 2 × 100 = 1 8.5 × 100 = 11.76 Elasticity of Supply = 33.33% 11.76% = 2.83 % change in quantity = 70 – 50 70 + 50 ÷ 2 × 100 = 20 60 × 100 = 33.33 % change in price = 9 – 8 9 + 8 ÷ 2 × 100 = 1 8.5 × 100 = 11.76 Elasticity of Supply = 33.33% 11.76% = 2.83$
The supply curve is elastic in this area; that is, its elasticity value is greater than one.
From point L to point M, the price rises from \$10 to \$11, while the Qs rises from 80 to 88:
$% change in quantity = 88 – 80 88 + 80 ÷ 2 × 100 = 8 84 × 100 = 9.52 %change in price = 11 – 10 11 + 10 ÷ 2 × 100 = 1 10.5 × 100 = 9.52 Elasticity of Demand = 9.52% 9.52% = 1.0 % change in quantity = 88 – 80 88 + 80 ÷ 2 × 100 = 8 84 × 100 = 9.52 %change in price = 11 – 10 11 + 10 ÷ 2 × 100 = 1 10.5 × 100 = 9.52 Elasticity of Demand = 9.52% 9.52% = 1.0$
The supply curve has unitary elasticity in this area.
From point N to point P, the price rises from \$12 to \$13, and Qs rises from 95 to 100:
$% change in quantity = 100 – 95 100 + 95 ÷ 2 × 100 = 5 97.5 × 100 = 5.13 % change in price = 13 – 12 13 + 12 ÷ 2 × 100 = 1 12.5 × 100 = 8.0 Elasticity of Supply = 5.13% 8.0% = 0.64 % change in quantity = 100 – 95 100 + 95 ÷ 2 × 100 = 5 97.5 × 100 = 5.13 % change in price = 13 – 12 13 + 12 ÷ 2 × 100 = 1 12.5 × 100 = 8.0 Elasticity of Supply = 5.13% 8.0% = 0.64$
The supply curve is inelastic in this region of the supply curve.
3.
The demand curve with constant unitary elasticity is concave because the absolute value of declines in price are not identical. The left side of the curve starts with high prices, and then price falls by smaller amounts as it goes down toward the right side. This results in a slope of demand that is steeper on the left but flatter on the right, creating a curved, concave shape.
4.
The constant unitary elasticity is a straight line because the curve slopes upward and both price and quantity are increasing proportionally.
5.
Carmakers can pass this cost along to consumers if the demand for these cars is inelastic. If the demand for these cars is elastic, then the manufacturer must pay for the equipment.
6.
If the elasticity is 1.4 at current prices, you would advise the company to lower its price on the product, since a decrease in price will be offset by the increase in the amount of the drug sold. If the elasticity were 0.6, then you would advise the company to increase its price. Increases in price will offset the decrease in number of units sold, but increase your total revenue. If elasticity is 1, the total revenue is already maximized, and you would advise that the company maintain its current price level.
7.
The percentage change in quantity supplied as a result of a given percentage change in the price of gasoline.
8.
$Percentage change in quantity demanded=[(change in quantity)/(original quantity)] × 100=[22 – 30]/[(22 + 30)/2] × 100=–8/26 × 100=–30.77Percentage change in income=[(change in income)/(original income)] × 100=[38,000 – 25,000]/[(38,000 + 25,000)/2] × 100=13/31.5 × 100=41.27Percentage change in quantity demanded=[(change in quantity)/(original quantity)] × 100=[22 – 30]/[(22 + 30)/2] × 100=–8/26 × 100=–30.77Percentage change in income=[(change in income)/(original income)] × 100=[38,000 – 25,000]/[(38,000 + 25,000)/2] × 100=13/31.5 × 100=41.27$
In this example, bread is an inferior good because its consumption falls as income rises.
9.
The formula for cross-price elasticity is % change in Qd for apples / % change in P of oranges. Multiplying both sides by % change in P of oranges yields:
% change in Qd for apples = cross-price elasticity X% change in P of oranges
= 0.4 × (–3%) = –1.2%, or a 1.2 % decrease in demand for apples. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.05%3A_Chapter_5.txt |
1.
The rows of the table in the problem do not represent the actual choices available on the budget set; that is, the combinations of round trips and phone minutes that Jeremy can afford with his budget. One of the choices listed in the problem, the six round trips, is not even available on the budget set. If Jeremy has only \$10 to spend and a round trip costs \$2 and phone calls cost \$0.05 per minute, he could spend his entire budget on five round trips but no phone calls or 200 minutes of phone calls, but no round trips or any combination of the two in between. It is easy to see all of his budget options with a little algebra. The equation for a budget line is:
$Budget = P RT × Q RT + P PC × Q PC Budget = P RT × Q RT + P PC × Q PC$
where P and Q are price and quantity of round trips (RT) and phone calls (PC) (per minute). In Jeremy’s case the equation for the budget line is:
$10 = 2 × Q RT + .05 × Q PC 10 .05 = 2Q RT + .05Q PC .05 200 = 40Q RT + Q PC Q PC = 200 - 40Q RT 10 = 2 × Q RT + .05 × Q PC 10 .05 = 2Q RT + .05Q PC .05 200 = 40Q RT + Q PC Q PC = 200 - 40Q RT$
If we choose zero through five round trips (column 1), the table below shows how many phone minutes can be afforded with the budget (column 3). The total utility figures are given in the table below.
Round Trips Total Utility for Trips Phone Minutes Total Utility for Minutes Total Utility
0 0 200 1100 1100
1 80 160 1040 1120
2 150 120 900 1050
3 210 80 680 890
4 260 40 380 640
5 300 0 0 300
Adding up total utility for round trips and phone minutes at different points on the budget line gives total utility at each point on the budget line. The highest possible utility is at the combination of one trip and 160 minutes of phone time, with a total utility of 1120.
2.
The first step is to use the total utility figures, shown in the table below, to calculate marginal utility, remembering that marginal utility is equal to the change in total utility divided by the change in trips or minutes.
Round Trips Total Utility Marginal Utility (per trip) Phone Minutes Total Utility Marginal Utility (per minute)
0 0 - 200 1100 -
1 80 80 160 1040 60/40 = 1.5
2 150 70 120 900 140/40 = 3.5
3 210 60 80 680 220/40 = 5.5
4 260 50 40 380 300/40 = 7.5
5 300 40 0 0 380/40 = 9.5
Note that we cannot directly compare marginal utilities, since the units are trips versus phone minutes. We need a common denominator for comparison, which is price. Dividing MU by the price, yields columns 4 and 8 in the table below.
Round Trips Total Utility Marginal Utility (per trip) MU/P Phone Minutes Total Utility Marginal utility (per minute) MU/P
0 0 - - 200 1100 60/40 = 1.5 1.5/\$0.05 = 30
1 80 80 80/\$2 = 40 160 1040 140/40 = 3.5 3.5/\$0.05 = 70
2 150 70 70/\$2 = 35 120 900 220/40 = 5.5 5.5/\$0.05 = 110
3 210 60 60/\$2 = 30 80 680 300/40 =7.5 7.5/\$0.05 = 150
4 260 50 50/\$2 = 25 40 380 380/40 = 9.5 9.5/\$0.05 = 190
5 300 40 40/\$2 = 20 0 0 - -
Start at the bottom of the table where the combination of round trips and phone minutes is (5, 0). This starting point is arbitrary, but the numbers in this example work best starting from the bottom. Suppose we consider moving to the next point up. At (4, 40), the marginal utility per dollar spent on a round trip is 25. The marginal utility per dollar spent on phone minutes is 190.
Since 25 < 190, we are getting much more utility per dollar spent on phone minutes, so let’s choose more of those. At (3, 80), MU/PRT is 30 < 150 (the MU/PM), but notice that the difference is narrowing. We keep trading round trips for phone minutes until we get to (1, 160), which is the best we can do. The MU/P comparison is as close as it is going to get (40 vs. 70). Often in the real world, it is not possible to get MU/P exactly equal for both products, so you get as close as you can.
3.
This is the opposite of the example explained in the text. A decrease in price has a substitution effect and an income effect. The substitution effect says that because the product is cheaper relative to other things the consumer purchases, the consumer will tend to buy more of the product (and less of the other things). The income effect says that after the price decline, the consumer could purchase the same goods as before, and still have money left over to purchase more. For both reasons, a decrease in price causes an increase in quantity demanded.
4.
This is a negative income effect. Because your parents’ check failed to arrive, your monthly income is less than normal and your budget constraint shifts in toward the origin. If you only buy normal goods, the decrease in your income means you will buy less of every product. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.06%3A_Chapter_6.txt |
1.
Accounting profit = total revenues minus explicit costs = \$1,000,000 – (\$600,000 + \$150,000 + \$200,000) = \$50,000.
2.
Economic profit = accounting profit minus implicit cost = \$50,000 – \$30,000 = \$20,000.
3.
Quantity Variable Cost Fixed Cost Total Cost Average Variable Cost Average Total Cost Marginal Cost
0 0 \$30 \$30 - -
1 \$10 \$30 \$40 \$10.00 \$40.00 \$10
2 \$25 \$30 \$55 \$12.50 \$27.50 \$15
3 \$45 \$30 \$75 \$15.00 \$25.00 \$20
4 \$70 \$30 \$100 \$17.50 \$25.00 \$25
5 \$100 \$30 \$130 \$20.00 \$26.00 \$30
6 \$135 \$30 \$165 \$22.50 \$27.50 \$35
4.
1. Total revenues in this example will be a quantity of five units multiplied by the price of \$25/unit, which equals \$125. Total costs when producing five units are \$130. Thus, at this level of quantity and output the firm experiences losses (or negative profits) of \$5.
2. If price is less than average cost, the firm is not making a profit. At an output of five units, the average cost is \$26/unit. Thus, at a glance you can see the firm is making losses. At a second glance, you can see that it must be losing \$1 for each unit produced (that is, average cost of \$26/unit minus the price of \$25/unit). With five units produced, this observation implies total losses of \$5.
3. When producing five units, marginal costs are \$30/unit. Price is \$25/unit. Thus, the marginal unit is not adding to profits, but is actually subtracting from profits, which suggests that the firm should reduce its quantity produced.
5.
The marginal product of the third painter is 75 square feet.
$marginal product=change in total product/change in variable output change in total product=275 square feet−200square feet change in total product=75 square feet marginal product=75 square feet/1worker marginal product=75 marginal product=change in total product/change in variable output change in total product=275 square feet−200square feet change in total product=75 square feet marginal product=75 square feet/1worker marginal product=75$
6.
The new table should look like this:
Labor Cost Machine Cost Total Cost
Cost of technology 1 10 × \$40 = \$400 2 × \$50 = \$100 \$500
Cost of technology 2 7 × \$40 = \$280 4 × \$50 = \$200 \$480
Cost of technology 3 3 × \$40 = \$120 7 × \$50 = \$350 \$470
The firm should choose production technology 3 since it has the lowest total cost. This makes sense since, with cheaper machine hours, one would expect a shift in the direction of more machines and less labor.
7.
Labor Cost Machine Cost Total Cost
Cost of technology 1 10 × \$40 = \$400 2 × \$55 = \$110 \$510
Cost of technology 2 7 × \$40 = \$280 4 × \$55 = \$220 \$500
Cost of technology 3 3 × \$40 = \$120 7 × \$55 = \$385 \$505
The firm should choose production technology 2 since it has the lowest total cost. Because the cost of machines increased (relative to the previous question), you would expect a shift toward less capital and more labor.
8.
This is the situation that existed in the United States in the 1970s. Since there is only demand enough for 2.5 firms to reach the bottom of the average cost curve, you would expect one firm will not be around in the long run, and at least one firm will be struggling. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.07%3A_Chapter_7.txt |
1.
No, you would not raise the price. Your product is exactly the same as the product of the many other firms in the market. If your price is greater than that of your competitors, then your customers would switch to them and stop buying from you. You would lose all your sales.
2.
Possibly. Independent truckers are by definition small and numerous. All that is required to get into the business is a truck (not an inexpensive asset, though) and a commercial driver’s license. To exit, one need only sell the truck. All trucks are essentially the same, providing transportation from point A to point B. (We’re assuming we not talking about specialized trucks.) Independent truckers must take the going rate for their service, so independent trucking does seem to have most of the characteristics of perfect competition.
3.
Holding total cost constant, profits at every output level would increase.
4.
When the market price increases, marginal revenue increases. The firm would then increase production up to the point where the new price equals marginal cost, at a quantity of 90.
5.
If marginal costs exceeds marginal revenue, then the firm will reduce its profits for every additional unit of output it produces. Profit would be greatest if it reduces output to where MR = MC.
6.
The firm will be willing to supply fewer units at every price level. In other words, the firm’s individual supply curve decreases and shifts to the left.
7.
With a technological improvement that brings about a reduction in costs of production, an adjustment process will take place in the market. The technological improvement will result in an increase in supply curves, by individual firms and at the market level. The existing firms will experience higher profits for a while, which will attract other firms into the market. This entry process will stop whenever the market supply increases enough (both by existing and new firms) so profits are driven back to zero.
8.
When wages increase, costs of production increase. Some firms would now be making economic losses and would shut down. The supply curve then starts shifting to the left, pushing the market price up. This process ends when all firms remaining in the market earn zero economic profits. The result is a contraction in the output produced in the market.
9.
Perfect competition is considered to be “perfect” because both allocative and productive efficiency are met at the same time in a long-run equilibrium. If a market structure results in long-run equilibrium that does not minimize average total costs and/or does not charge a price equal to marginal cost, then either allocative or productive (or both) efficiencies are not met, and therefore the market cannot be labeled “perfect.”
10.
Think of the market price as representing the gain to society from a purchase, since it represents what someone is willing to pay. Think of the marginal cost as representing the cost to society from making the last unit of a good. If P > MC, then the benefits from producing more of a good exceed the costs, and society would gain from producing more of the good. If P < MC, then the social costs of producing the marginal good exceed the social benefits, and society should produce less of the good. Only if P = MC, the rule applied by a profit-maximizing perfectly competitive firm, will society’s costs and benefits be in balance. This choice will be the option that brings the greatest overall benefit to society.
21.4.09: Chapter 9
1.
1. A patent is a government-enforced barrier to entry.
2. This is not a barrier to entry.
3. This is not a barrier to entry.
4. This is a barrier to entry, but it is not government-enforced.
5. This is a barrier to entry, but it is not directly government enforced.
2.
1. This is a government-enforced barrier to entry.
2. This is an example of a government law, but perhaps it is not much of a barrier to entry if most people can pass the safety test and get insurance.
3. Trademarks are enforced by government, and therefore are a barrier to entry.
4. This is probably not a barrier to entry, since there are a number of different ways of getting pure water.
5. This is a barrier to entry, but it is not government-enforced.
3.
Because of economies of scale, each firm would produce at a higher average cost than before. (They would each have to build their own power lines.) As a result, they would each have to raise prices to cover their higher costs. The policy would fail.
4.
Shorter patent protection would make innovation less lucrative, so the amount of research and development would likely decline.
5.
If price falls below AVC, the firm will not be able to earn enough revenues even to cover its variable costs. In such a case, it will suffer a smaller loss if it shuts down and produces no output. By contrast, if it stayed in operation and produced the level of output where MR = MC, it would lose all of its fixed costs plus some variable costs. If it shuts down, it only loses its fixed costs.
6.
This scenario is called “perfect price discrimination.” The result would be that the monopolist would produce more output, the same amount in fact as would be produced by a perfectly competitive industry. However, there would be no consumer surplus since each buyer is paying exactly what they think the product is worth. Therefore, the monopolist would be earning the maximum possible profits. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.08%3A_Chapter_8.txt |
1.
An increase in demand will manifest itself as a rightward shift in the demand curve, and a rightward shift in marginal revenue. The shift in marginal revenue will cause a movement up the marginal cost curve to the new intersection between MR and MC at a higher level of output. The new price can be read by drawing a line up from the new output level to the new demand curve, and then over to the vertical axis. The new price should be higher. The increase in quantity will cause a movement along the average cost curve to a possibly higher level of average cost. The price, though, will increase more, causing an increase in total profits.
2.
As long as the original firm is earning positive economic profits, other firms will respond in ways that take away the original firm’s profits. This will manifest itself as a decrease in demand for the original firm’s product, a decrease in the firm’s profit-maximizing price and a decrease in the firm’s profit-maximizing level of output, essentially unwinding the process described in the answer to question 1. In the long-run equilibrium, all firms in monopolistically competitive markets will earn zero economic profits.
3.
1. If the firms form a cartel, they will act like a monopoly, choosing the quantity of output where MR = MC. Drawing a line from the monopoly quantity up to the demand curve shows the monopoly price. Assuming that fixed costs are zero, and with an understanding of cost and profit, we can infer that when the marginal cost curve is horizontal, average cost is the same as marginal cost. Thus, the cartel will earn positive economic profits equal to the area of the rectangle, with a base equal to the monopoly quantity and a height equal to the difference between price (on the demand above the monopoly quantity) and average cost, as shown in the following figure.
2. The firms will expand output and cut price as long as there are profits remaining. The long-run equilibrium will occur at the point where average cost equals demand. As a result, the oligopoly will earn zero economic profits due to “cutthroat competition,” as shown in the next figure.
3. Pc > Pcc. Qc < Qcc. Profit for the cartel is positive and large. Profit for cutthroat competition is zero.
4.
Firm B reasons that if it cheats and Firm A does not notice, it will double its money. Since Firm A’s profits will decline substantially, however, it is likely that Firm A will notice and if so, Firm A will cheat also, with the result that Firm B will lose 90% of what it gained by cheating. Firm A will reason that Firm B is unlikely to risk cheating. If neither firm cheats, Firm A earns \$1000. If Firm A cheats, assuming Firm B does not cheat, A can boost its profits only a little, since Firm B is so small. If both firms cheat, then Firm A loses at least 50% of what it could have earned. The possibility of a small gain (\$50) is probably not enough to induce Firm A to cheat, so in this case it is likely that both firms will collude.
21.4.11: Chapter 11
1.
Yes, it is true. The HHI example is easy enough: since the market shares of all firms are included in the HHI calculation, a merger between two of the firms will change the HHI. For the four-firm concentration ratio, it is quite possible that a merger between, say, the fifth and sixth largest firms in the market could create a new firm that is then ranked in the top four in the market. In this case, a merger of two firms, neither in the top four, would still change the four-firm concentration ratio.
2.
No, it is not true. The HHI includes the market shares of all firms in its calculation, but the squaring of the market shares has the effect of making the impact of the largest firms relatively bigger than in the 4-firm or 8-firm ratio.
3.
The bus companies wanted the broader market definition (i.e., the second definition). If the narrow definition had been used, the combined bus companies would have had a near-monopoly on the market for intercity bus service. But they had only a sliver of the market for intercity transportation when everything else was included. The merger was allowed.
4.
The common expectation is that the definition of markets will become broader because of greater competition from faraway places. However, this broadening doesn’t necessarily mean that antitrust authorities can relax. There is also a fear that companies with a local or national monopoly may use the new opportunities to extend their reach across national borders, and that it will be difficult for national authorities to respond.
5.
Because outright collusion to raise profits is illegal and because existing regulations include gray areas which firms may be able to exploit.
6.
Yes, all curves have normal shapes.
7.
Yes it is a natural monopoly because average costs decline over the range that satisfies the market demand. For example, at the point where the demand curve and the average cost curve meet, there are economies of scale.
8.
Improvements in technology that allowed phone calls to be made via microwave transmission, communications satellites, and other wireless technologies.
9.
More consumer choice. Cheaper phone calls, especially long distance. Better-quality phone service in many cases. Cheaper, faster, and better-quality data transmission. Spin-off technologies like free Internet-based calling and video calling.
10.
More choice can sometimes make for difficult decisions—not knowing if you got the best plan for your situation, for example. Some phone service providers are less reliable than AT&T used to be. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.10%3A_Chapter_10.txt |
1.
1. positive externality
2. negative externality
3. positive externality
4. negative externality
5. negative externality
2.
1. supply shifts left
2. supply shifts left
3. supply stays the same
4. supply shifts left
3.
1. price will rise
2. price will rise
3. price stays the same
4. price will rise.
4.
The original equilibrium (before the external social cost of pollution is taken into account) is where the private supply curve crosses the demand curve. This original equilibrium is at a price of \$15 and a quantity of 440. After taking into account the additional external cost of pollution, the production becomes more costly, and the supply curve shifts up. The new equilibrium will be at a price of \$30 and a quantity of 410.
5.
The first policy is command-and-control because it is a requirement that applies to all producers.
6.
1. market-based
2. command-and-control
3. command-and-control
4. market-based
5. market-based
7.
Even though state or local governments impose these taxes, a company has the flexibility to adopt technologies that will help it avoid the tax.
8.
First, if each firm is required to reduce its garbage output by one-fourth, then Elm will reduce five tons at a cost of \$5,500; Maple will reduce 10 tons at a cost of \$13,500; Oak will reduce three tons at a cost of \$22,500; and Cherry will reduce four tons at a cost of \$18,000. Total cost of this approach: \$59,500. If the system of marketable permits is put in place, and those permits shrink the weight of allowable garbage by one-quarter, then pollution must still be reduced by the same overall amount. However, now the reduction in pollution will take place where it is least expensive.
Reductions in Garbage Who does the reducing? At what cost?
First 5 tons Cherry \$3,000
Second 5 tons Cherry \$4,000
Third 5 tons Cherry \$5,000
Fourth 5 tons Elm \$5,500
Fifth and sixth 5 tons Elm and Cherry \$6,000 each
Seventh 5 tons Maple \$6,300
Eighth 5 tons Elm \$6,500
Ninth and tenth 5 tons Elm and Cherry \$7,000 each
Thus, the overall pattern of reductions here will be that Elm reduces garbage by 20 tons and has 15 tons of permits to sell. Maple reduces by five tons and needs to buy five tons of permits. Oak does not reduce garbage at all, and needs to buy 15 tons of permits. Cherry reduces garbage by 25 tons, which leaves it with five tons of permits to sell. The total cost of these reductions would be \$56,300, a definite reduction in costs from the \$59,500 cost of the command-and-control option.
9.
Incentives to Go Beyond Flexibility about Where and How Pollution Will Be Reduced Political Process Creates Loopholes and Exceptions
Pollution Charges If you keep reducing pollution you reduce your charge Reducing pollution by any method is fine If charge applies to all emissions of pollution then no loopholes
Marketable Permits If you reduce your pollution you can sell your extra pollution permits Reductions of pollution will happen at firms where it is cheapest to do so, by the least expensive methods If all polluters are required to have permits then there are no loopholes
Property Rights The party that has to pay for the pollution has incentive to do so in a cost effect way Reducing pollution by any method is fine If the property rights are clearly defined, then it is not legally possible to avoid cleanup
10.
1. See the answers in the following table. The marginal cost is calculated as the change in total cost divided by the change in quantity.
Total Cost (in thousands of dollars) [marginal cost] Total Benefits (in thousands of dollars) [marginal benefit]
16 million gallons Current situation Current situation
12 million gallons 50 [50] 800 [800]
8 million gallons 150 [100] 1,300 [500]
4 million gallons 500 [350] 1,850 [350]
0 gallons 1,200 [700] 2,000 [150]
2. The “optimal” level of pollution is where the marginal benefits of reducing it are equal to the marginal cost. This is at four million gallons.
3. Marginal analysis tells us if the marginal costs of cleanup are greater than the marginal benefit, society could use those resources more efficiently elsewhere in the economy.
11.
1. See the next table for the answers, which were calculated using the traditional calculation of marginal cost equal to change in total cost divided by change in quantity.
Land Restored (in acres) Total Cost [marginal cost] Total Benefit [marginal benefit]
0 \$0 \$0
100 \$20 [0.2] \$140 [1.4]
200 \$80 [0.6] \$240 [1]
300 \$160 [0.8] \$320 [0.8]
400 \$280 [1.2] \$480 [0.6]
2. The optimal amount of restored land is 300 acres. Beyond this quantity the marginal costs are greater than the marginal benefits.
12.
Country B
Protect Not Protect
Country A Protect Both A and B have a cost of 10 and a benefit of 16; each country has net = 6 A has a cost of 10 and a benefit of 8 (net = –2); B has a cost of 0 and a benefit of 8 ( net = 8)
Not Protect A has a cost of 0 and a benefit of 8 (net = 8); B has a cost of 10 and a benefit of 8 (net = –2) Both A and B have a zero cost and a zero benefit; each country has net = 0
Country B will reason this way: If A protects the environment, then we will have benefits of 6 if we act to protect the environment, but 8 if we do not, so we will not protect it. If A is not protecting the environment, we will have losses of 2 if we protect, but have zero if we do not protect, so again, we will not protect it. Country A will reason in a similar manner. The result is that both countries choose to not protect, even though they will achieve the largest social benefits—a combined benefit of 12 for the two countries—if they both choose to protect. Environmental treaties can be viewed as a way for countries to try to extricate themselves from this situation.
13.
1. Of the choices provided, P, R, and S demonstrate productive efficiency. These are the choices on the production possibility frontier.
2. Allocative efficiency is determined by the preferences—in this case by the preferences of society as expressed through government and other social institutions. Because you do not have information about these preferences, you really cannot say much about allocative efficiency.
3. In the choice between T and R, R should clearly be preferred, because it has both more corn and more trees. This answer illustrates why productive efficiency is beneficial. Compared with choices inside the PPF, it means more of one or both goods.
4. In the choice between T and S, it is not possible to say which choice is better. True, S is on the PPF and T is not—but that only addresses the issue of productive efficiency. If a society has a strong preference for economic output and places a lower value on trees, then allocative efficiency may lead to a choice of T over S. Of course, the reverse could also be true, leading to a choice of S. Without information on society’s preferences to judge allocative efficiency, this question cannot be answered.
5. Compared with command-and-control policies, market-oriented policies allow either more output with the same environmental protection or more environmental protection with the same level of output—or more of both environmental protection and output. Thus, a choice like Q inside the PPF is more likely to represent a command-and-control policy demand than a choice like S on the frontier of the PPF. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.12%3A_Chapter_12.txt |
1.
No. A market demand curve reflects only the private benefits of those who are consuming the product. Positive externalities are benefits that spill over to third parties, so they create social benefits, and are not captured by a market (or private benefit) demand curve.
2.
Clearly Samsung is benefiting from the investment, so the 20% increase in profits is a private benefit. If Samsung is unable to capture all of the benefit, perhaps because other companies quickly copy and produce close substitutes, then Samsung’s investment will produce social benefits.
3.
1. \$102 million.
2. If the interest rate is 9%, the cost of financial capital, and the firm can capture the 5% return to society, the firm would invest as if its effective rate of return is 4%, so it will invest \$183 million.
4.
When the Junkbuyers Company purchases something for resale, presumably both the buyer and the seller benefit—otherwise, they would not need to make the transaction. However, the company also reduces the amount of garbage produced, which saves money for households and/or for the city that disposes of garbage. So the social benefits are larger than the private benefits.
5.
Government programs that either pay for neighborhood clean-up directly or that provide reduced tax payments for those who clean up or fix up their own property could be enacted. It is also easy to imagine how a city might allow its businesses to form a group that would pay for and manage neighborhood cleanup.
6.
Government programs that either pay for education directly or that provide loans or reduced tax payments for education could create positive spillovers. A city might allow its businesses to form a group that would coordinate business efforts with schools and local colleges and universities—allowing students to obtain real-world experience in their chosen fields and providing businesses with enthusiastic, trained workers.
7.
1. Once citizens are protected from crime, it is difficult to exclude someone from this protection, so it is nonexcludable.
2. Some satellite radio services, such as SiriusXM, are sold by subscription fee, so it is excludable.
3. Once a road is built it is difficult to exclude people, although toll roads can exclude non-payers.
4. Primary education can be provided by private companies and so it is excludable.
5. Companies sell cell phone service and exclude those who do not pay.
8.
1. Two people cannot enjoy the same slice of pizza at the same time, so private goods, such as a slice of pizza, are rivalrous.
2. Two people cannot use one laptop at the same time, so they are rivalrous in consumption.
3. Public radio can be heard by anyone with a radio, so many people can listen at the same time—the good is nonrivalrous.
4. It is difficult for two people to simultaneously eat an ice cream cone, so it is rivalrous in consumption.
21.4.14: Chapter 14
1.
1. For a firm operating in a perfectly competitive output market, the value of the marginal product is the marginal product of labor multiplied by the firm’s output price.
2. In a perfectly competitive labor market where the going market wage is \$12, a profit-maximizing firm will hire workers up to the point where the market wage equals the marginal revenue product. In this case, the market wage equals the marginal revenue product when the labor is 5 because at that level, the marginal revenue product is \$12.
2.
1. For firms with some market power in their output market, like a monopoly, the value of additional output sold is the firm’s marginal revenue, not the price. This is because they face a downward sloping demand curve for output, which means that in order to sell additional output, the firm must lower its price. The marginal revenue product equals the marginal product of labor multiplied by the marginal revenue.
2. A profit-maximizing firm will hire workers up to the point where the market wage equals the marginal revenue product. If the going market wage is \$20, in this scenario, the profit-maximizing level of employment is 4 because at that point, the marginal revenue product is \$20.
3.
1. With no union, the equilibrium wage rate would be \$18 per hour and there would be 8,000 bus drivers.
2. If the union has enough negotiating power to raise the wage to \$4 per hour higher than under the original equilibrium, the new wage would be \$22 per hour. At this wage, 4,000 workers would be demanded while 10,000 would be supplied, leading to an excess supply of 6,000 workers.
4.
Unions have sometimes opposed new technology out of a fear of losing jobs, but in other cases unions have helped to facilitate the introduction of new technology because unionized workers felt that the union was looking after their interests or that their higher skills meant that their jobs were essentially protected. And the new technologies meant increased productivity.
5.
In a few other countries (such as France and Spain), the percentage of workers belonging to a union is similar to that in the United States. Union membership rates, however, are generally lower in the United States. When the share of workers whose wages are determined by union negotiations is considered, the United States ranks by far the lowest (because in countries like France and Spain, union negotiations often determine pay even for nonunion employees).
6.
No. While some unions may cause firms to go bankrupt, other unions help firms to become more competitive. No overall pattern exists.
7.
From a social point of view, the benefits of unions and the costs seem to counterbalance. There is no evidence that in countries with a higher percentage of unionized workers, the economies grow more or less slowly.
8.
1. The marginal cost of labor is the cost to the firm of hiring one more worker. To find the marginal cost of labor, one must divide the change in wage by the change in labor.
2. Because the monopsonist is the sole employer in the labor market, it can offer any wage that it wishes. However, the marginal cost of labor will be greater than the wage for any number of workers more than one because hiring more than one worker requires paying a higher wage rate for both the new worker and all previous hires. A monopsony will hire workers up to the point where its demand for labor equals the marginal cost of additional labor.
9.
1. Firms have a profit incentive to sell to everyone, regardless of race, ethnicity, religion, or gender.
2. A business that needs to hire workers to expand may also find that if it draws only from its accustomed pool of workers—say, White men—it lacks the workers it needs to expand production. Such a business would have an incentive to hire more women and minorities.
3. A discriminatory business that is underpaying its workers may find those workers leaving for jobs with another employer who offers better pay. This market pressure could cause the discriminatory business to behave better.
10.
No. The earnings gap does not prove discrimination because it does not compare the wages of men and women in the same job who have the same amounts of education, experience, and productivity.
11.
If a large share of immigrants have relatively low skills, then reducing the number of immigrants would shift the supply curve of low-skill labor back to the left, which would tend to raise the equilibrium wage for low-skill labor. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.13%3A_Chapter_13.txt |
1.
1. Poverty falls, inequality rises.
2. Poverty rises, inequality falls.
2.
Jonathon’s options for working and total income are shown in the following table. His labor-leisure diagram is shown in the figure following the table.
Number of Work Hours Earnings from Work Government Benefits Total Income
1,500 \$9,000 \$1,000 \$10,000
1,200 \$7,200 \$2,800 \$10,000
900 \$5,400 \$4,600 \$10,000
600 \$3,600 \$6,400 \$10,000
300 \$1,800 \$8,200 \$10,000
0 \$0 \$10,000 \$10,000
3.
The following table shows a policy where only 30 cents in government support is pulled right back for every \$1 of income earned. Jonathon’s labor-leisure diagram is shown in the figure following the table. “Opportunity set after program” extends from (0, \$16,300) to (1,500, \$10,000). “Opportunity set before program” slopes downward from (0, \$9,000) to (1,500, \$0).
Number of Work Hours Earnings from Work Government Benefits Total Income
1,500 \$9,000 \$7,300 \$16,300
1,200 \$7,200 \$7,840 \$15,040
900 \$5,400 \$8,380 \$13,780
600 \$3,600 \$8,920 \$12,520
300 \$1,800 \$9,460 \$22,260
0 \$0 \$10,000 \$10,000
4.
The earned income tax credit works like this: a family receives a tax break that increases according to how much they work. Families that work more get more. In that sense it loosens the poverty trap by encouraging work. As families earn above the poverty level, the earned income tax credit is gradually reduced. For those near-poor families, the earned income tax credit is a partial disincentive to work.
5.
TANF attempts to loosen the poverty trap by providing incentives to work in other ways. Specifically, it requires that people work (or complete their education) as a condition of receiving TANF benefits, and it places a time limit on benefits.
6.
A useful first step is to rank the households by income, from lowest to highest. Then, since there are 10 households total, the bottom quintile will be the bottom two households, the second quintile will be the third and fourth households, and so on up to the top quintile. The quintiles and percentage of total income for the data provided are shown in the following table. Comparing this distribution to the U.S. income distribution for 2005, the top quintile in the example has a smaller share of total income than in the U.S. distribution and the bottom quintile has a larger share. This pattern usually means that the income distribution in the example is more equal than the U.S. distribution.
Income Quintile % of Total Income
\$10,000 Total first quintile income: \$22,000 6.0%
\$12,000
\$16,000 Total second quintile income: \$34,000 9.2%
\$18,000
\$24,000 Total third quintile income: \$48,000 13.0%
\$24,000
\$36,000 Total fourth quintile income: \$86,000 23.2%
\$50,000
\$80,000 Total top quintile income: \$180,000 48.6%
\$100,000
\$370,000 Total Income
7.
Just from glancing at the quintile information, it is fairly obvious that income inequality increased in the United Kingdom over this time: The top quintile is getting a lot more, and the lowest quintile is getting a bit less. Converting this information into a Lorenz curve, however, is a little trickier, because the Lorenz curve graphs the cumulative distribution, not the amount received by individual quintiles. Thus, as explained in the text, you have to add up the individual quintile data to convert the data to this form. The following table shows the actual calculations for the share of income in 1979 versus 1991. The figure following the table shows the perfect equality line and the Lorenz curves for 1979 and 1991. As shown, the income distribution in 1979 was closer to the perfect equality line than the income distribution in 1991—that is, the United Kingdom income distribution became more unequal over time.
Share of income received 1979 1991
Bottom 20% 7.0% 6.6%
Bottom 40% 18.5% 18.1%
Bottom 60% 35.5% 34.4%
Bottom 80% 60.3% 57.1%
All 100% 100.0% 100.0%
8.
In the market for low-wage labor, information technology shifts the demand for low-wage labor to the left. One reason is that technology can often substitute for low-wage labor in certain kinds of telephone or bookkeeping jobs. In addition, information technology makes it easier for companies to manage connections with low-wage workers in other countries, thus reducing the demand for low-wage workers in the United States. In the market for high-wage labor, information technology shifts the demand for high-wage labor to the right. By using the new information and communications technologies, high-wage labor can become more productive and can oversee more tasks than before. The following figure illustrates these two labor markets. The combination of lower wages for low-wage labor and higher wages for high-wage labor means greater inequality.
9.
In the market for low-wage labor, a skills program will shift supply to the left, which will tend to drive up wages for the remaining low-skill workers. In the market for high-wage labor, a skills program will shift supply to the right (because after the training program there are now more high-skilled workers at every wage), which will tend to drive down wages for high-skill workers. The combination of these two programs will result in a lesser degree of inequality. The following figure illustrates these two labor markets. In the market for high-wage labor, a skills program will shift supply to the right, which will tend to drive down wages for high-skill workers.
10.
A very strong push for economic equality might include extremely high taxes on high-wage earners to pay for extremely large government social payments for people with much lower incomes. Such a policy could limit incentives for the high-wage workers, lock the poor into a poverty trap, and thus reduce output. The PPF in this case will have the standard appearance: it will be downward sloping.
11.
For the second hypothesis, a well-funded social safety net might make people feel that even if their company goes bankrupt or they need to change jobs or industries, they will have some degree of protection. As a result, people may be more willing to allow markets to work without interference, and not to lobby as hard for rules that would prevent layoffs, set price controls, or block foreign trade. In this case, safety net programs that increase equality could also allow the market to work more freely in a way that could increase output. In this case, at least some portion of the PPF between equality and economic output would slope up.
12.
Pure redistribution is more likely to cause a sharp tradeoff between economic output and equality than policies aimed at the ladder of opportunity. A production possibility frontier showing a strict tradeoff between economic output and equality will be downward sloping. A PPF showing that it is possible to increase equality, at least to some extent, while either increasing output or at least not diminishing it would have a PPF that first rises, perhaps has a flat area, and then falls.
13.
Many view the redistribution of income to achieve greater equality as taking away from the rich to pay the poor, or as a “zero sum” game. By taking taxes from one group of people and redistributing them to another, the tax system is robbing some of the American Dream. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.15%3A_Chapter_15.txt |
1.
1. Imperfect information is relatively low; after all, you can see the apples.
2. Imperfect information is relatively low. The neighborhood restaurant probably has a certain local reputation.
3. Imperfect information is relatively high. How can you tell whether the computer is really in good working order? Why are they selling it?
4. Imperfect information is relatively high. What do those flowers really look like?
2.
Asymmetric information often exists in the labor market because employers cannot observe many key employee attributes until after the person is hired. Employees, however, know whether they are energetic or detailed-oriented. Employers, therefore, often seek schools to pre-screen candidates. Employers may not even interview a candidate unless he has a degree and often a degree from a particular school. Employers may also view awards, a high grade point average, and other accolades as a signal of hard work, perseverance, and ability. Finally, employers seek references for insights into key attributes such as energy level, work ethic, and so on.
3.
It is almost impossible to distinguish whether a health outcome such as life expectancy was the result of personal preferences that might affect health and longevity, such as diet, exercise, certain risky behavior, and consumption of certain items like tobacco, or the result of expenditures on health care (for example, annual check-ups).
21.4.17: Chapter 17
1.
1. The management of small companies might rather do an IPO right away, but until they get the company up and running, most people would not pay very much for the stock because of the risks involved.
2. A small company may be earning few or zero profits, and its owners want to reinvest their earnings in the future growth of the company. If this company issues bonds or borrows money, it is obligated to make interest payments, which can eat up the company’s cash. If the company issues stock, it is not obligated to make payments to anyone (although it may choose to pay dividends).
3. Venture capitalists are private investors who can keep close tabs on the management and strategy of the company—and thus reduce the problems of imperfect information about whether the firm is being well run. Venture capitalists often own a substantial portion of the firm and have much better information than a typical shareholder would.
2.
From a firm’s point of view, a bond is very similar to a bank loan. Both are ways of borrowing money. Both require paying interest. The major difference is who must be persuaded to lend money: a bank loan requires persuading the bank, while issuing bonds requires persuading a number of separate bondholders. Since a bank often knows a great deal about a firm (especially if the firm has its accounts with that bank), bank loans are more common where imperfect information would otherwise be a problem.
3.
1. Remember, equity is the market value of the house minus what is still owed to the bank. Thus: the value of the house is \$200,000, Fred owes \$180,000 to the bank, and his equity is \$20,000.
2. The value of Freda’s house is \$250,000. It does not matter what price she bought it for. She owes zero to the bank, so her equity is the whole \$250,000.
3. The value of Frank’s house is \$160,000. He owes \$60,000 to the bank (the original \$80,000 minus the \$20,000 he has paid off the loan). His equity is \$100,000.
4.
Over a sustained period of time, stocks have an average return higher than bonds, and bonds have an average return higher than a savings account. This is because in any given year the value of a savings account changes very little. In contrast, stock values can grow or decline by a very large amount (for example, the S&P 500 increased 26% in 2009 after declining 37% in 2008. The value of a bond, which depends largely on interest rate fluctuations, varies far less than a stock, but more than a savings account.
5.
When people believe that a high-risk investment must have a low return, they are getting confused between what risk and return mean. Yes, a high-risk investment might have a low return, but it might also have a high return. Risk refers to the fact that a wide range of outcomes is possible. However, a high-risk investment must, on average, expect a relatively high return or else no one would be willing to take the risk. Thus, it is quite possible—even likely—for an investment to have high risk and high return. Indeed, the reason that an investment has a high expected return is that it also has a high risk.
6.
Principal + (principal × rate × time)
\$5,000 + (\$5,000 × 0.06 × 3) = \$5,900
7.
Principal + (principal × rate × time); Interest = Principal × rate × time; \$500 = \$10,000 × rate × 5 years; \$500 = \$50,000 × rate; \$500/\$50,000 = rate; Rate = 1%
8.
Principal(1 + interest rate)time = \$1,000(1+0.02)5 =\$1,104.08
21.4.18: Chapter 18
1.
All other things being equal, voter turnout should increase as the cost of casting an informed vote decreases.
2.
The cost in time of voting, transportation costs to and from the polling place, and any additional time and effort spent becoming informed about the candidates.
3.
The costs of organization and the small benefit to the individual.
4.
Domestic cotton producers would lobby heavily to protect themselves from the competition, whereas the consumers have little incentive to organize.
5.
True. This is exactly what occurs in a voting cycle. That is, the majority can prefer policy A to policy B, policy B to policy C, but also prefer policy C to policy A. Then, the majority will never reach a conclusive outcome.
6.
The problem is an example of a voting cycle. The group will vote for mountain biking over canoeing by 2–1. It will vote for canoeing over the beach by 2–1. If mountain biking is preferred to canoeing and canoeing is preferred to the beach, it might seem that it must be true that mountain biking is the favorite. But in a vote of the beach versus mountain biking, the beach wins by a 2–1 vote. When a voting cycle occurs, choosing a single favorite that is always preferred by a majority becomes impossible.
7.
The four Coca-Cola candidates compete with each other for Coca-Cola voters, whereas everyone who prefers Pepsi had only one candidate to vote for. Thus the will of the majority is not satisfied. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.16%3A_Chapter_16.txt |
1.
False. Anything that leads to different levels of productivity between two economies can be a source of comparative advantage. For example, the education of workers, the knowledge base of engineers and scientists in a country, the part of a split-up value chain where they have their specialized learning, economies of scale, and other factors can all determine comparative advantage.
2.
Brazil has the absolute advantage in producing beef and the United States has the absolute advantage in autos. The opportunity cost of producing one pound of beef is 1/10 of an auto; in the United States it is 3/4 of an auto.
3.
In answering questions like these, it is often helpful to begin by organizing the information in a table, such as in the following table. Notice that, in this case, the productivity of the countries is expressed in terms of how many workers it takes to produce a unit of a product.
Country One Sweater One Bottle of wine
France 1 worker 1 worker
Tunisia 2 workers 3 workers
In this example, France has an absolute advantage in the production of both sweaters and wine. You can tell because it takes France less labor to produce a unit of the good.
4.
1. In Germany, it takes fewer workers to make either a television or a video camera. Germany has an absolute advantage in the production of both goods.
2. Producing an additional television in Germany requires three workers. Shifting those three German workers will reduce video camera production by 3/4 of a camera. Producing an additional television set in Poland requires six workers, and shifting those workers from the other good reduces output of video cameras by 6/12 of a camera, or 1/2. Thus, the opportunity cost of producing televisions is lower in Poland, so Poland has the comparative advantage in the production of televisions. Note: Do not let the fractions like 3/4 of a camera or 1/2 of a video camera bother you. If either country was to expand television production by a significant amount—that is, lots more than one unit—then we will be talking about whole cameras and not fractional ones. You can also spot this conclusion by noticing that Poland’s absolute disadvantage is relatively lower in televisions, because Poland needs twice as many workers to produce a television but three times as many to produce a video camera, so the product with the relatively lower absolute disadvantage is Poland’s comparative advantage.
3. Producing a video camera in Germany requires four workers, and shifting those four workers away from television production has an opportunity cost of 4/3 television sets. Producing a video camera in Poland requires 12 workers, and shifting those 12 workers away from television production has an opportunity cost of two television sets. Thus, the opportunity cost of producing video cameras is lower in Germany, and video cameras will be Germany’s comparative advantage.
4. In this example, absolute advantage differs from comparative advantage. Germany has the absolute advantage in the production of both goods, but Poland has a comparative advantage in the production of televisions.
5. Germany should specialize, at least to some extent, in the production of video cameras, export video cameras, and import televisions. Conversely, Poland should specialize, at least to some extent, in the production of televisions, export televisions, and import video cameras.
5.
There are a number of possible advantages of intra-industry trade. Both nations can take advantage of extreme specialization and learning in certain kinds of cars with certain traits, like gas-efficient cars, luxury cars, sport-utility vehicles, higher- and lower-quality cars, and so on. Moreover, nations can take advantage of economies of scale, so that large companies will compete against each other across international borders, providing the benefits of competition and variety to customers. This same argument applies to trade between U.S. states, where people often buy products made by people of other states, even though a similar product is made within the boundaries of their own state. All states—and all countries—can benefit from this kind of competition and trade.
6.
1. Start by plotting the points on a sketch diagram and then drawing a line through them. The following figure illustrates the average costs of production of semiconductors.
The curve illustrates economies of scale by showing that as the scale increases—that is, as production at this particular factory goes up—the average cost of production declines. The economies of scale exist up to an output of 40,000 semiconductors; at higher outputs, the average cost of production does not seem to decline any further.
2. At any quantity demanded above 40,000, this economy can take full advantage of economies of scale; that is, it can produce at the lowest cost per unit. Indeed, if the quantity demanded was quite high, like 500,000, then there could be a number of different factories all taking full advantage of economies of scale and competing with each other. If the quantity demanded falls below 40,000, then the economy by itself, without foreign trade, cannot take full advantage of economies of scale.
3. The simplest answer to this question is that the small country could have a large enough factory to take full advantage of economies of scale, but then export most of the output. For semiconductors, countries like Taiwan and Korea have recently fit this description. Moreover, this country could also import semiconductors from other countries which also have large factories, thus getting the benefits of competition and variety. A slightly more complex answer is that the country can get these benefits of economies of scale without producing semiconductors, but simply by buying semiconductors made at low cost around the world. An economy, especially a smaller country, may well end up specializing and producing a few items on a large scale, but then trading those items for other items produced on a large scale, and thus gaining the benefits of economies of scale by trade, as well as by direct production.
7.
A nation might restrict trade on imported products to protect an industry that is important for national security. For example, nation X and nation Y may be geopolitical rivals, each with ambitions of increased political and economic strength. Even if nation Y has comparative advantage in the production of missile defense systems, it is unlikely that nation Y would seek to export those goods to nation X. It is also the case that, for some nations, the production of a particular good is a key component of national identity. In Japan, the production of rice is culturally very important. It may be difficult for Japan to import rice from a nation like Vietnam, even if Vietnam has a comparative advantage in rice production. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.19%3A_Chapter_19.txt |
1.
This is the opposite case of the Work It Out feature. A reduced tariff is like a decrease in the cost of production, which is shown by a downward (or rightward) shift in the supply curve.
2.
A subsidy is like a reduction in cost. This shifts the supply curve down (or to the right), driving the price of sugar down. If the subsidy is large enough, the price of sugar can fall below the cost of production faced by foreign producers, which means they will lose money on any sugar they produce and sell.
3.
Trade barriers raise the price of goods in protected industries. If those products are inputs in other industries, it raises their production costs and then prices, so sales fall in those other industries. Lower sales lead to lower employment. Additionally, if the protected industries are consumer goods, their customers pay higher prices, which reduce demand for other consumer products and thus employment in those industries.
4.
Trade based on comparative advantage raises the average wage rate economy-wide, though it can reduce the incomes of import-substituting industries. By moving away from a country’s comparative advantage, trade barriers do the opposite: they give workers in protected industries an advantage, while reducing the average wage economy-wide.
5.
By raising incomes, trade tends to raise working conditions also, even though those conditions may not (yet) be equivalent to those in high-income countries.
6.
They typically pay more than the next-best alternative. If a Nike firm did not pay workers at least as much as they would earn, for example, in a subsistence rural lifestyle, they many never come to work for Nike.
7.
Since trade barriers raise prices, real incomes fall. The average worker would also earn less.
8.
Workers working in other sectors and the protected sector see a decrease in their real wage.
9.
If imports can be sold at extremely low prices, domestic firms would have to match those prices to be competitive. By definition, matching prices would imply selling under cost and, therefore, losing money. Firms cannot sustain losses forever. When they leave the industry, importers can “take over,” raising prices to monopoly levels to cover their short-term losses and earn long-term profits.
10.
Because low-income countries need to provide necessities—food, clothing, and shelter—to their people. In other words, they consider environmental quality a luxury.
11.
Low-income countries can compete for jobs by reducing their environmental standards to attract business to their countries. This could lead to a competitive reduction in regulations, which would lead to greater environmental damage. While pollution management is a cost for businesses, it is tiny relative to other costs, like labor and adequate infrastructure. It is also costly for firms to locate far away from their customers, which many low-income countries are.
12.
The decision should not be arbitrary or unnecessarily discriminatory. It should treat foreign companies the same way as domestic companies. It should be based on science.
13.
Restricting imports today does not solve the problem. If anything, it makes it worse since it implies using up domestic sources of the products faster than if they are imported. Also, the national security argument can be used to support protection of nearly any product, not just things critical to our national security.
14.
The effect of increasing standards may increase costs to the small exporting country. The supply curve of toys will shift to the left. Exports will decrease and toy prices will rise. Tariffs also raise prices. So the effect on the price of toys is the same. A tariff is a “second best” policy and also affects other sectors. However, a common standard across countries is a “first best” policy that attacks the problem at its root.
15.
A free trade association offers free trade between its members, but each country can determine its own trade policy outside the association. A common market requires a common external trade policy in addition to free trade within the group. An economic union is a common market with coordinated fiscal and monetary policy.
16.
International agreements can serve as a political counterweight to domestic special interests, thereby preventing stronger protectionist measures.
17.
Reductions in tariffs, quotas, and other trade barriers, improved transportation, and communication media have made people more aware of what is available in the rest of the world.
18.
Competition from firms with better or cheaper products can reduce a business’s profits, and may drive it out of business. Workers would similarly lose income or even their jobs.
19.
Consumers get better or less expensive products. Businesses with the better or cheaper products increase their profits. Employees of those businesses earn more income. On balance, the gains outweigh the losses to a nation. | textbooks/socialsci/Economics/Principles_of_Microeconomics_3e_(OpenStax)/21%3A_Appendix/21.04%3A_Answer_Key/21.4.20%3A_Chapter_20.txt |
Goals and Objectives:
In this chapter, we will do the following:
1. Define the subject of economics
2. Outline the history of the discipline of economics
3. Acknowledge the dominance of neoclassical economics
4. Analyze the method of neoclassical economics
5. Question the distinction between positive and normative statements in economics
6. Investigate the nature of economic models
7. Review the basic mathematical concepts that are required to understand economic models
What is Economics?
It is common for people with very little knowledge of economics to assume that the subject is all about money. Other times people assume that economics is a study of commerce and business relationships. Although money and commerce are topics of great interest to economists, the subject is far broader than these areas. A far more accurate definition of economics identifies the subject as a discourse. A discourse is simply a conversation or a discussion. Economics, however, is not just any conversation or discussion. It is a discourse about how human societies function. To be more exact, we may define economics in the following way:
• Economics is an intellectual discourse concerned with the manner in which societies produce, circulate, and distribute products and services, as well as the consequences for human welfare that follow.
As the definition indicates, economics is an intellectual discourse. That is, it requires the use of the intellect. Economics is about big ideas and requires logical thinking and careful reasoning. Frequently, the conversation takes place within academia. Professors discuss these ideas with students within college and university classrooms. They also discuss these ideas with one another at professional conferences and in academic journals that deal with specialized areas of economics. Economic discussion also occurs among government officials as they debate the most appropriate economic policies at the local, state, and federal levels. For example, public officials discuss whether tax rates should be increased or decreased, or whether to increase or decrease government spending. The discourse of economics, however, is something in which all people participate at some point. The discussion need not be highly sophisticated to be an economic conversation. When a person tells a friend why she thinks the price of an item is higher at one store than at another store, the person and her friend are participating in the discourse of economics.
Economics, therefore, is a subject that explores certain social processes in our society, but it is also an investigation into how social processes affect our well-being. For example, economic discussion might involve questions about how changes in tax policy might influence economic growth or how price differentials might affect consumer welfare. Such questions are central to the subject of economics.
This way of thinking about economics might seem straightforward to the reader, but it turns out that most professional economists, if asked, would offer a very different definition of economics than the discourse definition provided above. How most economists define the subject of economics and the reason this author is proposing the discourse definition of economics will become clear once we briefly explore the history of the discipline of economics.
A Brief History of the Discipline of Economics
It might surprise the reader to learn that economics is a relatively young discipline when considering the entire history of human knowledge. The ancient Greeks studied geometry, moral philosophy, and politics, but they did not have a discipline that they referred to as economics. In fact, it was not until the seventeenth and eighteenth centuries that a distinct discipline emerged that is anything like what we today refer to as economics. At the time, people called the subject “political economy.” Economic ideas had been discussed prior to that time, but they were embedded in discussions of politics and moral philosophy, and so no one held a conception of a body of thought referred to as “economics.”
It is natural for the reader to wonder why economics emerged at such a relatively late date in human history. The reason is that certain parts of the world were undergoing a massive transformation during those centuries that ultimately helped bring about a revolution in human ways of understanding the social world. This massive shift in human organization coincided with the decline of the feudal system that existed in Western Europe prior to that time. The old feudal system had been based on a strict social hierarchy with a king at the top, followed by feudal lords who employed serfs to work on large tracts of land. The king ruled by divine (God-given) right, and each person’s place in the social hierarchy was accepted as part of a natural order established by God. Those who questioned it were dealt with harshly, and the system continued in this manner for hundreds of years.
With the growth of markets and long-distance trade, however, the old feudal system began to weaken. As market towns emerged, the surplus income of feudal lords was increasingly spent on items that could only be obtained by merchants engaged in long distance trade. As individual property rights began to spread and commerce flourished, those with the means to do so began to assert property rights over the land. The feudal serfs, who once worked the land in accordance with religious custom and tradition, were now being driven from the land. The so-called enclosure movement, which first began in England and then spread to other parts of Western Europe, involved the forceful expulsion of serfs from privately owned plots of land as private property in agriculture began to spread. Forced from the land, the former serfs made their way to the towns, which grew into large industrial cities. There they sought work in the factories and the mines as wage laborers. Their search for paid work reinforced the spread of private ownership of the means of production. In this manner, market capitalism (a system based on the private ownership of land and the means of production as well as the voluntary exchange of products) gradually displaced the old feudal system.
With the growth of markets and long-distance trade, most people’s livelihoods came to depend for the first time in human history upon movements in prices and wages. It is difficult to overstate the magnitude of this change. Never before had the majority of people experienced anything quite like it. Now they were at the mercy of movements in monetary variables that appeared to follow no clear logic of their own. As unpredictable as the weather, people struggled to understand why and how these variables moved as they did. As a result, they were becoming conscious of something called “the economy,” which was a subject that prior to that time simply did not exist. That is, the act of producing, acquiring, and consuming previously had been deeply embedded in other aspects of social life. These acts had been a part of the religious order and traditional ways of living. Now they appeared to have a separate life of their own, independent of other areas of life, whether religious, cultural, or familial. People struggled to understand the changes. Scholars emerged, claiming to have answers. These scholars were the first political economists.
For a fuller discussion of the first political economists, the reader should consult a history of economic thought textbook. Certain key figures should be mentioned at this stage, however, to justify the discourse definition of economics provided in the previous section. Without question, the person that most professional economists today regard as the father of modern economics is the Scottish political economist and philosopher Adam Smith (1723-1790). Smith’s most famous work, published in 1776, is titled, An Inquiry into the Nature and Causes of the Wealth of Nations. The metaphor for which Smith is famous is introduced in this book and is commonly referred to as the invisible hand of the market. According to this notion, within an economic system that is based on private property and voluntary market exchange, each person is led as if by an invisible hand to pursue the social interest. That is, even though everyone pursues only their own self-interest and no one intends to serve the social interest, the social interest is served nevertheless. To understand the reason, simply consider a person who wishes to receive a haircut. If the person pays a hair stylist $10 for a haircut, then the person obtains the desired haircut and fulfills his or her self-interest. At the same time, the reader should notice that the hair stylist’s primary aim is to obtain an income. When the customer pays the hair stylist the$10, the customer serves the interest of another person (i.e., the hair stylist) even though it was not his or her intention to do so. Similarly, by pursuing an income, the hair stylist serves the interest of the customer by providing the haircut even though serving the interest of the customer was not the primary aim of the hair stylist. Both the buyer and seller of the haircut serve each other’s interest in this case even though each only pursues his or her own interest. To use Adam Smith’s phrase, each market participant is led as if by an invisible hand to serve another person.
Another major figure in the history of political economy is the English political economist and financier David Ricardo (1772-1823). Ricardo’s most famous work, published in 1817, is titled, The Principles of Political Economy and Taxation. Ricardo developed many very influential ideas within this relatively small treatise. One of the most important theories Ricardo developed is today the bedrock of international trade theory. This theory, known as the theory of comparative advantage, holds that countries may benefit from international trade even if one of the countries is better able to produce both the product that it is selling and the product that it is buying from the other country. This startling result suggests that a rich and powerful nation may benefit from trade with a relatively weak nation, and vice versa. Mutual gains from trade thus extend to the international marketplace, according to Ricardo. In Chapter 19, we will consider Ricardo’s argument in detail and demonstrate the conditions under which his claim holds true.
Although Smith and Ricardo offered generally positive assessments of the new market capitalist system that had developed in Western Europe, not all political economists shared their optimism. One final political economist that we will consider is the German political economist and revolutionary socialist Karl Marx (1818-1883). Marx is famous for several works, including The Communist Manifesto (1848) and Capital (1867-1894). Capital (which is written as Das Kapital in German) is a multi-volume work that contains Marx’s most sophisticated theory of market capitalism. According to Marx, the new capitalist system was leading to the most rapid development of human productive technology that the world had ever known. At the same time, these developments were occurring within the context of an economic system in which a majority of the population (the working class or proletariat) was being exploited by a small minority of property owners (the capitalist class or bourgeoisie). In Marx’s view, the struggle between these social classes was the source of economic crises and many other social problems characteristic of the new economic system.
In addition to these political economists, many others wrote long treatises describing in detail their conclusions about the advantages or disadvantages of the new economic system. Around these major thinkers, schools of economic thought developed that aimed to refine and extend the ideas of each major thinker. It will now be easier for the reader to understand why the discourse definition of economics offered in the previous section is the most appropriate one. The clashes between economic ideas and the depth of the disagreements between different schools of economic thought were so great that they were not easily resolved. Conversations and discussions often have participants with very different viewpoints and when the discussion is about something as complex as the functioning of human societies, one cannot expect to find easy resolutions. Therefore, by referring to economics as a discourse, we are being honest about the challenges that face human understanding and how those challenges produce different and competing conceptions of the world in which we live.
The Dominance of Neoclassical Economics
Given what has been said about the history of political economy and the reasons for adopting a discourse definition of economics, the reader might expect economics textbooks to be filled with many different economic worldviews and opinions as represented by different schools of economic thought. In fact, the opposite is true. Readers of introductory economics textbooks are introduced to the ideas of a single school of economic thought. Towards the end of the nineteenth century, this school of economic thought became the dominant voice in the economics discourse, particularly within the western capitalist nations. In the 1870s, three political economists working independently in France, Britain, and Austria developed ideas that would form the foundation of a school of economic thought that shared many features with the classical political economy of Smith and Ricardo. At the same time, the methods and concepts used were sufficiently new and different to warrant the new title of neoclassical economics. By the end of World War II, this school of economic thought had become so dominant in the United States that today students are introduced to economics as if it is a single school of economic thought without any challengers at all. During the Cold War, Marxian economics continued to be the dominant school of economic thought in the command socialist economies such as the Soviet Union. Now that the Cold War is over, however, neoclassical economics reigns supreme. Its dominance is the reason that it is sometimes referred to as mainstream economics or orthodox economics.
How then should we define neoclassical economics? The following definition places emphasis on the dominance of neoclassical economics even as it includes the key elements of the definition of economics that most professional economists accept.
• Neoclassical economics is the dominant school of economic thought that defines economics as the social science concerned with the efficient use of scarce resources to achieve the maximum satisfaction of unlimited individual wants.
Neoclassical economists, therefore, define economics in a manner that is much narrower than the discourse definition provided earlier in this chapter. Neoclassical economists define economics first and foremost as a science, much like physics, and in fact many professional economists have welcomed the analogy. Indeed, many of the concepts that ultimately became part of neoclassical economics were transferred to economics directly from physics.[1] The definition of economics as a science also indicates that it is a subject in which only experts can participate in a meaningful way. It, therefore, restricts the growth of participation in the discourse of economics insofar as many people decide that they simply do not have the expertise to form their own opinions about the subject or to challenge experts on economic issues.
In addition, it should be clear that neoclassical economists strictly limit the scope of their inquiry with their definition of economics. The focus on efficiency in the use of scarce or limited resources is far more specific than the focus on the social processes of production, circulation, and distribution that are emphasized in the discourse definition of economics. Should efficiency (or obtaining the most from the least) really be the primary focus of economics? Should equality also be a concern of economists? If not, why not? Furthermore, the neoclassical definition of economics makes a major claim about human beings that is absent in the discourse definition. It is asserted that humans have wants that are unlimited. Is there really no limit to human desires? Will the answer be the same for all people, at all times, and in all places? These aspects of the neoclassical definition raise serious questions as to whether efficiency should be the exclusive focus of economics and whether human wants really are unlimited.
Regardless of our answers to these questions, it is important to understand that neoclassical economists dominate modern discourse about economic issues. Furthermore, that dominance has become so extensive that introductory textbooks almost universally refuse to acknowledge that the perspective represented corresponds to a single school of economic thought. The great majority of economics textbooks have titles that refer to economics only and almost never to neoclassical economics. Moreover, the textbooks include virtually no discussions of the history of the discipline so that students may consider how the ideas were developed through a process of historical debate and discussion. Students do not learn, for example, that many other approaches to economics exist, including Marxian economics, Austrian economics, Post-Keynesian economics, Sraffian economics, feminist economics, and institutionalist economics. This very diverse group of schools of economic thought that reject at least some part of the neoclassical approach to economics may collectively be referred to as heterodox economics. Because this textbook is subtitled, A Pluralistic Approachto Economic Theory, the reader may look forward to lengthy discussions of many different approaches to economics.
These different schools of economic thought frequently have little in common except for their rejection of neoclassical economics. It is that opposition to the dominant school of economic thought that really binds them. Furthermore, the reader should not assume that the distinction between neoclassical economics and heterodox economics is one of right versus left in the political sense. While neoclassical economics is firmly on the right side of the political spectrum and Marxian economics is firmly on the left side, Austrian economics is even further right than neoclassical economics. It is helpful to understand the political orientation of each school of economic thought, but one should not assume that a rejection of neoclassical economics is driven only by different perspectives on the role of government in the economy. Frequently, methodological differences are behind a school’s rejection of the neoclassical approach to economics, which is a subject to which we now turn.
The Entry Point and Logic of Neoclassical Economics
As explained in the previous section, today most professional economists are members of the neoclassical school of economics. For that reason and because heterodox schools of economic thought frequently define themselves in relation to the dominant school of thought, we give neoclassical economics extensive treatment in this chapter and throughout the book. In this section, we consider the method that most professional economists use.
If asked about the method that they use to acquire knowledge in their discipline, most economists will quickly mention the scientific method. As every high school science student knows, the scientific method has several key steps: the formulation of a question, the formation of a hypothesis, the making of predictions, the testing of the predictions against observed reality, and the analysis of the results. If we were operating with the neoclassical definition of economics, which defines economics as a science, then we would certainly identify the scientific method as the method of economics. Because we have adopted the discourse definition of economics, however, we will describe the method of economics rather differently. Our objective will be to identify the method of neoclassical economics in a manner that is compatible with this definition.[2]
Whenever a person enters a discourse with another person, she brings to the discussion certain bedrock assumptions. These foundational concepts are sometimes mentioned explicitly, but frequently they are introduced without the other participants in the discourse, and perhaps not even the person introducing them, being fully aware of them. For example, a person who argues that tax rates ought to be reduced may implicitly assume that people have a moral claim to any income they earn in the marketplace. That people have moral rights of this kind may be an implicit assumption that the person holds that he has never critically examined. Nevertheless, it will be used as the foundation upon which many arguments will be constructed as that individual participates in the discourse in which he is engaged. To operate without such assumptions is like trying to make an argument without any starting point at all. Can you imagine trying to proceed in this fashion?
Economists also possess certain bedrock assumptions whenever they are engaged in the discourse of economics. When discussing the bedrock assumptions of a school of economic thought, we will refer to those assumptions as the entry point. An entry point serves as the starting point in a discourse. Each school of economic thought has an entry point. For neoclassical economists, the entry point is physical and human nature.[3] That is, neoclassical economists make certain assumptions about the physical world and about the nature of human beings that serve as the foundation upon which they erect a complex economic worldview.
The point of entry of neoclassical economics can be broken down into three parts as follows:[4]
1. Society’s endowment of resources is taken as given.
2. Society’s production technology is taken as given.
3. The individual preferences of every person in society are taken as given.
The first two components of the neoclassical entry point relate to the physical world and so we will discuss these together. Neoclassical economists assume that our society is endowed with a specific amount of resources (i.e., a resource endowment) that can be used to produce products and services. They also assume that our society has a specific amount of knowledge of the methods that may be used to transform those resources into products and services (i.e., technology).
Both the resource endowment and the production technology are taken as given. What does it mean to state that these elements of the physical world are taken as given? It means that the specific amount of available resources and the available production technology are the bedrock assumptions that will form the starting point for any further analysis. Furthermore, neoclassical economists do not aim to explain how society came into possession of this combination of resources or this knowledge of how to produce products and services. It is here that the disciplinary boundaries are sharply drawn so that only certain questions are to be regarded as economic questions. For example, a neoclassical economist would not consider a question about how the United States acquired its territory to be an economic question. The neoclassical economist would consider this question to be one for historians to answer but not economists. Whether the territory of the United States was acquired through conquest or through purchase is not something that a neoclassical economist would consider important in terms of answering strictly economic questions. Similarly, a neoclassical economist would not consider a question about how we came into possession of modern information technology to be an economic question. It would also be regarded as a question for historians but not for economists.
Similarly, the third component of the neoclassical entry point takes individual human preferences as given, which is an assumption about human nature. That is, each person is assumed to have certain preferences for products and services, and the origin of these preferences is beyond the scope of neoclassical economics. For example, a question about how a smoker developed a preference for smoking cigarettes would be regarded as a non-economic question within the neoclassical economics profession. This question might be one for psychologists or marketing experts to explore, but economists simply accept that people have preferences and then build their arguments using that starting point. As the reader can observe, the neoclassical entry point places strict limits on what can be regarded as falling within the purview of economic discourse.
To successfully participate in a discourse, it is necessary also to possess a logic or method of reasoning.[5] Successful argument requires not only the building blocks of analysis but also the ability to link them together in a way that creates a unified structure.[6] The logic of neoclassical economics may be referred as one of unidirectional causality (or cause-and-effect).[7] According to this logic, one variable always affects another variable in a unidirectional manner. That is, variable A causes a change in variable B, but it is never the case that variable B causes a change in variable A. The direction of causality only runs in a single direction. This method of proceeding lends itself well to mathematical reasoning, as we shall observe later in this chapter. Nevertheless, we can imagine situations in which this logic may be restrictive. For example, consider the claim that consumer preferences directly affect the price of diamond rings. According to this simple theory, as consumers desire more diamond rings, the price is driven upwards, other factors held constant. Is it possible, however, that the causal connection might be reversed at times? That is, could a rise in the price of diamond rings cause some consumers to desire more of these items? It may be possible if consumers rely on price as an indicator of the quality of the item. If so, then prices may influence preferences just as preferences influence prices. This situation involving mutual causality between variables[8] is not consistent with the neoclassical logic and such cases are strictly forbidden within neoclassical economic theory. As we will observe later, practitioners of other schools of economic thought have sometimes applied this type of logic in the construction of their theories.
The Positive/Normative Distinction in Neoclassical Economics
Another major aspect of the neoclassical method relates to the distinction between positive statements and normative statements in economics. A positive statement is supposedly purely factual and without any value or moral content. For example, the statement, “Dave is an American citizen,” would be considered a descriptive statement, which may be either true or false. A normative statement, on the other hand, is a value-laden statement that is neither true nor false, regardless of how interesting and important to an individual it may be to determine whether one agrees or disagrees with the statement. For example, the statement, “U.S. officials should pursue a policy of full employment,” would be considered a normative statement.
The distinction has its roots in the ideas of the famous Scottish philosopher and historian David Hume (1711-1776) who famously wrote in his Treatise of Human Nature (1738) that “No ‘is’ implies an ‘ought.’” According to Hume, no matter how much we might investigate a fact, we can never extract any moral content from it. The problem, of course, is that if we cannot derive moral implications from facts then how can we ever acquire any moral knowledge at all? This manner of thinking has become central to the neoclassical method of reasoning. According to neoclassical economists, because moral knowledge is impossible, the only purely scientific statements are positive statements. Neoclassical economists aim to generate meaningful positive statements in economics (using their unique entry point and logic) and then determine whether they are true or false. They are also interested in normative questions, but they do not consider those questions to be ones that can be answered once and for all. Similarly, they do not consider normative statements to have correct or incorrect answers. Of course, if we agree on certain ends (e.g., full employment should be our goal), then positive economics can help us reach that goal. If we disagree about the ends, however, we will never resolve our normative debate.
Many people learn at a young age about the difference between fact and opinion. This distinction might seem to be an easy one for the reader to accept. A critical examination of the distinction between these two kinds of statements, however, reveals that it is more problematic than one might initially believe. For example, consider the following statement: “John is not unemployed.” At first glance, this statement might appear to be a purely positive statement. Let’s add a bit of context to the statement, however, and then reevaluate it. Consider the following facts surrounding the statement:
1. John lost his job about 13 weeks ago.
2. After losing his job, John searched for a new one for about 7 weeks with great effort.
3. About 6 weeks ago, John became so frustrated with his failed job search that he gave up looking for a job. He now sits at home and watches TV all day as his bills pile up.
Returning to our earlier statement that John is not unemployed, the reader might be surprised to discover that the statement is true. The reason is that the U.S. Bureau of Labor Statistics (BLS), which publishes the official unemployment rate each month for the U.S. Department of Labor, defines unemployment such that a person must have been actively searching for a job within the last four weeks to be considered unemployed. A worker like John, who has given up on his search, is officially counted as being outside of the labor force rather than unemployed. According to the BLS definition of unemployment, John is not unemployed.
It should be clear now just how much normative content the statement really possesses. Many people might look at this example and argue that John should be counted as unemployed. After all, he wants a job and cannot find one. Other people will look at this situation and argue that we must exclude John because he has given up his search. From a practical standpoint, how are we to count frustrated workers like John when they are not even making a token effort to find work? The point here is not to argue that John should be counted as employed or unemployed. Instead, the point is that a statement that appears, on the surface, to be entirely descriptive, in fact contains a great deal of normative content.
The reader might wonder whether this example is a far-fetched one that is unlikely to arise. On the contrary, examples such as these are not difficult to find within the discourse of economics. Many economic variables are constructed by economists, and in each case, the theorist must decide which elements to include and which elements to exclude. The very act of selection is a value-laden decision. Once constructed, any statements that refer to changes in these variables may appear to be unambiguously positive statements when in fact they are anything but purely descriptive.
For this reason, it is important to be cautious regarding claims to objectivity in economics. We close this section with words from a famous economist by the name of Joan Robinson who had a habit of challenging many aspects of mainstream economics. In Robinson’s words,
There has been a good deal of confused controversy about the question of ‘value judgments’ in the social sciences. Every human being has ideological, moral and political views. To pretend to have none and to be purely objective must necessarily be either self-deception or a device to deceive others. A candid writer will make his preconceptions clear and allow the reader to discount them if he does not accept them. This concerns the professional honour of the scientist.[9]
T he Ceteris Paribus Assumption in Neoclassical Economic Models
Armed with the neoclassical entry point and a unidirectional causal logic, neoclassical economists develop theories to explain different aspects of economic life. These theories are expressed with the use of formal economic models. Economic models are quite like physical models in that the purpose of each type of model is to simplify a complex reality. For example, a model airplane is designed to capture the key features of an actual airplane. To serve as a good model airplane, the model should include a propeller, the landing gear, the fuselage, a rudder, wings, a windshield, and other component parts. If any of the essential components are missing, then the model is not a good model. On the other hand, the model should exclude many inessential elements that actual airplanes possess. In the extreme case, if a model included every element of an actual airplane, then it would cease to be a model and would instead be an actual airplane. As a result, the model builder must make some careful choices about which elements to include and which elements to exclude from the model.
Economic models are very similar to physical models in that both represent simplifications of complex realities. Economic models, however, are abstract in nature, which means that they generally do not possess a physical form. Instead, they are mental constructs that theorists design. Aside from that important difference, they are much like the physical models with which the reader is no doubt already familiar.
One point that the reader should consider at this stage is how likely moral judgments are to creep into neoclassical analysis. All theorists confront an infinite amount of data when they begin to construct theories to explain various phenomena. Because the theorist must choose which elements to include and which elements to exclude from the model, it is inevitable that the personal values of the theorist will influence these choices.[10] Once again, we see that even theories that are framed in purely positive or descriptive terms will inevitably contain implicit moral content. It is the job of the astute observer to detect this normative content when it is not explicitly acknowledged by the model-builder.
Before we look more closely at the construction of neoclassical economic models, it is essential to introduce the key assumption that is present in all such models. The assumption that is often only implicit in neoclassical models is the ceteris paribus assumption. This assumption, also referred to as the other-things-equal assumption, allows a theorist to hold all other variables constant so that she can focus only on the relationship between the variables in which she is most interested.
An example from the natural sciences will help clarify the critical role of the ceteris paribus assumption in the construction of neoclassical economic models. For example, consider a biologist who performs an experiment using two different but identical plants, as shown below in Figure 1.1.
The biologist’s purpose is to test the hypothesis that a moderate amount of sunlight encourages plant growth. Suppose that during the month, the biologist gives each plant the same amount of water and the same amount of plant food. Assume, however, that the biologist gives Plant A a moderate amount of sunlight and Plant B zero sunlight. We might expect Plant A to grow and thrive whereas Plant B dies, thus providing evidence in support of the hypothesis. The conditions chosen for this experiment as well as the observed result are represented in Table 1.1.
Now suppose that the experiment is conducted once again with two new plants that are identical to the ones used in the previous experiment. This time, however, the biologist gives each plant the same amount of plant food, but Plant A is given zero water whereas Plant B is given a moderate amount of water. As before, Plant A is given a moderate amount of sunlight and Plant B is given zero sunlight. The conditions chosen for this experiment as well as the observed result are represented in Table 1.2.
The reader might notice that the reason the observed outcome fails to support the hypothesis in the case of Experiment 2 is that other conditions differ for the two plants other than the variable in which the biologist is most interested. That is, because Plant A received zero water, it no longer matters that it received a moderate amount of sunlight. In other words, the hypothesis can only be tested when all other conditions are the same across the two plants except for the amount of sunlight. Without all other conditions being the same, we lose our ability to draw conclusions about the effect on plant growth of the variable in which we are most interested because these other conditions may interfere with plant growth as well.
This manner of proceeding appears to provide neoclassical economists with a way to test economic hypotheses. For example, suppose a neoclassical economist wishes to test the hypothesis that tax cuts in the United States stimulate economic growth. All the economist needs to do is find another economy just like the United States and then convince the government in one country to cut taxes by the prescribed amount while convincing the government in the other country to keep taxes at a constant level. It is also necessary that nothing else change in the two economies during the period of this investigation. If economic growth occurs in the country where the tax cut occurred, then the hypothesis has been supported by the evidence. The reader will, without a doubt, recognize the absurdity of this example. No economy in the world is identical to the United States economy, and even if one existed, it would not be possible to alter only the variables of interest while holding all other variables constant. The biologist, therefore, has a great advantage over the economist in that the biologist may perform a controlledexperiment. That is, the biologist can impose the conditions that she finds most suitable to the testing of her hypothesis. Economists generally cannot perform these kinds of experiments.
To solve the problem, the economist must rely primarily on thought experiments. That is, the economist will imagine that all other variables are held constant except for those that are of greatest interest to the economist. Then allowing the variables of interest to change, she will consider what happens to other variables of interest in the model. Historical economic data and statistical tests may then be used to test economic hypotheses. These statistical tests allow the economist to hold other variables constant to check for the influence of one variable upon another. Clearly, however, these types of tests provide much less convincing evidence than the type that is acquired in a laboratory setting where conditions may be monitored and controlled directly. To the extent that neoclassical economists wish to have their science compared favorably to other sciences, such as physics, it should be clear that the case is a difficult one to make.
The Centrality of Graphical Analysis in Neoclassical Economics
As we have learned, the logic of neoclassical economics requires reference to causal relationships between economic variables. Graphical analysis lends itself well to discussions of relationships between variables, and so the two-dimensional Cartesian coordinate system is widely used in neoclassical economic theory.
The reader might recall that a two-dimensional graph makes it possible to create an image of the way that two variables relate to one another. In addition, an ordered pair may be used to represent any point in a two-dimensional space. With an ordered pair, the coordinate on the horizontal axis is always listed first and the coordinate on the vertical axis is always listed second, as shown in Figure 1.2.
Relationships between variables may also be represented with lines connecting a series of ordered pairs in this same space. When both variables move in the same direction along a line, it is said that they are positively relatedvariables or directly relatedvariables. When one variable increases as another variable declines, it is said that they are negatively related variables or inversely related variables. Figure 1.3 provides examples of positively related variables and negatively related variables.
Suppose that the ordered pairs on the line in the graph depicting a positive relationship represent combinations of the average points scored by basketball players per game and the hours they spend practicing per season. What is the causal relationship between these variables, according to the graph? The reader might conclude that an increase in hours spent practicing per season causes an increase in the average points scored per game. A moment’s reflection reveals, however, that the answer may not be so straightforward. For example, isn’t it possible that players score more points due to greater natural ability and that these players practice more because people generally like activities at which they excel? In that case, the higher average number of points scored per game causes players to practice more and the causal relationship is reversed. The point is that we cannot observe the causal connection between these variables. All we observe when we look at the graph is a correlation between the variables.
A similar question might be raised about the inverse relationship depicted in Figure 1.3. The reader might conclude that the cause of lower average numbers of points scored per game is that the players are spending more hours per season relaxing. It is possible, however, that players with lower average numbers of points scored per game due to less natural ability decide that basketball is not very enjoyable anyway and decide to relax more. In fact, both causal arguments may be true to some degree. The point is that causal relationships are not directly observable and so we only observe correlations between variables.
Once again, this insight stems from the work of the philosopher David Hume. Hume argued that we can never observe a causal connection. For example, suppose we are looking at the balls on a pool table, and we observe one ball strike another. After the first ball contacts the second ball, we observe the second ball moving away from the first ball. We repeat the experiment and observe the same result. If we repeat the experiment hundreds, thousands, even millions of times, we always observe the same result. We conclude that the one ball causes the other ball to move. Hume’s great insight is that we never actually observe this causal connection, only a correlation. No matter how many times we witness the second ball moving after the first ball strikes it, we can never know that the next time the first ball strikes the second ball that the second ball will move. This insight is now known as Hume’s critique of induction. Furthermore, any claim that the second ball moves because the first ball strikes it is a conclusion that only the observer (or the theorist) can draw. It is the theorist who imposes causal connections upon observed correlations. Those causal connections are never observed but always imposed. As all students of science should know, correlation does not imply causation.
A Neoclassical Model of Production Cost
When neoclassical economists construct theoretical models, they assert causal relationships between variables in accordance with the neoclassical logic of unidirectional causality. The variables that are regarded as the causal variables are referred to as independent variables. Similarly, the variables that are regarded as effects in neoclassical models are referred to as dependent variables. In other words, the dependent variables depend upon the independent variables.
As an example, consider the relationship between the total cost (TC) of production and the quantity (Q) of output. In neoclassical economic theory, it is claimed that total cost depends on the level of output and so total cost is treated as the dependent variable and output is treated as the independent variable. The claim can be stated more precisely as TC = f(Q). According to this mathematical statement of the relationship, total cost is a function of output. This function, which plays a key role in neoclassical microeconomic theory, is known as the cost function. Neoclassical economists assert that the relationship is a positive one for a single firm. That is, as production increases, the total cost of production rises. Figure 1.4 represents the relationship as both linear and positive.
Frequently, students have a difficult time placing variables other than x and y on the horizontal and vertical axes. Because we are interested in economic applications, we will generally use variables other than the highly abstract x and y variables. That is, the variables on the axes measure specific economic quantities. In this case, we are measuring the daily cost of production in dollar terms and the daily production of output in physical terms (e.g., boxes of cereal).
In Figure 1.5, a series of points may be found in the graph with a straight line connecting the points.
Each point represents a combination of daily cost and daily output. Point v is especially significant. At point v, daily output is zero and yet the firm still incurs a positive amount of cost. That is, the firm incurs $60 of cost even though its output level is zero. How is this combination possible? Well, firms must incur costs even when they do not produce any output. For example, a firm that has a factory must still pay rent. Because this amount of cost does not appear to depend in any way on the amount of output produced, it is referred to as total fixed cost (TFC). As the level of output rises, total production cost also rises and so any amount over and above the fixed cost of production is referred to as total variable cost (TVC). It should also be noted that this claim that a positive relationship exists between total cost and output assumes that other variables are held constant. For example, a change in rent would certainly affect total cost even though the output level remains unchanged. A rise in rent, for example, would increase the cost of fixed capital assets for the firm and would increase total cost at every output level. The cost curve would thus shift in an upward direction. The ceteris paribus assumption would be violated in that case, as shown in Figure 1.6, and the upward shift would be the result of a change in the firm’s total fixed cost. It is also possible to write the cost function that exactly fits the data shown in Figure 1.5. To accomplish this task, it is necessary to first determine the slope of the cost function, which can be achieved using any two combinations of output and cost from the table in Figure 1.5. For example, if we use points x and y, then we can calculate the slope as follows: $\frac{\Delta TC}{\Delta Q}=\frac{180-140}{240-160}=\frac{40}{80}=\frac{1}{2}$ The slope in this case is 1/2 or 0.50, which means that a 1 unit increase in output is always associated with a$0.50 increase in total cost. Because the slope tells us the additional cost that the firm incurs when production increases by 1 unit, it is referred to as the marginal cost of production. As explained in the chapter on production technology and cost, a constant marginal cost at every level of output is not to be expected, and neoclassical economists typically make a different assumption about the impact of output changes on marginal cost. We will return to this topic in Chapter 7.
Next, we write the cost function using the following form:
$TC=TFC+\frac{\Delta TC}{\Delta Q}Q$
In this function, TFC represents total fixed cost and (ΔTC/ΔQ)Q represents total variable cost. TFC is also the vertical intercept in the graph of the cost function. As mentioned previously, the slope is ΔTC/ΔQ. Finally, TC and Q remain as variables in the function. To determine the amount of total fixed cost, we can pull that information directly from the table in Figure 1.5. That is, when the output level is zero, the cost of production is $60. If that information was not directly available in the table, then that information could be obtained by plugging the slope into the cost function and using any single point in the table. For example, if we use point w, then we obtain the following result: $100=TFC+\frac{1}{2}(80) \Rightarrow TFC=60$ With this information, we can now write the cost function that fits the data as follows: $TC=60+\frac{1}{2}Q$ Additionally, it is possible to use this cost function to carry out economic forecasts of expected future levels of production cost. That is, it is possible to predict the level of cost for other levels of output, assuming this linear relationship continues to hold. For example, if we want to predict the cost of production when output is 120, then we can simply plug the output level into the cost function that we just found as follows: $TC=60+\frac{1}{2}(120)=120$ That is, the predicted level of cost is$120. In this example, the total fixed cost and the total variable cost are both \$60.
A Review of Basic Mathematical Concepts
In this section, a few basic mathematical concepts will be reviewed. We will make use of these concepts in later chapters and so it is important to have a firm grasp of them. In this chapter, we have discussed the concept of the slope of a straight line. At times, we will encounter straight lines that are either perfectly horizontal or perfectly vertical as shown in Figure 1.7.
The reader might recall that the vertical line has a slope that is undefined (or one that we might say is infinite). Similarly, the reader might also recall that the horizontal line has a slope that is equal to zero. It is important, however, to know also why these slopes are the correct ones. To prove that these slopes are the correct ones, we need only select two points on each line and calculate the slope. For example, if we select points (x1, y1) and (x2, y2) on the vertical line and then calculate the slope, we obtain the following:
$\frac{\Delta y}{\Delta x}=\frac{y_{2}-y_{1}}{x_{2}-x_{1}}=\frac{y_{2}-y_{1}}{0}\approx\infty$ (or undefined)
Similarly, if we select points (x1, y1) and (x2, y2) on the horizontal line and then calculate the slope, we obtain the following:
$\frac{\Delta y}{\Delta x}=\frac{y_{2}-y_{1}}{x_{2}-x_{1}}=\frac{0}{x_{2}-x_{1}}=0$
At other times, we will encounter lines that are not straight. These nonlinear curves do not have constant slopes but rather variable slopes. That is, the slope varies all along the curve in question. Readers who have taken a differential calculus course know that these slopes can be calculated using differentiation techniques.
In this book, we use a simpler approach to measuring slope at a point on a nonlinear curve. According to the tangent line method, the slope of a nonlinear curve at a specific point is equal to the slope of the unique straight tangent line that just touches the curve at that point. For example, Figure 1.8 shows an example of a nonlinear curve.
In Figure 1.8, a unique straight tangent line is drawn through point A such that it just touches the nonlinear curve at that point. The slope of the curve at point A is easily computed by calculating the slope of the tangent line as follows:
$\frac{\Delta y}{\Delta x}=\frac{-40}{30}=\frac{-4}{3}$
The reason that the straight tangent line must be unique is that without uniqueness the slope may be impossible to calculate. An example illustrates the point. Consider the absolute value function, which has the following form:
$y=|x|$
Figure 1.9 shows how the graph of this function appears in a two-dimensional space.
To obtain the equation of the straight line, it is necessary to first find the slope (m) as follows:
$m=\frac{\Delta y}{\Delta x}=\frac{5-3}{4-12}=\frac{2}{-8}=-\frac{1}{4}$
Once the slope is calculated, it is then possible to use one of two different approaches. One approach is to use the point-slope form of the equation, which is y – y0 = m(x – x0). In this equation, (x0, y0) refers to any point on the line. Plugging in (4,5) as well as the slope leads to the following result:
$y-5=-\frac{1}{4}(x-4)$
Solving for y yields the result below:
$y=-\frac{1}{4}x+6$
Plugging in (12,3) and the slope would have led to the same result. The second approach involves the use of the slope-intercept form of the equation, which is y = mx+b. Plugging the slope and point (12,3) (or any other point on the line) into the equation yields the following result:
$3=-\frac{1}{4}(12)+b$
Solving the equation for b yields the result below:
$b=6$
We thus obtain the same result that we obtained when we used the point-slope form of the equation. That is:
$y=-\frac{1}{4}x+6$
The mathematical concepts used in this textbook are relatively basic. The challenge is not so much in the mathematics but rather in the application of mathematical concepts to economic life. This review of basic mathematics is only intended to provide the reader with a helpful refresher as we begin our exploration of a wide variety of economic theories.
Following the Economic News [11]
In a recent article in The Wall Street Journal, Joseph Epstein raised the question as to whether economics is a science. Epstein explains that doubts about the status of economics have existed for a long time because the subject is so “heavily politicized.” Epstein explains that disagreements within economics often lead to political divisions within the discipline with Marxists, neoclassical economists, Keynesian economists, Austrian economists, and others, in sharp conflict with one another. Epstein tells an interesting story about a conversation he had with his cousin who once served as the Chair of the University of Chicago economics department. Epstein explained to his cousin how an acquaintance once complained to him about a Burger King that moved in across the street from his apartment because it spoiled his view. Epstein’s cousin sharply disagreed with the acquaintance’s reaction to the arrival of the Burger King near his home. Rather than condemning the presence of the fast food restaurant, Epstein’s cousin argued that the acquaintance should celebrate the positive contribution that Burger King would make to local tax revenues, which would ease the resident’s tax burden. It would also employ low-income people and eventually reduce the crime rate. The story is interesting because it provides an example of how different people can interpret the same circumstances in entirely different ways. While one person might see in this scenario an intrusive employer of cheap labor that spoils the appearance and atmosphere of the neighborhood, another person might see a job creator that provides a boost to local employment and commerce. Other observers may hold different opinions. Clearly, economics is a discourse with many competing and contrasting perspectives.
Summary of Key Points
1. Economics is best understood as an intellectual discourse about key social processes in our society and how those processes affect human well-being.
2. Economics is a relatively young discipline that developed during the transition from feudalism to capitalism in Western Europe.
3. Adam Smith, David Ricardo, and Karl Marx were central figures in the evolving discourse of political economy in the eighteenth and nineteenth centuries.
4. Neoclassical economics dominates the discourse of economics today, and it is the perspective that is almost always presented to students in college economics courses as simply “economics.”
5. Aside from the neoclassical school, all other schools of economic thought may be regarded as practicing heterodox economics.
6. The neoclassical entry point includes given resources, given technology, and given preferences, and its logic is one of unidirectional causality.
7. The distinction between positive economics and normative economics is central to neoclassical economics, and it is controversial.
8. The ceteris paribus assumption is the central assumption in all neoclassical economic models.
9. Independent variables are causes and dependent variables are effects in neoclassical models.
10. The cost function asserts that a positive relationship exists between output and total cost, other factors held constant.
11. The equation of a straight line passing through two points on the line may be found using either the point-slope form or the slope-intercept form.
List of Key Terms
Discourse
Economics
Feudal system
Market capitalism
Invisible hand
Neoclassical economics
Mainstream economics
Orthodox economics
Heterodox economics
Scientific method
Entry point
Logic
Unidirectional causality
Mutual causality
Positive statement
Normative statement
Economic models
Ceteris paribus assumption
Positively related variables
Negatively related variables
Independent variables
Dependent variables
Cost function
Total fixed cost (TFC)
Total variable cost (TVC)
Marginal cost
Economic forecasts
The tangent line method
Point-slope form
Slope-intercept form
Problems for Review
1. Suppose a reduction in income taxes occurs in the same year as a decrease in economic growth.
• Is the relationship between these variables positive or negative?
• Would you expect a positive relationship or a negative relationship between these variables?
• If these variables are not related in the way that you were expecting, what might be a possible reason?
2. On a graph, plot the points (7,8) and (1,4).
3. Using the graph you drew in response to question 2, connect the points with a straight line.
• Using point-slope form, write the equation of the straight line that passes through the points.
• Using slope-intercept form, write the equation of the straight line that passes through the points.
4. Using the graph in Figure 1.11, use the tangent line method to determine the slope at point C. Assume the line also passes through point D when calculating the slope.
5. Using the data below, write the cost function using the form TC = TFC+(∆TC/∆Q)Q. Then draw the function on a graph with TC on the vertical axis and Q on the horizontal axis. Be sure to label both axes correctly. Also identify the level of total fixed cost on the graph.
Quantity (Q) Total Cost (TC)
90 70
180 100
270 130
360 160
450 190
540 220
1. For an advanced analysis of how these developments occurred, see Mirowski (1991).
2. The discussion of the neoclassical method described in this chapter draws upon ideas presented in Contending Economic Theories by Wolff and Resnick (2012).
3. Wolff and Resnick (2012), p. 37.
4. Ibid.
5. Ibid. Pp. 35-36.
6. Ibid. Pp. 35.
7. Ibid. Pp. 38.
8. Ibid. Pp. 36.
9. Robinson’s quote is from Hunt (2002), p. 465.
10. Wolff and Resnick (2012), p. 7.
11. Epstein, Joseph. The Wall Street Journal, Eastern Edition. New York. 04 Sep. 2019. A.17. | textbooks/socialsci/Economics/Principles_of_Political_Economy_-_A_Pluralistic_Approach_to_Economic_Theory_(Saros)/01%3A_An_Introduction_to_Economic_Theory/01%3A_The_Discourse_of_Economics.txt |
Goals and Objectives:
In this chapter, we will do the following:
1. Describe different perspectives of what constitutes a good society
2. Define the economic problem as understood within neoclassical economics
3. Identify the key prerequisites of economic efficiency in neoclassical economics
4. Analyze the production possibilities model of neoclassical economics
5. Develop two essential measures of opportunity cost that neoclassical economists use
6. Explain how economic efficiency is represented in the production possibilities model
7. Apply the production possibilities model to a number of different situations
8. Build a classification scheme for different economic systems
Competing Perspectives of What Constitutes a Good Society
The question of what constitutes a good society is one that has been discussed and debated for thousands of years. Many different answers have been offered, and no single answer is universally recognized as the best answer. The question was of interest in Ancient Greece. In The Republic, Plato described what he regarded to be the ideal society. Plato’s ideal society was hardly a democracy. In fact, it contained a strict social hierarchy. For Plato, the best society was one in which the philosopher-kings ruled. This structure worked out well for Plato since he was a philosopher himself! The reason Plato regarded this feature to be an essential one in his ideal society is that philosophers were the wisest members of society. As a result, only they could be trusted to make decisions that would best serve the population. This class-based society also included a warrior class and a class of slaves, leading many to reject this notion of the ideal society.
Sir Thomas More offered another perspective on the question in the sixteenth century with the publication of his book Utopia. More approached the question from a Christian perspective in this famous work. In Utopia, More describes a fictional island named Utopia that is an ideal one from his perspective. The island of Utopia consists of several cities spread out across the island. The Utopians rotate living in the city and in the countryside. Their economy is based on communally owned property and the free distribution of necessities. They also have a short, six-hour workday and the least pleasant work is performed by slaves. The slaves are mostly criminals and prisoners of war. Freed from the toil of work, the Utopians were free most of the day to enjoy socializing with one another and learning about new subjects.
Mohandas Gandhi, the leader of the independence movement in India during the twentieth century, had a different perspective on what constitutes a good society. Gandhi advocated economic self-sufficiency, protectionism for local economies, and the avoidance of materialism.[1] The emphasis on local production and the resistance to long-distance trade in Gandhi’s economic philosophy stem from the British legacy of colonialism in India. In the nineteenth century, a flood of British imports of cheap cloth helped bring about a rapid decline of the Indian textile industry. To this day, Indians have serious concerns about the possible consequences of unrestricted imports for domestic producers. An avoidance of materialism and excess consumption stems from a belief that spiritual values would suffer from an excessive devotion to the acquisition of material wealth. Gandhi also emphasized elevating the worst-off members of society in the pursuit of greater equality and a sense of brotherhood.[2]
Islamic economists hold a different vision of what constitutes a good society. Muslims believe that in the seventh century, God spoke to the Prophet Mohammad through the angel Gabriel.[3] These revelations were subsequently recorded in the Quran, and Mohammad’s other declarations are documented in the Hadith.[4] These texts form the basis of the Islamic law code.[5] According to Islamic economists then, the ideal society is one that adheres strictly to Islamic law as set forth in the Quran and the Hadith. Whereas western nations abide by the principle of the strict separation of church and state, Islamic nations often have governments in which church and state are merged. These theocratic governments have the power to enforce compliance with Islamic law. Key features of Islamic economics include profit-sharing but a prohibition on the payment of interest, proper consumption that excludes the consumption of alcohol and pork, a wealth tax for redistribution to the poor, the avoidance of uncertainty (e.g., gambling), and a belief in universal brotherhood.[6]
Another thinker who advocated an ideal society in the nineteenth century was Karl Marx. Marx’s advocacy of socialism (and ultimately communism) is somewhat unusual in that he did not specify with much precision how these superior societies were supposed to work. Instead, he concentrated his attention on the exploitative nature of market capitalism with the belief that his critique would ultimately lead to a revolutionary socialist transformation of human society. In Marx’s theory, the capitalist class (the bourgeoisie) exploits the working class (the proletariat) within capitalist societies. According to Marx, the working class will eventually establish a society in which working people own the means of production in common and all class distinctions are abolished. Although Marx’s description of the future socialist society is incomplete, he argued that workers would be compensated according to their work and would contribute to production as they are able. In the later communist society, workers would be compensated according to their need and would contribute to production as they are able.
The novelist and philosopher Ayn Rand is another thinker who offered a vision of the ideal society in the twentieth century. According to Rand, capitalism is the ideal society, as it is the only society, in her opinion, that protects human rights. For Rand, human rights are not granted by God, or society, or the state. Rather, rights derive from the very nature of human beings. These rights include the right to life and the right to property. That is, each individual human being has a right to do with his or her life or property whatever he or she wishes, provided he or she does not interfere with anyone else’s rights. Therefore, no one has the right to take another person’s life or property without first obtaining that person’s consent. For that reason, the voluntary exchange of property is the only kind of transaction that respects the right to property. Market capitalism is thus the ideal society in Rand’s view. Furthermore, the state has one function only and that is to protect the individual rights to life and property. If the state acts in a way that violates these rights, then it acts immorally.[7]
Alongside all these competing perspectives of the ideal society is the neoclassical perspective that the ideal society is the one that achieves efficiency. Simply put, the ideal society is the one that obtains the most advantages with the least use of resources. It may also be thought of as the avoidance of all waste. In the next section, we begin to explore the neoclassical concept of efficiency. As the reader will soon discover, neoclassical economists have a more complicated definition of efficiency than the brief definition offered in this section. Nevertheless, it should be clear that neoclassical economists possess their own concept of the good society.
The Economic Problem and the Scarcity of Resources
According to neoclassical economists, all human societies face the same basic problem, regardless of whether we are discussing a primitive tribal community or a modern, highly advanced industrialized economy. The economic problem, as it is called, may be stated as follows:
• How can society best transform scarce and limited economic resources with its given state of technology into goods and services in the presence of unlimited and insatiable human wants?[8]
Figure 2.1 connects the key components of the economic problem.
At first glance, it might appear that the situation is entirely hopeless. The reason is that the resources used for production are limited and yet human wants are claimed to be limitless. It is, therefore, impossible to completely solve the economic problem. An infinite amount of production would be necessary to satisfy unlimited wants and that is simply impossible. It may be clear now why neoclassical economics is regarded as the dismal science. It begins with a problem facing all of humanity that can never be solved! What is the ideal society then if all societies confront this insoluble problem?
Before we investigate this issue further, it will be helpful to explore what neoclassical economists mean when they refer to resources. Resources, also referred to as factors of production or inputs, are classified into three different categories: land, labor, and capital. Land (T) refers to natural resources. That is, land includes all elements of production that are not previously passed through some production process, such as rivers, forests, and minerals that have not yet been extracted. Capital (K) is understood by neoclassical economists to mean something very different from what businesspeople often mean when they refer to capital. Businesspeople often have in mind a sum of money that is used to start a business. Occasionally, economists refer to financial capital when they wish to use the meaning that businesspeople assign to capital. Because economists are primarily interested in physical resources, however, they define capital as physical goods. Specifically, when neoclassical economists refer to capital, they have in mind goods that are used to produce other goods, including machinery, tools, and production plants. Similarly, the neoclassical use of the term investment (I) is rather different from the way the term is used in the financial services industry. Instead of referring to financial investments in stocks and bonds, neoclassical economists have in mind the growth of capital through time by means of production or purchase.
At this stage, it will be helpful to distinguish between two types of variables: stock variables and flow variables. A stock variable is a variable that is measured as of a point in time. A flow variable, on the other hand, is a variable that is measured per unit of time. For example, a household’s wealth is a stock variable. That is, as of this moment, the household’s total assets minus its debts can be measured in dollar terms (e.g., $250,000). The income of the household, on the other hand, is a flow variable. Household income can be measured in dollar terms, but the period must be specified. For example, it is not helpful to state that household income is$75,000. Is the income level $75,000 per year, per month, or per week? Similarly, capital is a stock variable, and investment is a flow variable. The capital stock may be 500 factories, but the amount of investment may be 15 factories per year. Finally, labor (L) refers to the work that individuals perform. It may be measured as a stock variable or as a flow variable. For example, the size of the labor force might be measured in terms of the number of individual workers available for work at this moment, in which case it would be measured as a stock variable. On the other hand, it might be measured in terms of hours of employment each year, in which case it would be measured as a flow variable. Depending on the problem being considered, it may make sense to measure labor as a stock variable or as a flow variable. To avoid errors, it is important to know which type of variable has been chosen for the measurement of labor, capital, or land. Furthermore, regardless of how these variables are measured, it is crucial to remember that they are always regarded as scarce. It should also be mentioned briefly that technology here means nothing more than the methods or techniques that are used to transform economic resources into goods and services. At a point in time, the knowledge of different production techniques is given or fixed. It is, therefore, an additional constraint that gives rise to the economic problem. The Neoclassical Ideal: Economic Efficiency It is now possible to consider what neoclassical economists consider to be the ideal society. The ideal society is one that achieves economic efficiency. The concept of economic efficiency in neoclassical theory has three key components. If any one of these three components is missing, then economic efficiency is not being achieved. First, the full employment of all resources must be achieved. That is, all land, labor, and capital must be fully used for production. Granted, it is necessary to consider efficiency in the use of resources over time. For example, if we use all our natural resources this year, then we will have nothing left in future years. As a result, it is necessary to distinguish between static efficiency, which refers to efficiency in the present moment, versus dynamic efficiency, which refers to efficiency over time. Although questions of sustainability are very important, our focus will be only on static efficiency in this chapter. That is, given the amount of resources our society has available in the present period, if all these resources are employed then full employment is achieved. The second requirement for economic efficiency is productive efficiency, which refers to the least-cost or cost-minimizing method of production. It is possible that all resources are fully employed but not in the least cost manner. For example, suppose that for one day the heart surgeons trade places with the professional basketball players. Everyone continues to be fully employed but now they are employed in a way that is rather costly. The heart surgeries that take place that day will have a very high cost indeed, and the basketball games will probably not be especially well played. The third requirement for economic efficiency is allocative efficiency, which refers to the most desirable mix of goods. That is, it is possible that all resources are fully employed and in the least-cost way but that the goods that are produced are not at all what people want to consume. For example, suppose that all that is produced in the economy is silly string. Everyone may have a job, but consumers will have no food, housing, or clothing to consume. To sum up, for an economy to achieve economic efficiency, it must fully employ its resources in the least-cost manner and produce the combination of goods and services that consumers most desire. That is, full employment, productive efficiency, and allocative efficiency must all be achieved. The reader should note that an economy that achieves economic efficiency does not solve the economic problem. Instead, an economically efficient economy does the best that it possibly can in the face of the insoluble economic problem. The economically efficient economy is, therefore, the ideal society according to neoclassical economists. It is natural to ask which form of society will achieve this ideal outcome. We will return to this question towards the end of this chapter. In the next section, we will see how the different components of economic efficiency may be represented in an economic model. The Production Possibilities Model In this section, we will consider how to represent the economic problem within the context of an economic model called the production possibilities model. The model is a graphical depiction of the economic problem confronting any form of society. That is, because the economic problem is one that all societies face, this model is a completely general one in the sense that nothing is assumed about the type of economic system to which it applies. As with all economic models, it is necessary to identify the assumptions of the model. The model has several assumptions. It is assumed that the society only produces two goods, and they are measured in physical terms. The first assumption that the goods are measured in physical terms is significant because it is consistent with the notion that the model may apply to any form of society. Strictly speaking, the goods should not be measured in monetary terms because the economy being considered many not have money at all. It may be a barter economy or have some other mechanism of resource allocation and product distribution. It is also assumed that the society possesses fixed stocks of land, labor, and capital, and a fixed production technology. The second and third assumptions that the resource stocks and production technology are given are central to the neoclassical entry point. Finally, it is assumed that the society is currently achieving full employment and productive efficiency. The assumption of full employment and productive efficiency is one requirement short of economic efficiency. That is, allocative efficiency is not assumed, and so at this stage, no assumptions are made about what society regards as the most desirable combination of goods. After the model is more developed, societal preferences will be introduced.[9] Figure 2.2 shows an example of a production possibilities schedule with a corresponding production possibilities frontier (PPF). The table may be understood in the following way. A society may choose between production combination A, B, C, D, or E at any given time. For each production combination that it might choose, the society is able to produce the corresponding combination of computers and automobiles. For example, if society chooses production combination A, then it can produce both 0 computers and 50 automobiles. If it chooses production combination B, then it can produce both 60 computers and 45 automobiles, and so on. When each of these production combinations is plotted on a two-dimensional graph, a line can be drawn that connects them. This line is referred to as the production possibilities frontier (PPF). By assumption, each point on the PPF represents a combination of automobiles and computers that fully employs society’s resources using the least-cost method of production (i.e., the best available production technology). The production possibilities model teaches us two important lessons. The first lesson is that all societies face tradeoffs. One can easily observe from looking at the table in Figure 2.2 that an increase in the production of one of the goods necessarily leads to a reduction in the production of another good. Similarly, the negative slope of the PPF also indicates that society faces tradeoffs. As society moves along the curve from one production combination to another, a rise in the production of one good is only achieved due to a reduction in the production of another good. Another way of stating that all societies face tradeoffs is to state that all societies incur opportunity costs. The opportunity cost of an option X is the next best alternative Y that must be sacrificed to obtain X. Individuals incur opportunity costs all the time. The reader has chosen to read this book rather than take a nap, which might be the next best alternative. The opportunity cost of reading the book is the nap that cannot be taken. Similarly, societies incur opportunity costs. If society desires more computers, then it can only obtain additional computers by sacrificing the production of a certain number of automobiles. Due to full employment and productive efficiency, it is only possible to increase computer production by shifting resources away from the production of automobiles and towards computers. The loss of resources in the automobile sector is the reason that automobile production declines. The second lesson that we learn from the production possibilities model is that all societies face increasing opportunity costs. That is, the opportunity cost of producing an additional unit of a good rises as more of it is produced. To really understand this concept, it is necessary to have a way of measuring opportunity cost. Otherwise, it does not make much sense to claim that opportunity costs are increasing. We have two ways of measuring opportunity cost.[10] The first way of measuring opportunity cost involves the use of something called total opportunity cost. The best way to understand total opportunity cost is to consider an example. Using the table from Figure 2.2, the reader will observe that if society produces 120 computers, then the entire amount of automobile production lost is 15 automobiles. That is, automobile production falls from 50 automobiles to 35 automobiles. In this case, the total opportunity cost of producing 120 computers is 15 automobiles. The reader should notice that the opportunity cost of a given amount of production of one good is always stated in terms of the other good that is lost. To consider a similar example, the total opportunity cost of 45 automobiles is 180 computers (because computer production falls from 240 to 60). A second way of measuring opportunity cost, referred to as marginal opportunity cost, requires that we only look at small or marginal changes in the production of one good and the subsequent impact on the production of another good. For example, using the information from the table in Figure 2.2, we observe that an increase in computer production from 60 to 120 computers leads to a reduction in automobile production from 45 to 35 automobiles. That is, the marginal opportunity cost of the additional 60 computers is 10 automobiles. To consider a similar example, the marginal opportunity cost of increasing automobile production from 20 to 35 is 60 computers (because computer production falls from 180 to 120 computers). When confronted with discrete as opposed to continuous data, it is sometimes necessary to calculate marginal opportunity cost using an approximation. For example, if we are interested in calculating the marginal opportunity cost of the 60th computer, then we do not have the information available in the table to answer the question with perfect precision. That is, we would need to see the movement from 59 to 60 computers and observe what happens to automobile production over this limited range. To approximate the marginal opportunity cost in this case, we will use the next lowest number in the table and divide the corresponding change in automobiles by the change in computer production as follows: $\frac{\Delta A}{\Delta C}=\frac{45A-50A}{60C-0C}=-\frac{5A}{60C}=\frac{-\frac{1}{12}A}{C}$ According to this calculation, the marginal opportunity cost of the 60th computer is approximately 1/12 of an automobile. The perceptive reader might notice that ΔA/ΔC is also the slope of the PPF. The negative sign in our calculation indicates that the slope of the PPF is negative, which again implies that additional computer production has an opportunity cost (i.e., it leads to a loss of automobile production). Now consider another example in which we attempt to calculate the marginal opportunity cost of producing the 120th computer. Again, we lack the information about how automobile production is affected when society increases production from 119 computers to 120 computers. Therefore, we use the next lowest number available, which in this case happens to be 60 computers. As before, we approximate the marginal opportunity cost as follows: $\frac{\Delta A}{\Delta C}=\frac{35A-45A}{120C-60C}=-\frac{10A}{60C}=\frac{-\frac{1}{6}A}{C}$ Again, we observe that additional computer production carries an opportunity cost. However, we notice in this case that the opportunity cost has increased from 1/12 of an automobile to 1/6 of an automobile. That is, the marginal opportunity cost is increasing, which the reader will recall is the second lesson that we learn from the production possibilities model. Because neoclassical economists argue that all human societies experience the phenomenon of increasing marginal opportunity cost, they elevate it to the status of an economic law, which they call the law of increasing opportunity cost. Because the marginal opportunity cost is measured using the slope of the PPF, we can easily observe the operation of this law by noting how the slope becomes steeper (and thus the opportunity cost greater) as society moves along the PPF. Of course, the reader might wonder why all human societies experience this phenomenon. After all, the numbers were simply assumed. They were not gathered during an empirical analysis of an actual economy. Why then do neoclassical economists regard it as self-evident that all human societies will experience this phenomenon? The reason relates to the underlying resources used in the production of the two goods. In general, societies possess heterogeneous resources. That is, among the resources societies use, some of the resources are better suited to the production of one good and other resources are better suited to the production of another good. If all resources were equally suited to the production of all goods, then society would possess homogenous resources. Because heterogeneous resources are the general rule, however, neoclassical economists assert that all human societies experience the phenomenon of increasing marginal opportunity cost. To understand why the presence of heterogeneous resources leads to increasing opportunity cost, consider what happens when society begins at production combination A with 0 computers and 50 automobiles. As our society shifts resources from the automobile sector to the computer sector, computer production rises and automobile production falls. Notice, however, that automobile production only falls by 5 units when society moves to production combination B. The reason is that the first resources to be shifted to computer production will be the resources that are best suited to the production of computers and those that are least suited to the production of automobiles. When society moves to production combination C, computer production increases by 60 units again, but this time automobile production falls by 10 units. The reason for the larger decline in automobile production is that the resources shifted are now better suited to automobile production (and less suited to computer production) than those shifted previously. As a result, automobile production must fall by a larger amount to obtain the same rise in computer production that occurred previously. This pattern continues until automobile production must fall by a full 20 units (in the move from production combination D to E) to obtain a 60 unit rise in computer production. At this point, the best automobile resources must be shifted to computer production to obtain the 60 unit rise in computer production. It is the heterogeneity of the resource base that generates the pattern of rising marginal opportunity cost. It should be noted that we could also approximate the marginal opportunity cost of an additional automobile in a similar manner. For example, if we wish to calculate the marginal opportunity cost of the 45th automobile, then we lack the information in the table that would allow us to calculate the answer exactly (i.e., the movement from 44 to 45 automobiles with the corresponding reduction in computer production). As a result, we can approximate the marginal opportunity cost of the 45th automobile as follows: $\frac{\Delta C}{\Delta A}=\frac{60C-120C}{45A-35A}=-\frac{60C}{10A}=\frac{-6C}{A}$ Again, the negative sign indicates that additional automobile production carries an opportunity cost (i.e., lost computer production). The reader should notice, however, that ΔC/ΔA is the reciprocal of the slope of the PPF rather than the slope itself. Depending on which good we are considering, the marginal opportunity cost may be approximated using the slope or the reciprocal of the slope of the PPF. The important point to remember is that the other good is always placed in the numerator when carrying out this approximation. The reason the other good is placed in the numerator is that opportunity cost is always measured in terms of the lost amount of the other good and never in terms of the same good. Sometimes the phenomenon of increasing marginal opportunity cost is described in terms of the law of diminishing returns. For example, consider the situation in Figure 2.2 where the society begins with 240 computers and 0 automobiles. As computer production declines in increments of 60 computers, the increases in automobile production become smaller and smaller. Society can boost automobile production a great deal initially, but the more it devotes land, labor, and capital to the production of automobiles, the more difficult it is to increase automobile production. The Role of Societal Preferences in the Production Possibilities Model Now that we have learned the two most important insights of the production possibilities model, we need to consider how economic efficiency is represented in the model. Because full employment and productive efficiency were assumed at the outset, any point on the PPF must satisfy these two conditions of economic efficiency. For society to achieve economic efficiency, however, allocative efficiency is another requirement that must be met. The reader will recall that for society to achieve allocative efficiency, the most desirable mix of goods must be produced. But what is the most desirable mix of goods for all members of society? We all have very different preferences and so sorting out what society’s preferences are will not be an easy task.[11] We can begin to think about how neoclassical economists address this question by dropping our earlier assumption that money values do not exist in this economy. If we consider an economy in which goods and resources have monetary values, then we can use something called cost-benefit analysis to determine the most desirable mix of goods for a given society.[12] Figure 2.3 shows how this analysis may be carried out using the computer industry from our previous example. In Figure 2.3, it should be clear that as computer production rises, the marginal opportunity cost of production (here measured in dollar terms) increases. This increase in marginal cost (MC) is consistent with the law of increasing opportunity cost discussed previously. In addition, a new concept is introduced that we will refer to as marginal benefit (MB). The marginal benefit of a specific unit of a good represents the maximum dollar amount that members of society are willing to pay for that unit. In this case, when zero computers are produced, someone in society is willing to pay as much as$1100 for the first computer. By the time 60 computers are produced, the maximum amount someone is willing to pay is $900. The reason for the decline in marginal benefit is intuitive. As people consume more of a good, they experience less and less additional benefit from its consumption. Eventually, the marginal benefit of an additional unit declines to$100 once 240 computers are produced. What we observe in the table and the graph then are the diminishing marginal benefit of consumption and the increasing marginal cost of production.
When using cost-benefit analysis to determine the most desirable quantity of a good, it is only necessary to compare marginal benefit and marginal cost at each step. For example, when zero computers are produced, someone in society is willing to pay $1100 for the first computer, but the marginal cost to society is only$100. The production of the first computer clearly represents a net gain to society, and cost-benefit analysis indicates that it should be produced. When 60 computers are produced, a net gain to society exists from the production of another unit because the marginal benefit is $900 and the marginal cost is$200. The same holds true when 120 computers are produced. In that case, the marginal benefit of $700 exceeds the marginal cost of$300. It should be clear, however, that the net marginal gain (= marginal benefit minus marginal cost) is declining as more computers are produced. The marginal cost is rising due to the presence of heterogeneous resources, and the marginal benefit is declining as the population experiences a reduction in satisfaction from each additional unit consumed. Eventually, society reaches the point where marginal benefit and marginal cost are equal and net marginal gain is zero. When 180 computers are produced, the marginal benefit to society of an additional computer is $400, and this amount is exactly equal to the marginal cost of$400. In a sense, society just breaks even at this level of computer production. Although the net marginal gain of producing another computer is zero in this case, the computer can be produced without generating an inefficient outcome. Any additional production, however, will undermine economic efficiency. For example, if society produces 240 computers, then the marginal cost of $500 will exceed the marginal benefit of$100.
The general rule may be stated as follows. Society should produce a good up to the point where the marginal benefit of the last unit consumed equals the marginal cost of the last unit produced. If the marginal benefit exceeds the marginal cost of production, then society should produce more of the good. If the marginal benefit is below the marginal cost of production, then society should produce less of the good. Once the point is reached where marginal benefit equals marginal cost, then the allocatively efficient quantity of the good is being produced. This point occurs at the intersection of the MB and MC lines in the graph on the right in Figure 2.4.
We can then identify in the graph on the left this quantity of computers. It is necessary to carry out a similar cost-benefit analysis for all goods produced in the economy. When all goods are produced such that marginal benefit equals marginal cost, then society has achieved economic efficiency. That is, society is not only producing on the PPF, indicating full employment and productive efficiency, it is also producing at the optimal (or best) point on the PPF from the standpoint of societal preferences, accounting for production costs. Again, we might return to the question of which form of society will bring about this result? Once again, the reader is asked to wait until the end of the chapter for the neoclassical answer to this question.
Relaxing the Assumptions of the Model
Up until now, we have continued to maintain the basic assumptions of the model. It is possible to relax these assumptions, however, and allow other variables to change. This violation of the ceteris paribus assumption is a useful way of understanding the role that the assumptions play. It also opens the door to applications of the model to historical and current events.
Let’s begin by considering the assumption of full employment of resources. Suppose the economy is initially at point W in the graph on the left in Figure 2.5.
At point W, all resources are fully employed. Now suppose that some resources in the automobile sector become unemployed. Even though computer production will not be affected, automobile production will decline. This kind of change is reflected in the movement from point W to point X. Similarly, suppose that we begin at point W, but then resources in the computer industry become unemployed. Automobile production will not be affected, but computer production will decline. A change of this kind is reflected in the movement from point W to point Y. Finally, suppose that resources become unemployed in both sectors simultaneously. In that case, we would expect to see reductions in the production of both goods as reflected in the movement from point W to point Z.
The important point to notice here is that the economy moves inside its PPF when resources become unemployed. The PPF, however, does not move. The reason the PPF remains in the same place is that the resources to produce goods and services still exist. Hence, production combinations on the PPF are still possible. These production combinations are not produced, however, because some of the existing resources are idle.
It is also worth pointing out that the economy can move inside the PPF in a similar manner for a very different reason. Suppose that all resources are fully employed at point W, but then the automobile industry fails to use the least-cost method of production in that industry. In that case, the cost-minimizing production technology still exists, but it is not being used. As a result, automobile production declines below the maximum amount possible for that level of computer production, and the economy moves from point W to point X. Notice that resources are still fully employed at point X in this example. The reader should consider how similar failures to use the least-cost methods of production may lead to movements from point W to points Y or Z. Finally, such movements inside the PPF may involve a combination of the failure to fully employ society’s resources and the failure to use the cost-minimizing production technology.
Another possible change worth considering involves a change in the amount of resources available to society. Suppose that the economy acquires additional stocks of land, labor, or capital. In that case, it will be possible to increase the production of both goods beyond combinations available on the PPF. The entire PPF will shift outwards in that case, and society will be able to produce more of both goods. Such an expansion of society’s production capabilities is referred to as economic growth. This case is represented in the graph on the right in Figure 2.5. Similarly, a loss of resource stocks due to war, population decline, or sale will lead to an economiccontraction, or an inward shift of the PPF. The reason the PPF shifts inward in this case is that the resources themselves have been lost. This loss of resources is very different from the unemployment of existing resources. In the latter case, the resources still exist, but they are not employed. In the former case, the resources are no longer available at all and so society’s production possibilities have changed.
Outward and inward shifts of the PPF may also result from a change in the existing state of technological knowledge. If society discovers new production technologies then it will be possible to produce production combinations that are beyond the initial PPF. That is, greater production of both goods becomes possible and economic growth occurs. On the other hand, a loss of production technology would lead to an economic contraction and an inward shift of the PPF. A loss of production technology may not seem like a very likely scenario, but it can occur if, for example, skilled workers begin to lose their skills due to long spells of unemployment. In this case, the knowledge of how to produce is lost, which is a very different scenario than the situation mentioned previously involving a failure to use the best available production technology.
Applications of the Production Possibilities Model
We now have all the tools necessary to apply the production possibilities model to concrete situations. For example, consider the case of U.S. economic growth during the twentieth century. A number of factors led to the rapid expansion of the U.S. economy during that period, including population growth, growth of the nation’s capital stock, and technological change. This situation is depicted in the graph on the right in Figure 2.5. Economic historians generally agree that, even though each of these factors contributed to the growth of the U.S. economy, technological change had the greatest impact and made possible the large increase in living standards that occurred during this period.
Another application involves the role of investment in the economy. The reader should recall that investment refers to the growth of the capital stock through time. To explore the implications of an increase in investment, we might begin by treating capital goods and consumer goods as our two goods in the production possibilities model. This approach departs a bit from our earlier presentation in that capital goods are simultaneously treated as a produced good and as a resource. Figure 2.6 shows an example of two different economies that have capital goods and consumer goods as their produced outputs.
It is also possible that one industry experiences economic growth while another industry experiences economic contraction. This situation is depicted in Figure 2.8.
At the same time, the loss of oil resources led to a contraction of production possibilities in the Middle East, particularly because a large amount of the petrodollars received were not used to obtain more resources or improved technology. Instead, as Figure 2.9 shows, the dollars were recycled through the purchase of U.S. financial assets. Additionally, U.S. banks loaned the petrodollars to Latin American nations, including Mexico, Brazil, and Argentina. These funds were badly needed due to high oil prices, but they were also used for an expansion of these nations’ production possibilities, as shown in Figure 2.9. Once interest rates began to rise in the early 1980s in the United States, however, the burden of the rising debt became too great for these Latin American nations. Mexico defaulted on its debt in 1982. The ensuing panic led U.S. banks to restrict their lending to Latin American nations. The consequence was a sharp rise in unemployment, stagnant economic growth, and falling incomes. The economic boom in Latin America represented in the movement from D to E in Figure 2.9 was followed by a bust as represented in the movement from E to F. Because this process appeared to benefit the United States at the expense of Latin American nations, many critics have accused the U.S. of developing a neocolonial relationship with these nations.[13]
The Neoclassical Classification Scheme for Economic Systems
Even though the production possibilities model is a completely general model in that it may be applied to any economic system, neoclassical economists are primarily interested in understanding how market capitalist economies function. To better understand the differences between alternative economic systems, we will consider the neoclassical classification scheme for economic systems in this section.
According to neoclassical economists, economic systems have two primary elements.[14] The first element is the form of property ownership. Property ownership may take different forms, but the two forms that neoclassical economists consider to be the worthiest of our attention are private ownership and state ownership. Private ownership refers to ownership of the means of production and land by private citizens whereas state ownership refers to ownership of means of production and land by the government. The second element is the allocation mechanism that is used to allocate resources and to distribute goods and services. Different allocation mechanisms exist as well, but the two types that neoclassical economists consider to be the worthiest of our attention are market allocation and centrally planned allocation. Market allocation refers to the allocation of resources and the distribution of goods and services by means of markets. That is, resources and goods are transferred from buyers to sellers in the competitive marketplace where prices for these items are established by the free interaction of economic agents. Centrally planned allocation, on the other hand, involves the allocation of resources and the distribution of goods and services according to a central plan developed by government officials.
Because two forms of property ownership and two types of allocation mechanism have been identified, it is possible to name four possible economic systems based on how we mix and match these different elements. Figure 2.10 reveals that the neoclassical classification scheme gives rise to two types of market systems and two types of command systems.
Market capitalism is the economic system that combines private ownership of the means of production and land with market allocation of resources and goods and services. Presently, most of the nations on Earth are either market capitalist economies, or they are in the process of transition towards market capitalist economies. The United States, Japan, Germany, the United Kingdom, Canada, Mexico, and so on, can all be regarded as market capitalist economies.
Not long ago, however, the defenders of market capitalism were engaged in a bitter dispute with the defenders of command socialism. In fact, these two economic systems were in direct competition with one another during the Cold War which ended with the dissolution of the Soviet Union in 1991. Command socialism merges state ownership of land and the means of production with a centrally planned allocation of resources. During the Cold War, many nations could be regarded as possessing command socialist economies, including the Soviet Union, the People’s Republic of China, Cuba, and many other nations. Today, only Cuba and North Korea possess economies based on the traditional command socialist model.
Private ownership and market allocation frequently have been linked in an historical sense. Similarly, state ownership and the central allocation of resources have been linked throughout history. Figure 2.10 reveals, however, that two other economic systems are theoretically possible using this classification scheme. These hybrid forms or cross forms, as they are called, have existed historically, but they are much less common than market capitalism and command socialism.[15]
One of the hybrid forms is market socialism, which combines state ownership of the means of production and land with the market allocation of resources. Probably the best-known example of a market socialist economy is that of Yugoslavia from the early 1950s until the early 1980s. The Yugoslav economy was based on worker-managed enterprises that were “socially owned,” but these enterprises operated in competitive markets.[16] The fact that Yugoslavia pursued a path that sharply deviated from the one Stalin wished to see coincided with considerable tension between the Yugoslav leadership and the Soviet leader.[17] In the 1980s, the economic system began to unravel due to ethnic and religious warfare that ultimately led to the fragmentation of the nation.[18]
People often believe Sweden and other Scandinavian economies to be market socialist economies. This view is incorrect, however, if we rely on the neoclassical classification scheme. Sweden, for example, is characterized mainly by the market allocation of resources and goods as well as private ownership of land and the means of production. What leads many people to assume that Sweden is market socialist is that the government also engages in a significant amount of income redistribution. With high tax rates and extensive government programs to provide job training and income security, people regard it as socialist. Because the element of state ownership is not dominant, however, it cannot be correctly regarded as socialist using our schema. On the other hand, Sweden is sometimes regarded as a social market economy.[19] A social market economy is a market capitalist economy that is characterized by extensive income redistribution and a social safety net.[20] Sweden as well as other nations like it may, therefore, be correctly regarded as a special kind of market capitalist economy.
The second hybrid form is command capitalism. This economic system combines central planning and private ownership of the means of production and land. This economic system has existed at times, mainly during periods of wartime. The best-known example of a command capitalist economy is Nazi Germany.[21] Nazi Germany was characterized by the private ownership of the means of production, but government planning was used to direct the flow of resources to support the war effort. Major industrial producers, like Krupp, were privately owned and the profits from production were collected by the owners.[22] At the same time, they were not free to set production levels but instead accepted the orders of government officials.[23] Interestingly, the U.S. economy possessed significant elements of command capitalism during World War II.[24] Major American producers continued to be privately owned but wartime boards set production levels and prices to ensure victory in the war.
Of course, any given society will possess elements of both types of property ownership and both kinds of allocation mechanism. In other words, all economies are mixed economies to some degree, and we should not expect to observe any economic system in its pure form.[25] Which type of property ownership dominates and which type of allocation mechanism dominates in that society will determine how we choose to classify it using the classification scheme given here.
Now that we have a method of classifying different economic systems, we might ask whether any of these economic systems will achieve economic efficiency. In other words, we know that the ideal society according to neoclassical theory is the one that achieves economic efficiency, but which economic system is most likely to generate this outcome? If we can answer that question, then we will have a much clearer idea of what neoclassical economists regard as the good society, which is the main concern of this chapter. It turns out that neoclassical economists argue that market capitalism is the one economic system that can generate economic efficiency. That is, competition within markets between buyers and sellers of privately owned property will automatically lead, as if by an invisible hand, to the economically efficient outcome. The economy will end up both on the PPF and at the optimal point on the PPF accounting for societal preferences, as represented by point A in Figure 2.11.
Unfortunately, the reader must wait for a complete explanation as to how market capitalism achieves this result. The neoclassical demonstration of this claim will be explored in detail in chapters 3 and 8.
Before leaving this subject, however, it might be worth mentioning that the widespread use of money in market capitalist societies is an important reason why neoclassical economists argue that such societies achieve economic efficiency. The use of money promotes efficiency because it solves a serious problem that exists in barter economies called the double coincidence of wants problem. Barter economies are economies in which goods are directly traded for one another without the mediating role of money to facilitate exchange. For example, suppose that Dave has 2 cows that he wishes to exchange for so many desks. In the absence of money, to successfully carry out this exchange, Dave must find someone who is willing to sell desks, but that same person must want to purchase cows. Hence, a double coincidence of wants problem exists in this case. That is, Dave must find a person willing to sell desks and that person must be willing to buy cows. If Dave finds such a person, then the price of the two cows in terms of desks must be negotiated as well. If money is present, on the other hand, then Dave only needs to sell his cows for money, and then he can use the money to buy desks from a seller of desks. Of course, the price of each good must still be negotiated, but it is no longer necessary that the seller of desks also be the buyer of cows. The double coincidence of wants problem is thus solved as soon as money enters the picture.
Money thus promotes efficiency because it reduces transaction costs, which are the costs associated with carrying out an exchange. Transaction costs are much higher in a barter economy than in a monetary economy because the time spent searching for a buyer who is simultaneously a seller is rather great in a barter economy. Furthermore, because money reduces transaction costs, it encourages people to rely more heavily on exchange to meet their needs. As a result, people are encouraged to specialize more than they otherwise would. Specialization increases efficiency, and so money promotes efficiency in this way as well.
A Marxian Classification Scheme for Social Formations
Before closing this chapter, we might consider an alternative to the neoclassical classification scheme for economic systems. Marxian economists use very different language to differentiate between economic systems. Even when the language overlaps, Marxists understand similar sounding economic systems in very different ways from their neoclassical counterparts.
To begin, Marxian economists generally refer to social formations rather than economic systems. The concept of a social formation is a very broad concept that has two major components. The first component is the economic base or mode of production. All the economic processes in society comprise the economic base. These processes relate specifically to how production is carried out and by whom. The second component is the socialsuperstructure. The social superstructure consists of all the political, religious, cultural, and familial processes that reflect the underlying economic base.
Marxian economists recognize that the economic base and the social superstructure may each influence the other. For example, changes in the methods of production employed might influence political decision makers. Similarly, changes in religious beliefs and customs might influence how production is carried out. Although Marxian economists recognize multi-directional causality in their analyses of these concepts, traditionally they have given the greatest attention to the economic base. As Richard Wolff and Stephen Resnick argue, a twofold reason exists for this emphasis on the economic base and the conflict-ridden class relationships that often characterize it.[26] First, Marxists assert that class conflict is a greatly under-theorized aspect of human society. As a result, Marxists have frequently striven to place it at the center of their economic analyses. Second, Marxists believe that the neglect of class relationships in economic analysis has served as a barrier to the construction of an alternative society capable of eliminating class conflict. As a result, Marxian analyses often appear to give greater causal weight to the economic base even though this appearance stems primarily from a desire to call attention to the role of economic processes and class conflict in our society.
The economic base or mode of production also consists of two key parts. First, the social forces of production refer to the entire stock of accumulated knowledge of how to produce. All the production techniques, scientific expertise, and engineering capabilities of members of society fall into this category. The second major feature that defines a mode of production is the social relations of production. The social relations of production refer to all the patterns of interaction that exist between producers within a given society. One major difference that exists between modes of production is the presence or absence of class exploitation. Whenever a class other than the direct producers appropriates and distributes the products of the direct producers, then that mode of production is considered exploitative.[27]
Using the two key components of a mode of production, Marxian economists differentiate between several different modes of production.[28] The primitive communist mode of production consists of rather primitive social forces of production, including primarily hunting and gathering techniques. The social relations of production in the primitive communist mode of production involve production within relatively small familial or tribal groups that own the land and means of production in common. This kind of society does not involve class exploitation because not enough wealth is produced to create class distinctions and conflict.
The social forces of production in the slave-based mode of production consist mainly of agricultural production techniques. The social relations of production in the slave-based mode of production involve primarily the master/slave relationship. A small class of masters owns the land and means of production as well as a much larger class of slaves. The slaves carry on agricultural production, and the products that the slaves produce are appropriated and distributed by the master class. Because the production that occurs in slave societies is appropriated and distributed by someone other than the direct producers, slave-based forms of society are definitely exploitative.
The social forces of production in the feudal mode of production consist mainly of agricultural production methods as well. The social relations of production in the feudal mode of production involve primarily the lord/serf relationship. A small class of feudal lords within this mode of production employs a much larger class of serfs to work the land. The serfs are not exactly slaves, but they are not free either. Instead, serfs within the feudal mode of production are bound to the land by tradition, custom, and religious belief. The social hierarchy is accepted as part of the natural order. The serfs view it as their right to work the land by handing over a portion of their produce to the lord, and the lord views it as his right to appropriate and distribute this production. In return, the feudal lord provides the serfs with protection from hostile, outside forces. The feudal mode of production is also exploitative in nature because the direct producers do not directly appropriate and distribute the fruits of their labor.
The capitalist mode of production has been the mode of production of greatest interest to Marxian economists much as market capitalism has been the economic system of greatest interest to neoclassical economists. The social forces of production within the capitalist mode of production include large-scale machinery and mass production techniques employed within factories and large production plants. The social relations of production, on the other hand, involve production by a large class of wage laborers and the appropriation and distribution of their products by a small class of capitalists who employ them. The wage laborers are not slaves because the capitalists do not own them in the way that masters own slaves. Nevertheless, Marxian economists regard this mode of production as exploitative because the wage laborers do not appropriate or distribute the products of their labor. Instead, capitalists appropriate and distribute the products of wage workers because they own the means of production and the land.
The socialist mode of production is another mode of production of great interest to Marxian economists. According to Marxian economists, this mode of production will only come into being due to a revolutionary upheaval that abolishes capitalism and the distinction between capital and wage labor. Because this mode of production has not yet replaced capitalism, our description of it is based mostly on conjecture. Nevertheless, the social forces of production within the socialist mode of production are likely to include large-scale machinery and mass production techniques within complex enterprises. The social relations of production, on the other hand, will likely involve direct control of production enterprises by the direct producers. The direct producers will most likely own these enterprises in common, and compensation within enterprises will be linked directly to the duration and intensity of the work performed. The socialist mode of production is not exploitative because class distinctions will be abolished, and the direct producers will appropriate and distribute the fruits of their own labor.
The communist mode of production is another mode of production that has not yet come into existence. For Marxian economists, it represents the most advanced form of human society in which human beings have entered a harmonious relationship with nature. The communist mode production thus marks the end of history in the sense that the class struggle that underlies humanity’s current economic problems permanently ends. Although the socialist mode of production abolishes the class struggle, some remnants of the capitalist mode of production will persist within the socialist mode of production. For example, only with the transition to the communist mode of production will compensation according to work performed be replaced with compensation according to need. This difference in compensation, which marks a difference in the social relations of production, is the primary difference between the socialist and communist modes of production. Otherwise, Marxian economists expect the two modes of production to be quite similar.
Figure 2.12 summarizes the differences between the modes of production that have been discussed in this section.
Marxian economists have identified other modes of production that are interesting, including the ancient mode of production and the Asiatic mode of production. The main purpose here is to introduce the reader to an alternative classification scheme for social formations (or modes of production to be more precise). These terms will be used repeatedly throughout the book and so it will be helpful to have a firm grasp on them moving forward.
Following the Economic News [29]
In an opinion piece that appeared in the Ottawa Citizen, Christine McAllister analyzes the potential impact on the city budget of fare-free public transit. McAllister recognizes the great benefits of a public transportation system, including greater accessibility to transportation, reduced traffic congestion, and environmental benefits. In an interesting play on words, McAllister notes, however, that “no such thing as a free bus” exists. Neoclassical economists are fond of reminding non-economists that “no such thing as a free lunch” exists because everything we desire has a cost associated with it even if the user does not pay a monetary price for the product or service. In this case, the $3 billion budget for the City of Ottawa will need to involve reallocations of expenditure away from some important priorities to fund a massive expansion of the public transportation system. The budgetary shift might involve cutting back on “affordable housing, better city services, or fighting climate change.” If expenditure is not reallocated, then tax increases can be adopted to fund the expansion of the public transit system. McAllister asserts that funding for the$200 million project will require an increase in property taxes of \$500 for each household in the city. Therefore, the tradeoff between fare-free public transit and other economic priorities remains. That is, households will purchase fewer commodities so that they can pay the taxes to finance the expansion of the transportation system. The harsh reality of opportunity cost cannot be avoided, and difficult decisions must be made. McAllister argues that the tradeoffs involved in such budget proposals must be clearly demonstrated and that planning must take these tradeoffs into account. As a candidate for City Council, McAllister draws upon fundamental principles of neoclassical economics to warn citizens about the potential costs of fare-free transit.
Summary of Key Points
1. Throughout history many different views of the good society have been put forward including, but not limited to, the Platonic, Christian, Hindu, Muslim, Marxist, Randian, and neoclassical perspectives.
2. The neoclassical economic problem facing all human societies is how to transform scarce resources into goods and services to satisfy unlimited economic wants.
3. Land, labor, and capital are the three major resource categories in neoclassical economic theory.
4. Stock variables are measured as of a point in time and flow variables are measured per unit of time.
5. The neoclassical ideal of economic efficiency requires full employment of resources, productive efficiency, and allocative efficiency.
6. The production possibilities model offers a graphical representation of the economic problem and the conditions for economic efficiency.
7. The production possibilities model reveals that all societies incur opportunity costs and increasing opportunity costs due to the presence of heterogeneous resources.
8. Society achieves allocative efficiency when it equates the marginal benefit and the marginal cost of the last unit produced of each good or when net marginal gain is zero for each good.
9. When resources are unemployed or the cost-minimizing technology is not used, society moves inside its PPF. When resource stocks or the available technology changes, however, the PPF itself shifts.
10. The form of property ownership and the allocation mechanism determine the type of economic system a society possesses in neoclassical economic theory.
11. In Marxian economic theory, a social formation depends on the mode of production and the social superstructure. The mode of production, in turn, depends on the social forces of production and the social relations of production.
List of Key Terms
Theocratic governments
Economic problem
Resources (factors of production or inputs)
Technology
Wants
Land
Capital
Financial capital
Investment
Stock variable
Flow variable
Wealth
Income
Labor
Economic efficiency
Full employment
Static efficiency
Dynamic efficiency
Productive efficiency
Allocative efficiency
Production possibilities model
Production possibilities schedule
Production possibilities frontier (PPF)
Tradeoffs
Opportunity costs
Total opportunity cost
Marginal opportunity cost
Law of increasing opportunity cost
Heterogeneous resources
Homogeneous resources
Law of diminishing returns
Cost-benefit analysis
Marginal cost (MC)
Marginal benefit (MB)
Diminishing marginal benefit of consumption
Increasing marginal cost of production
Net marginal gain
Economic growth
Economic contraction
Unbalanced growth
Unbalanced contraction
Form of property ownership
Private ownership
State ownership
Allocation mechanisms
Market allocation
Centrally planned allocation
Market capitalism
Command socialism
Hybrid forms
Cross forms
Market socialism
Social market economy
Command capitalism
Mixed economies
Barter economies
Double coincidence of wants problem
Transaction costs
Social formations
Economic base (or mode of production)
Social superstructure
Social forces of production
Social relations of production
Class exploitation
Primitive communist mode of production
Slave-based mode of production
Feudal mode of production
Capitalist mode of production
Socialist mode of production
Communist mode of production
Problems for Review
1. Suppose society’s production possibilities table and PPF are the ones shown in Figure 2.13. Answer the following questions:
• What is the total opportunity cost of producing 360 pizzas?
• What is the total opportunity cost of producing 900 burgers?
• What is the marginal opportunity cost of increasing pizza production from 120 to 240 pizzas?
• What is the marginal opportunity cost of increasing burger production from 400 to 700 burgers?
• What is the marginal opportunity cost of the 480th pizza?
• What is the marginal opportunity cost of the 700th burger?
• What is the marginal opportunity cost of producing the 900th burger?
• Considering your answers to the previous two questions, what happens to the marginal opportunity cost of producing burgers when burger production rises from 700 to 900 burgers? How would a neoclassical economist answer this question?
2. Using the graph and the table in Figure 2.14, can you fill in the missing pieces of information that are marked with a question mark?
Explain the meaning of each number that you fill in as well as the significance of this row in the table.
1. For a nice summary of Gandhi’s economic perspective, see Rosser and Rosser (2004), p. 90-91.
2. Ibid. p. 467.
3. Ibid. p. 94.
4. Ibid. 95.
5. Ibid. 95.
6. Ibid. 100-105. Rosser and Rosser provide a detailed overview of these Islamic economic principles.
7. See Rand (1966).
8. The reader should notice the emphasis on the neoclassical entry point in this statement of the economic problem. That is, given resources, given technology, and given wants or preferences are assigned a central place.
9. McConnell and Brue (1996), p. 25, postpone discussion of allocative efficiency until the details of the model are developed.
10. The use of the total opportunity cost and marginal opportunity cost measures may be found in McConnell and Brue’s earlier editions. For example, see McConnell and Brue (1996). p. 26.
11. OpenStax College (2014), p. 36, asserts that the controversial nature of this question makes it a relevant question for sociologists, philosophers, and political scientists.
12. See Bade and Parkin (2013), p. 141-144, for one example of how this method is used to arrive at the allocatively efficient quantities of the two commodities.
13. For an overview of these issues and an explanation of how the debt crisis eliminated social welfare gains in the debtor countries, see Carrasco (2011).
14. Rosser and Rosser (2004), p. 6, identify six dimensions but agree that these two dimensions are the most important ones.
15. Ibid. p. 8. Rosser and Rosser also identify these four commonly recognized types of economic system.
16. Ibid. p. 389-390.
17. Ibid. p. 397.
18. Ibid. p. 389-390.
19. Ibid. p. 203.
20. Ibid. p. 203.
21. Ibid. p. 9.
22. Ibid. p. 9.
23. Ibid. p. 9.
24. Ibid. p. 9
25. Ibid. p. 9.
26. Wolff and Resnick (2012), p. 47.
27. Ibid. p. 27.
28. Ibid. p. 160-163. Wolff and Resnick describe these different modes of production as different forms of the fundamental class process.
29. McAllister, Christine. “There’s no such thing as a free (bus); Transit comes with cost tradeoffs, says candidate Christine McAllister.” Ottawa Citizen. Early Edition. 15 Oct. 2018. | textbooks/socialsci/Economics/Principles_of_Political_Economy_-_A_Pluralistic_Approach_to_Economic_Theory_(Saros)/01%3A_An_Introduction_to_Economic_Theory/02%3A_What_is_a_Good_Society%3F.txt |
Goals and Objectives:
In this chapter, we will do the following:
1. Describe the neoclassical circular flow model
2. Define supply, demand, and equilibrium
3. Analyze changes in equilibrium market outcomes
4. Learn how to apply the supply and demand model to actual events
5. Define and calculate the neoclassical measure of social welfare
6. Investigate situations in which markets fail to produce desirable results
The Neoclassical Circular Flow Model
Because neoclassical economists are primarily interested in understanding and defending market capitalist systems, they require a basic model that describes how the various parts of such economies are linked together. The neoclassical circular flow model achieves this goal. To understand this model, it is first necessary to define more carefully what we mean by a market. People often use the term to refer to a physical location where buying and selling occurs. For example, people will speak of “going to the market.” Our definition of a market is much broader. It does refer to a coming together of buyers and sellers of a common good, service, or asset, but the buyers and sellers need not meet face to face. What is important is that they interact in some way through purchases and sales of a common item of exchange. For example, buyers and sellers may be spread out across the globe, interacting by computer only. Despite the distance between them, they participate in a market.
Given this definition of a market, we now turn to the neoclassical circular flow model represented in Figure 3.1.
As Figure 3.1 shows, the business sector and the household sector are linked together as a result of their interaction in two broad categories of markets. The first type of market is the resource market. Households own resources (or factors of production or inputs) that they sell to businesses. These resources include land, labor, and capital and so the major types of resource markets are the land, labor, and capital markets. The businesses use these resources to produce goods and services. In exchange for the resources, the businesses make factor payments to the households, which the households receive as factor income. For example, the payment for land generates rental income, the payment for labor generates wage income, and the payment for capital generates interest and profit income. The households use their factor income to purchase the goods and services that their resources produced in the second type of market referred to as the product market. The firms receive as revenue the consumer expenditure of the households.
Several important points need to be made about the circular flow model represented here. First, it should be noted that “real quantities” (i.e., resources and goods and services) flow in one direction in the diagram, and “nominal quantities” (i.e., dollar amounts) flow in the opposite direction.
Second, the model suggests that market economies are characterized by a strong element of social harmony. That is, buyers and sellers of resources and goods and services come together peacefully. Each gives up something he or she wants less than the thing obtained in exchange. Each market participant ends up better off at the end of each exchange than at the beginning. This world is the world of Adam Smith’s Invisible Hand in which self-interested individuals are guided as if by an invisible hand to promote the social interest. The process will continue indefinitely as long as buyers and sellers are allowed to interact freely in the marketplace.
Third, it is easy to be misled by the diagram into believing that market economies possess a rigid class structure. That is, one might interpret the model to mean that business owners confront members of households in the markets. In fact, the entire population is represented in the household sector. Remember, the household sector includes all resource owners, including the owners of land, labor, and capital. Even a person who owns no capital or land still owns his or her own labor, even if it is unskilled labor.
Who then, is included in the business sector? The answer is that any members of the household sector may decide to start up businesses. They simply enter the resource markets and purchase resources from other resource owners. They then establish businesses and sell the finished goods and services to other members of the household sector. Business owners sell goods and services, but they also purchase goods and services for their own consumption as members of the household sector. Similarly, they purchase resources as business owners, but they may even sell their resources in the resource markets as members of the household sector. If they use their own resources to establish their businesses, then they need not sell to themselves although they will expect to receive enough revenue to compensate themselves for the use of these self-owned resources. The important point here is that the owners of businesses need not be owners of capital or land who then purchase labor. They may just as easily be owners of labor who purchase capital and land. In other words, no resource owner has a privileged position within the economic system. As Paul Samuelson famously remarked, in a perfectly competitive market, it does not matter whether capital hires labor or labor hires capital.[1] Therefore, no class structure exists, and no class conflict is inherent in the model.
The Buyers’ Side of the Market
Now that we have a detailed overview of the interconnections that exist within a market economy, we can begin to analyze the neoclassical theory of how markets function. The neoclassical theory of supply and demand has three parts: market demand, market supply, and marketequilibrium. Its purpose is to explain the two major outcomes of market competition: the price of the good, service or asset and the quantity exchanged of it. Before we combine the three parts of the model to show how they explain these two market outcomes, it will be helpful to provide a general overview of the method employed in the construction of the model. The method used is called methodological individualism. According to this approach, all social and economic outcomes are explained using individual actions. In terms of the supply and demand model, the starting point is individual buyers and individual sellers. Their actions are used to obtain the individual demands of the buyers and the individual supplies of the sellers. The individual demands are then aggregated (or summed up) to obtain market demand and the individual supplies are aggregated to obtain market supply. Finally, market demand and market supply are brought together to determine the market price and the market quantity exchanged. All these linkages are captured in Figure 3.2.
We will begin with the buyers’ side of the market first and discuss individual demand. The individual demand for a good is the amount of a good that a buyer is willing and able to buy at each price during a given period. It is important to note that both willingness and ability to pay are central to the definition of demand. If an individual lacks the dollars to back up his or her willingness to pay, then his or her preferences do not count in the marketplace. Furthermore, according to neoclassical economists, all consumers are subject to an economic law known as the law of demand. The law of demand states the following:
Other things equal, a reduction in price causes the quantity demanded of a good to rise, and a rise in price causes the quantity demanded of a good to fall.
In other words, price and quantity demanded are inversely related, ceteris paribus. This negative relationship can be represented symbolically as follows:[2]
$-\Delta P\Rightarrow +\Delta Q_{D},\;ceteris\;paribus$
$+\Delta P\Rightarrow -\Delta Q_{D},\;ceteris\;paribus$ We represent the individual demand for a good using an individual demand schedule and an individual demand curve, as shown in Figure 3.3.
The individual demand schedule shows clearly that the quantity demanded of apples (measured in pounds) per month rises as the price per pound of apples falls and vice versa. When the combinations of price and quantity demanded are plotted, we obtain a downward sloping individual demand curve. The downward slope implies that an inverse relationship exists between price and quantity demanded (i.e., that the law of demand holds).
At this stage, we have simply assumed that the law of demand holds, but it is important to understand why it is expected to hold. Neoclassical economists identify two reasons that we typically expect the individual demand curve to slope downwards:
1. As the price of apples declines, the consumer substitutes away from relatively higher priced goods, like bananas, and towards apples. This movement is known as the substitution effect. We might say that the consumer’s willingness to purchase apples has increased because it is relatively cheaper.
2. As the price of apples declines, the consumer feels that his or her purchasing power has increased and so he or she decides to purchase more of all goods, including apples. This movement is known as the income effect. We might say that the consumer’s ability to purchase apples has increased because his or her purchasing power has risen.
It is now possible to move from individual demand to market demand. Market demand refers to the quantity of a good that all buyers in a market are willing and able to purchase at each possible price during a given period. To obtain market demand, we must aggregate the individual demands of all individual buyers in the market. In terms of the individual demand schedules, we simply sum up the individual quantities demanded at each price to obtain the market quantity demanded at each price, as shown in Figure 3.4.
Graphically, this method of aggregation requires the summation of the horizontal distances from the vertical axis to the individual demand curve in each graph. For this reason, the method is referred to as horizontal summation. In Figure 3.5, this method is used to show the market quantity demanded at a price of $1.50. The other points on the market demand curve would be obtained in a similar fashion beginning with different prices. Now that we have obtained the market demand curve, it is time to introduce a key terminological distinction in the discussion of demand. Neoclassical economists distinguish between a change in quantity demanded and a change in demand. Figure 3.6 shows the downward sloping market demand curve for apples. As the price falls from$2.00 per lb. to $1.50 per lb., the quantity demanded of apples rises from 9 lbs. to 17 lbs. per month. Such movements along the demand curve are referred to as changes in quantity demanded. In this case, the quantity demanded increases due to a price reduction. The quantity demanded also decreases when the price rises. It is important to note that the only factor that can cause a change in quantity demanded is a price change. In the case of the market demand curve, the price is the independent variable and the quantity demanded is the dependent variable. That is, the quantity demanded depends on the price. In mathematical terms, it is said that the quantity demanded is a function of the price of apples. That is: $Q_{D}=f(P)$ Up until this point, we have acted as though the quantity demanded of a good depends only on the price charged for the good. Other factors are important to consumers as well, however, when they consider how much of a good to purchase. It is here that we begin to grasp the importance of the ceteris paribus assumption in the statement of the law of demand. The negative relationship between price and quantity demanded assumes that all other factors are held constant. If other factors change in addition to price, then this negative relationship may not hold. As a result, neoclassical economists assume that other factors are constant when tracing the demand curve. Nevertheless, neoclassical economists want to consider the possibility that other factors may change. These non-price determinants of demand include the following factors: 1. Consumer preferences or tastes 2. The number of buyers in the market 3. Consumers’ incomes 4. The prices of related goods 5. Consumer expectations about future prices This list of factors implies that the quantity demanded of a product is a function of the good’s own price as well as all these other variables. That is: $Q_{D}=f(own\;price,\;\overline{preferences},\;\overline{number\;of\;buyers},\;\overline{incomes},\;\overline{prices\;of\;related\;goods},\;\overline{expectations})$ The overbars indicate that these variables are held constant so that we can focus exclusively on the relationship between price and quantity demanded. When these variables change, however, the quantity demanded will be affected at every price. For example, Figure 3.7 shows what happens as Halloween approaches and the number of buyers in the market for apples increases. The quantity demanded of apples at a price of$2/lb. rises from 9 lbs. per month to 26 lbs. per month. Similar increases in the quantity demanded occur at every possible price. As a result, the entire demand curve shifts to the right. Neoclassical economists refer to such a shift as an increase in demand (as opposed to an increase in quantity demanded). After Halloween, we might expect the quantity demanded of apples to fall at every price and the demand curve might shift to the left, back to its original position. Such a shift is referred to as a decrease in demand.
It is now possible to identify how changes in each of the non-price determinants of demand influence the demand curve. The case of a change in consumer preferences has already been discussed above in the context of a rise in the demand for apples:
Consumer preferences or tastes:
• A strengthening of preference $\Rightarrow$ An increase in demand
• A weakening of preference $\Rightarrow$ A decrease in demand
If more buyers enter a market, then the demand will also increase simply because it becomes necessary to aggregate a larger number of individual demands. If buyers exit the market, then fewer individual demands are aggregated and demand will decline.
The number of buyers in the market:
• An increase in the number of buyers $\Rightarrow$ An increase in demand
• A decrease in the number of buyers $\Rightarrow$ A decrease in demand
How changes in consumers’ incomes affect demand depends on how consumers perceive the good in question. The demands of many goods are positively related to income. If consumers experience a rise in their incomes, they demand more of the good. If consumers experience a reduction in their incomes, they demand less of the good. These goods are called normal goods. The demands of some goods, however, are negatively related to income. When consumers experience a rise in their incomes, they demand less of the good. When consumers experience a drop in their incomes, they demand more of the good. These goods are called inferior goods. The reader might wonder why a consumer would purchase more of a good as his or her income falls. Examples of inferior goods include used goods and generic goods. As consumers experience a fall in their incomes, they substitute away from new goods and brand name products and instead purchase used goods and generic products. Hence, we have the following results:
Consumers’ incomes:
• An increase in the incomes of consumers of a normal good $\Rightarrow$ An increase in demand
• A decrease in the incomes of consumers of a normal good $\Rightarrow$ A decrease in demand
• An increase in the incomes of consumers of an inferior good $\Rightarrow$ A decrease in demand
• A decrease in the incomes of consumers of an inferior good $\Rightarrow$ An increase in demand
Figure 3.8 shows how the market demand curves of normal and inferior goods are affected differently when incomes increase.
Changes in the prices of related goods may also cause changes in the demand for a good. If the price of a substitute for good A increases, for example, the demand for good A will rise, other things held constant. The reason is that consumers will substitute towards good A because it is now relatively cheaper. If the price of the substitute falls, then the demand for good A will fall as consumers substitute away from good A. For example, if the price of tea rises, we might expect the demand for coffee to rise as consumers switch from tea to coffee.
Alternatively, two goods may be complements in the sense that they are consumed together. If the price of a complement to good B increases, for example, then we would expect the demand for good B to fall, other things equal. If the price of a complement to good B falls, on the other hand, then we would expect the demand for good B to rise, other things equal. For example, if the price of peanut butter rises, then the demand for jelly will probably fall, other things equal. These results are summarized below:
Prices of related goods:
• An increase in the price of a substitute $\Rightarrow$ An increase in demand
• A decrease in the price of a substitute $\Rightarrow$ A decrease in demand
• An increase in the price of a complement $\Rightarrow$ A decrease in demand
• A decrease in the price of a complement $\Rightarrow$ An increase in demand
Finally, if consumers expect the price of a good to increase soon, then they frequently increase their demand for the good because they want to purchase the good before its price rises. For example, if consumers expect the price of gasoline to rise during Memorial Day weekend, they might demand more gasoline the weekend before that holiday to avoid paying the higher price. Alternatively, if the price is expected to fall in the future, then current demand will decline as consumers postpone their purchases in anticipation of a lower future price.[3]
Consumer expectations:
• A rise in the expected price of gasoline $\Rightarrow$ An increase in demand
• A fall in the expected price of gasoline $\Rightarrow$ A reduction in demand
The Sellers’ Side of the Market
We now turn to the sellers’ side of the market and discuss individual supply. (The reader will most likely notice a great many similarities between this discussion and the discussion of the buyers’ side of the market!) The individual supply of a good is the amount of a good that a seller is willing and able to sell at each price during a given period. According to neoclassical economists, all sellers are subject to an economic law known as the law of supply. In particular, the law of supply states the following:
Other things equal, an increase in price causes the quantity supplied of a good to rise, and a decrease in price causes the quantity supplied of a good to fall.
In other words, price and quantity supplied are positively related, ceteris paribus. This positive relationship can be represented symbolically as follows:
$+\Delta P\Rightarrow +\Delta Q_{S},\;ceteris\;paribus$ $-\Delta P\Rightarrow -\Delta Q_{S},\;ceteris\;paribus$ We represent the individual supply of a good using an individual supply schedule and an individual supply curve, as shown in Figure 3.9.
The individual supply schedule shows clearly that the quantity supplied of apples (measured in pounds) per month rises as the price per pound of apples rises and vice versa. When the combinations of price and quantity supplied are plotted, we obtain an upward sloping individual supply curve. The upward slope implies that a positive relationship exists between price and quantity supplied (i.e., that the law of supply holds).
At this stage, we have simply assumed that the law of supply holds, but it is important to understand why it is expected to hold. Neoclassical economists identify two reasons that we typically expect the individual supply curve to slope upwards:
1. As a firm increases production, the expansion puts upward pressure on per unit cost due to the scarcity of the firm’s resources. The firm requires a higher price to cover the higher unit cost of production.
2. As the price rises, the firm finds it profitable to produce additional units of the product. It eventually stops due to the rising unit costs mentioned above.
It is now possible to move from individual supply to market supply. Market supply refers to the quantity of a good that all sellers in a market are willing and able to sell at each possible price during a given period. To obtain market supply, we must aggregate the individual supplies of all individual sellers in the market. Just as in the case of demand, we use the method of horizontal summation. Graphically, this method of aggregation requires the summation of the horizontal distances from the vertical axis to the individual supply curve in each graph. In Figure 3.10, this method is used to show the market quantity supplied at a price of $1.50. The other points on the market supply curve would be obtained in a similar fashion beginning with different prices. Now that we have obtained the market supply curve, it is time to reintroduce the key terminological distinction that arose in the discussion of demand. Neoclassical economists distinguish between a change in quantity supplied and a change in supply. Figure 3.11 shows the upward sloping market supply curve for apples. As the price rises from$1.50 per lb. to $2.00 per lb., the quantity supplied of apples rises from 16 lbs. to 23 lbs. per month. Such movements along the supply curve are referred to as changes in quantity supplied. In this case, the quantity supplied increases due to a price increase. The quantity supplied also decreases when the price decreases. It is important to note that the only factor that can cause a change in quantity supplied is a price change. In the case of the market supply curve, the price is the independent variable and the quantity supplied is the dependent variable. That is, the quantity supplied depends on the price. In mathematical terms, it is said that the quantity supplied is a function of the price of apples. That is: $Q_{S}=f(P)$ Up until this point, we have acted as though the quantity supplied of a good depends only on the price charged for the good. Other factors are important to sellers as well, however, when they consider how much of a good to sell. It is here that we should again recall the importance of the ceteris paribus assumption in the statement of the law of supply. The positive relationship between price and quantity supplied assumes that all other factors are held constant. If other factors change in addition to price, then this positive relationship may not hold. As a result, neoclassical economists assume that other factors are constant when tracing the supply curve. Nevertheless, neoclassical economists want to consider the possibility that other factors may change. These non-price determinants of supply include the following factors: 1. The number of sellers in the market 2. Factor prices 3. Production technology 4. Taxes and subsidies 5. The prices of related goods 6. The sellers’ expectations about future prices This list of factors implies that the quantity supplied of a product is a function of the good’s own price as well as all these other variables. That is: $Q_{S}=f(own\;price,\;\overline{factor\;prices},\;\overline{number\;of\;sellers},\;\overline{technology},\; \overline{taxes},\;\overline{subsidies},\;\overline{prices\;of\;related\;goods},\;\overline{expectations})$ The overbars indicate that these variables are held constant so that we can focus exclusively on the relationship between price and quantity supplied. When these variables change, however, the quantity supplied will be affected at every price. For example, Figure 3.12 shows what happens in late summer and fall when apples are in season and thus the number of sellers in the market for apples increases. The quantity supplied of apples at a price of$1.50/lb. rises from 16 lbs. per month to 22 lbs. per month. Similar increases in the quantity supplied occur at every possible price. As a result, the entire supply curve shifts to the right. Neoclassical economists refer to such a shift as an increase in supply (as opposed to an increase in quantity supplied). By late fall, we might expect the quantity supplied of apples to fall at every price and the supply curve might shift to the left, back to its original position. Such a shift is referred to as a decrease in supply.
It is now possible to identify how changes in each of the non-price determinants of supply influence the supply curve. The case of a change in the number of sellers has already been discussed above in the context of a rise in the supply of apples:
Number of sellers:
• An increase in the number of sellers $\Rightarrow$ An increase in supply
• A decrease in the number of sellers $\Rightarrow$ A decrease in supply
If factor prices change, then supply is affected. Factor prices (or resource prices or input prices) refer to the prices of land, labor, and capital. Specifically, if any of these factor prices rise causing rental payments, wage payments, or interest payments to rise, then firms will reduce their supply because their production costs have risen. Alternatively, if factor prices fall, then supply will rise because production costs are lower.
Factor prices:
• An increase in factor prices $\Rightarrow$ A decrease in supply
• A decrease in factor prices $\Rightarrow$ An increase in supply
Production technology is another important non-price determinant of supply. For example, when mass production methods were introduced in the automobile industry, production costs fell dramatically. Therefore, the supply of automobiles increased because firms could produce more at a given price. Although the implementation of an inferior technology is unlikely, it is theoretically possible and would lead to a reduction in supply as production costs rise.
Production technology:
• A technological advance $\Rightarrow$ An increase in supply
• The implementation of an inferior technology $\Rightarrow$ A decrease in supply
Changes in per unit taxes or subsidies on goods and services also influence product supply. For example, if the government increases the per unit tax on cigarettes, then production costs are higher and firms reduce the quantity supplied at every price. If the per unit tax on cigarettes falls, then firms increase their supply. Subsidies, on the other hand, have the opposite effect of taxes. Subsidies are cash payments that the government gives to sellers for each unit produced. If the government increases its subsidies for sellers, then production costs are effectively lower and product supply will rise. Alternatively, if the government cuts its subsidies to sellers, then product supply will fall.
Taxes and subsidies:
• An increase in taxes $\Rightarrow$ A decrease in supply
• A decrease in taxes $\Rightarrow$ An increase in supply
• An increase in subsidies $\Rightarrow$ An increase in supply
• A decrease in subsidies $\Rightarrow$ A decrease in supply
Prices of related goods sometimes also are important from the seller’s perspective. For example, if the same firms produce two different goods and each firm possesses a fixed amount of resources, then a change in the price of one good will affect the supply of the other good. For example, suppose that the same firms produce breath mints and chewing gum. If the price of breath mints increases, then it becomes relatively more profitable to produce breath mints, other factors held constant. Because firms possess fixed resources, they will reallocate resources towards breath mints and away from chewing gum. As a result, the supply of chewing gum decreases as shown in Figure 3.13.
Prices of related goods:
• An increase in the price of another good the firm produces $\Rightarrow$ A decrease in supply
• A decrease in the price of another good the firm produces $\Rightarrow$ An increase in supply
Finally, the expectations of producers about the future price may influence the supply of the product in a couple different ways.[4] For example, if the sellers expect the price to rise, then the sellers might expand supply now so that an increased quantity is present on the market when the price increase occurs. If they expect the price to fall, then supply might be reduced so that production is lower when the price decline occurs. On the other hand, a higher expected future price might lead sellers to store their current production and reduce supply. A lower expected future price might lead sellers to increase current supply so that they are able to sell before the price reduction.
Expectations about future prices:
• A rise in the expected price $\Rightarrow$ An increase in supply (current expansion)
• A fall in the expected price $\Rightarrow$ A reduction in supply (current contraction)
• A rise in the expected price $\Rightarrow$ A decrease in supply (expansion of inventories)
• A fall in the expected price $\Rightarrow$ An increase in supply (depletion of inventories)
Which outcome occurs depends on the circumstances related to the product. For example, durable goods can be stored for future sale whereas nondurable goods cannot be stored for long. Also, some price changes are expected soon whereas other price changes are expected in the distant future. The durability of the product and how soon the price change is expected are likely to interact to determine the impact on supply of an expected price change.
Equilibrium
We are almost to the point where we can combine the buyers’ side and the sellers’ side of the market to provide an explanation for the price and quantity exchanged of the product. Before we do so, we need to introduce a very important definition in neoclassical economics: equilibrium. The equilibrium concept is central to the theorizing of all neoclassical economists. Its definition is simple:
An equilibrium state refers to a state from which there is no inherent tendency to change.
To understand this definition, consider a non-economic example.[5] For example, imagine a bowl that has a marble resting on the edge. If the marble slips into the bowl, it will move down along the inside edge eventually reaching the bottom and then rising again along the opposite inside edge. From that point, it will slip back down again where it will reach the bottom and then rise again on the other side. This back and forth motion will continue until finally, the marble finds its position at the bottom of the bowl. Is this state an equilibrium state? Yes, it is. Notice that I can shake the bowl and cause the marble to move. Nevertheless, it is an equilibrium state because the marble has no inherent tendency to move from this point. In other words, the definition of equilibrium does not preclude the possibility that external shocks might cause a disruption.
Neoclassical economists argue that market prices and quantities exchanged reach equilibrium levels much like the marble in the example. How is such a thing possible? The answer becomes clear when we bring together market supply and market demand as shown in Figure 3.14.
To understand how the equilibrium price and quantity exchanged come about in this market, it is best to begin at a price that is not the equilibrium price. For example, suppose the price begins at $1.75 per unit. In that case, the quantity demanded is 0 units, but the quantity supplied is 18 units. Because sellers wish to sell 18 more units at this high price than buyers wish to buy, we say that an excess supply, or a surplus, of the good exists. Due to the surplus, sellers will feel pressure to cut price. Suppose that sellers cut the price to$1.50 per unit. As the price falls, the quantity demanded rises to 3 units due to the law of demand. Similarly, the quantity supplied falls to 15 units due to the law of supply. The result is a smaller surplus of 12 units (= 15 units – 3 units). The sellers will continue to feel pressure to cut price as long as a surplus exists. The reader should try to determine what the quantity demanded, the quantity supplied, and the surplus are at a price of $1.25 per unit. Now consider what happens if the price begins at$0.25 per unit. In that case, the quantity supplied is 0 units, but the quantity demanded is 18 units. Because buyers wish to purchase 18 more units than are currently supplied, an excess demand, or a shortage, of the good exists. Due to the shortage, sellers will feel that they can increase the price. Suppose the sellers increase the price to $0.50 per unit. The quantity supplied will then rise to 3 units, according to the law of supply. Similarly, the quantity demanded will fall to 15 units due to the law of demand. The result is a smaller shortage equal to 12 units (= 15 units – 3 units). The sellers will continue to raise price if a shortage exists. The reader should try to determine the quantity demanded, the quantity supplied, and the amount of the shortage when the price rises to$0.75 per unit.
In the case of a shortage, the price will continue to rise until the price reaches $1.00 per unit. At this point, the quantity demanded is 9 units and the quantity supplied is 9 units. Therefore, neither a shortage nor a surplus exists in the market. As a result, sellers will not have an incentive to raise or lower the price. Every buyer who wishes to pay the current market price will be able to purchase the product, and every seller who wishes to sell at the current market price will be able to sell. All plans are consistent with one another. There is no inherent tendency for the price of$1.00 per unit or the quantity exchanged of 9 units to change. The outcome is, therefore, an equilibrium outcome. It is said that the market clears and so the equilibrium price and quantity are also referred to as the market-clearing price and quantity. These general results are summarized below:
• $Surplus: Q_{S}>Q_{D}\Rightarrow P\downarrow$
• $Shortage: Q_{D}>Q_{S}\Rightarrow P\uparrow$
• $Equilibrium: Q_{D}=Q_{S}\Rightarrow \overline{P}$
It is very important to note that the equilibrium condition states that quantity supplied equals quantity demanded. It is false to express the equilibrium condition in terms of supply and demand being equal (S = D). If supply equals demand, then the supply and demand curves are identical. That is, supply and demand refer to the curves themselves, whereas quantity supplied and quantity demanded both refer to specific points on the curves.
One other point should be made about the forces at work that bring about the equilibrium outcome. In the case of the marble moving towards its equilibrium level at the bottom of the bowl, the force at work is gravity. What is the analogous force at work in the market? The answer is competition. When economists refer to market forces, they have in mind competition between buyers and sellers.
Comparative Statics Analysis
It was mentioned earlier that equilibrium states can be disrupted by external shocks. The external shocks that can disrupt the equilibrium market price and quantity are changes in the non-price determinants of demand and supply that were discussed previously. When such changes occur, the supply curve or the demand curve will shift, bringing about a new equilibrium outcome. The analysis that allows us to compare these static equilibrium states is known as comparative statics analysis.
Let us consider changes in the non-price determinants of demand. For example, in the years following the Second World War, Americans were eager to purchase automobiles and household appliances. They had been deprived of many material things due to the Great Depression of the 1930s and the wartime rationing. With the postwar economic boom, many Americans experienced rising incomes, and they were ready to spend. Because these goods were normal goods, the demand for these goods rose. Figure 3.15 (a) shows the effect of an increase in demand on the market price and quantity exchanged for a good.
To understand how the movement from one equilibrium point to another occurs, it is useful to break up the movement into three steps. The first step is to identify whether supply or demand shifts and in which direction. The second step is to explain whether a surplus or a shortage exists at the initial equilibrium price of P1. The third and final step is to explain the direction of the changes in price and quantity exchanged.
Figure 3.15 (b) shows what happens in the market for apples when the number of buyers decreases in late fall. The reduction in demand causes a surplus, which then causes the price and quantity exchanged to decline.
Similarly, Figure 3.16 (a) shows the effect of an increase in supply, which might occur due to a reduction in per unit taxes on cigarettes. Such a change creates a surplus and causes the price to fall and the quantity exchanged to rise. On the other hand, if a shortage of steelworkers causes wages to rise in the steel industry, then the rise in factor prices will lead to a reduction in the supply of steel as shown in Figure 3.16 (b).
Simultaneous Shifts in Supply and Demand
Each of the cases discussed in the previous section involves a shift in supply or demand only. It is possible, however, that both supply and demand might shift simultaneously. For example, the supply of oil might increase due to the development of new production technologies while the demand for oil increases as developing nations become more industrialized. This case is illustrated in Figure 3.17.
Based on the figure, it is clear that an increase in demand raises the equilibrium price and quantity exchanged. The equilibrium point moves from point 1 to point 2. The increase in supply, however, causes the equilibrium price to fall and the quantity exchanged to rise further. The final equilibrium point is at point 3. In this case, the reader can see that the quantity exchanged must rise because both factors contribute to a higher equilibrium quantity. On the other hand, the equilibrium price rises but then falls again. In this case, the price returns to its former level. One can easily imagine, however, a slightly larger increase in supply. Such a change would cause an overall reduction in price. Alternatively, a slightly smaller increase in supply would lead to an overall rise in price. The point is that unless we know the magnitudes of the shifts in supply and demand, we cannot determine whether price rises, falls, or stays the same overall. Our general conclusion, in this case, is that the quantity exchanged must rise, but the change in price is indeterminate (i.e., cannot be determined).
It turns out that in all four of the possible cases involving simultaneous shifts in supply and demand, the change in one of the variables (i.e., price or quantity) will be known for sure, and the change in the other variable will be indeterminate. The four possibilities are summarized below:
1. Supply and demand both rise: Q must rise but ∆P is indeterminate
2. Supply and demand both fall: Q must fall but ∆P is indeterminate
3. Supply rises and demand falls: P must fall but ∆Q is indeterminate
4. Supply falls and demand rises: P must rise but ∆Q is indeterminate
The reader should draw the graphs for cases 2-4, perhaps with the help of an instructor.
The Measurement of Social Welfare
We have been discussing the determination of the equilibrium price and quantity exchanged using supply and demand analysis. Neoclassical economists are also interested in measuring how well-off consumers and producers are when the market is in equilibrium. To measure the well-being of consumers and producers, neoclassical economists use the concepts of consumers’ surplus and producers’ surplus, respectively. We will consider each concept in turn.
• Consumers’ surplus refers to the difference between the maximum amount that consumers are willing and able to pay for a good and the amount they do pay for it.
For example, if you go to the mall to purchase a shirt, you may be willing and able to pay as much as $30 for the shirt. Because the price on the tag (the market price) is only$20, however, you enjoy the $10 difference in the sense that you acquire the shirt, and you retain the additional$10 that you would have been willing and able to pay. This surplus that the consumer enjoys is a measure of how well-off he or she is.
To calculate consumers’ surplus for the entire market, we only need to recall the fact that the market demand curve represents the maximum prices that consumers are willing and able to pay for a good. Furthermore, because consumers pay the market price for the good, the consumers’ surplus can always be represented as the area below the demand curve and above the current market price. Figure 3.18 shows how to approximate consumers’ surplus by treating the demand curve as if it possesses a staircase shape. The shaded area represents this approximation of the consumers’ surplus given the current market price of $1.00 per unit. To calculate the consumers’ surplus using this approach, it is only necessary to add up the shaded areas. We add the surplus of$0.50 on each of the units from 0 to 3, the surplus of $0.25 on each of the units from 3 to 6, and the surplus of$0.00 on the units from 6 to 9.
$CS=(1.50-1.00)(3-0)+(1.25-1.00)(6-3)+(1.00-1.00)(9-6)$ $=1.50+0.75+0=\2.25$
To calculate the consumers’ surplus exactly, it would be necessary to include the entire area below the demand curve and above the price line. It should be clear that a larger area implies a greater welfare for consumers because the difference between the amount they are willing and able to pay and the amount they do pay is larger. The reader should also note that consumer expenditure is equal to $9.00 (=$1.00 per unit times 9 units).
We now turn to the related concept of producers’ surplus. It is defined as follows:
• Producers’ surplus refers to the difference between the amount that producers receive for a good and the minimum amount producers are willing and able to accept.
To calculate producers’ surplus for the entire market, we only need to recall the fact that the market supply curve represents the minimum prices that producers are willing and able to accept for a good that they are selling. Furthermore, because producers receive the market price for the good, the producers’ surplus can always be represented as the area above the supply curve and below the current market price. Figure 3.19 shows how to approximate producers’ surplus by treating the supply curve as if it possesses a staircase shape. The shaded area represents this approximation of the producers’ surplus given the current market price of $1.00 per unit. To calculate the producers’ surplus using this approach, it is only necessary to add up the shaded areas. We add the surplus of$0.50 on each of the units from 0 to 3, the surplus of $0.25 on each of the units from 3 to 6, and the surplus of$0.00 on the units from 6 to 9.
$PS=(1.00-0.50)(3-0)+(1.00-0.75)(6-3)+(1.00-1.00)(9-6)$
$=1.50+0.75+0=\2.25$
To calculate the producers’ surplus exactly, it would be necessary to include the entire area below the price line and above the supply curve. It should be clear that a larger area implies a greater welfare for producers because the difference between the amount they receive and the minimum amount they are willing and able to receive is larger. The reader should also note that the revenue that producers receive is equal to $9.00 (=$1.00 per unit times 9 units). It should also be noted that the revenue that producers receive is equal to the expenditure of consumers. This result is perfectly consistent with the neoclassical circular flow diagram represented in Figure 3.1.
Although the concepts of consumers’ surplus and producers’ surplus have been represented here as being entirely consistent with the neoclassical worldview, we will consider two very important criticisms of these concepts in chapter 6.
The Economic Efficiency of Competitive Markets
We now come to an important conclusion that neoclassical economists draw. According to neoclassical economists, competitive markets achieve economic efficiency, as defined in chapter 2. In chapter 2, it is explained that a society achieves economic efficiency when it achieves productive efficiency, allocative efficiency, and full employment. Another way of thinking about economic efficiency is in terms of the maximization of consumers’ surplus and producers’ surplus. The total surplus (TS) is simply the sum of consumers’ surplus and producers’ surplus. When it is maximized, economic efficiency is achieved. Neoclassical economists argue that total surplus is maximized when the market is in equilibrium.
To understand their reasoning, we must take a slight detour into the analysis of government intervention in the marketplace. Suppose, for example, that the government imposes a price ceiling in the market for gasoline. A price ceiling is a maximum legal price that may be charged for a good or service. If the equilibrium price in the market for gasoline is $3.75 per gallon and the price ceiling is set at$3.25 per gallon, then the situation in Figure 3.20 is the result.
Because the price is prevented from falling below $4.00 per gallon, an excess supply equal to Q2 – Q1 is the result. Furthermore, the excess supply will persist indefinitely unless something else changes. The efficiency implications of the price floor are of great interest just as in the case of the price ceiling. Because only Q1 units of output are demanded at the high price, the consumers’ surplus and producers’ surplus on units Q* – Q1 are simply lost. As in the case of the price ceiling, deadweight loss is the result. Therefore, any price set above the equilibrium price will reduce the total surplus realized in the market. For price floors to be effective or binding, they must be placed above the equilibrium price. A price floor set below the equilibrium price would not have any effect on the marketplace because price has no tendency to fall that low. Price will simply move to its equilibrium level. Similarly, price ceilings must be placed below the equilibrium price if they are to be binding. A price ceiling set above the equilibrium price would have no effect on the market participants. The price would simply fall to its equilibrium level because a price ceiling does not prohibit downward movements in price. Maximum efficiency is, therefore, equivalent to maximization of total surplus and is achieved when the market reaches equilibrium. Any price charged other than the equilibrium price leads to deadweight loss. At the societal level, it is possible to understand how market equilibrium leads to economic efficiency in a different way. Specifically, economic efficiency requires full employment of resources, productive efficiency, and allocative efficiency. If each resource market clears, then the entire quantity supplied of each resource will also be demanded. As a result, full employment will be achieved. In addition, if we interpret the supply curve as representing the marginal cost (MC) of production and the demand curve as representing the marginal benefit (MB) of a good, then the equilibrium outcome implies that MB = MC, which is the condition for allocative efficiency. Unfortunately, we must wait until chapter 8 for a demonstration that market equilibrium leads to productive efficiency (or least-cost production). The Possibility of Market Failure It has been shown that free and unfettered markets lead to economic efficiency or the maximization of consumers’ and producers’ surplus. We now ask whether exceptions to this general rule can be found. When competition in the marketplace fails to bring about economic efficiency, we call this situation market failure. Several types of market failure have been identified. In this section, we briefly explore two broad types of market failure. The first kind of market failure occurs with the production of public goods. Public goods are goods that have two key characteristics: non-rivalry and non-excludability. A good is non-rival if one individual’s consumption of the good does not in any way reduce another individual’s consumption of the good. The classic example is a lighthouse. Once the lighthouse is constructed and operational, all boats entering a harbor enjoy the benefit of the light, and one boat’s consumption of the light does not diminish another boat’s consumption of the light. By contrast, a private good, like a sandwich, is a rival good because one individual’s consumption necessarily reduces another individual’s consumption. A lighthouse also has the characteristic of non-excludability. That is, it is not possible to exclude any one boat from consuming the service that the lighthouse provides once it is operating. As a result, if the lighthouse owner wishes to charge a fee for the use of the lighthouse, it will not be possible to do so. That is, a boat can consume the service without paying. This situation creates a free-rider effect in the sense that each boat has an incentive to free ride on the efforts of other boat owners to pay for the construction of the lighthouse. Because all boat owners face this same situation, no one is willing to pay for the construction of the lighthouse, and it is not built even though the benefit to the boat owners outweighs the cost of construction. Therefore, the market fails to deliver the efficient amount of the good, and so it is a case of market failure. The case is frequently made that the government can enhance efficiency in these situations by imposing a tax on the boat owners to force the collection of the fees that would be needed to build the lighthouse. The other kind of market failure that we will consider is referred to as an externality. Externalities are external effects of a market transaction on third parties that are not directly involved in the transaction. Externalities may be positive or negative. For example, a negative externality may occur when a steel company dumps waste into a nearby river. The waste imposes a cost on those living down the river. The price of steel, however, will not reflect this cost because it is not part of the private cost of production for the steel company. Neither the buyers nor the sellers of steel will experience the negative effects of this added cost of production. This situation is depicted in Figure 3.22 where MPC represents marginal private cost, MSC represents the marginal social cost of production, and MPB represents the marginal private benefit. The MSC includes both the MPC and the external cost of pollution. For this reason, the MSC is higher than the MPC. In Figure 3.22, the market clears at P* and Q*. The efficient outcome, however, occurs where MPB intersects MSC at P1 and Q1. Because the efficient outcome occurs at a higher price and a lower quantity, the implication is that the good is under-priced and over-produced in a competitive market. The case might be made that a unit tax imposed on producers can be used to reduce supply and bring it into line with MSC. Such a tax is known as a Pigouvian tax after the economist A.C. Pigou.[6] On the other hand, a positive externality may occur when consumption of a good leads to benefits for third parties that are not directly involved in the market transaction. For example, education is a good that is often argued to have positive spillover benefits in that other members of society benefit when people have more education rather than less. For example, a better educated population will have higher earning potential and so is less likely to resort to crime. Therefore, the marginal social benefit (MSB) exceeds the MPB in this case because the MSB includes the benefits that third parties receive in addition to the private benefits received by the direct consumers of education. This situation is depicted in Figure 3.23. In Figure 3.23, the market clears at P* and Q*. The efficient outcome, however, occurs where MSB intersects MPC at P1 and Q1. Because the efficient outcome occurs at a higher price and a higher quantity, the implication is that the good is under-priced and under-produced in a competitive market. The case might be made that a subsidy per unit given to consumers can be used to increase demand and bring it into line with MSB. Of course, it is difficult to know just how much of a tax or subsidy to impose in these cases of market failure. An error might lead to an even greater inefficiency than the one resulting in the case of competitive equilibrium. Following the Economic News [7] In July 2019, The Australian reported that the price of thermal coal fell significantly during the previous year. According to Nick Evans, Whitehaven Coal experienced a 25% reduction in the price of the coal it sells. Evans identifies a couple reasons for the significant reduction in coal prices. First, reductions in the demand for Australian coal exports hit Australian producers of coal hard. The lower foreign demand for Australian coal led to downward pressure on coal prices. A second factor that contributed to the lower coal prices is “tumbling gas prices.” Because gas is a substitute for coal, when gas prices fall, the demand for substitutes like coal falls. This factor has contributed to the lower demand for coal and to the lower coal prices. Despite the downward pressure on coal prices, Evans explains that coal prices are expected to moderate. The reason is that high-cost producers of coal will be driven out of business due to the low price of coal. Other high-cost producers, even if not forced to close, will cut production in response to the lower coal prices. As market supply contracts in the industry, upward pressure on the price occurs. If supply contracts sufficiently, then it may offset the reductions in demand and allow the market price of coal to stabilize. This case offers a good example of a complex case in which both supply and demand shift. The overall impact on the price in this case will be indeterminate. That is, the price may rise, fall, or remain the same overall, but the quantity exchanged in the market is sure to fall, as both the reduction in market demand and the reduction in market supply reduce the quantity exchanged in the market. Summary of Key Points 1. The neoclassical circular flow model represents the linkages between the business sector and the household sector as harmonious and without class antagonisms. 2. The law of demand states, that other factors held constant, price and quantity demanded are inversely related. 3. A change in quantity demanded is due to changes in price only whereas a change in demand is due to changes in non-price determinants of demand. 4. The law of supply states, that other factors held constant, price and quantity supplied are positively related. 5. A change in quantity supplied is due to changes in price only whereas a change in supply is due to changes in non-price determinants of supply. 6. In market equilibrium, quantity supplied equals quantity demanded and neither a shortage nor a surplus exists. 7. Changes in the non-price determinants of demand and supply lead to changes in equilibrium prices and quantities exchanged. 8. Market equilibrium leads to the maximization of consumers’ surplus and producers’ surplus. 9. Binding price ceilings and binding price floors prevent the movement to equilibrium and reduce consumers’ surplus and producers’ surplus. 10. Market failures occur when markets fail to achieve economic efficiency. List of Key Terms Neoclassical circular flow model Market Resource market Product market Market demand Market supply Market equilibrium Methodological individualism Individual demands Individual supplies Law of demand Substitution effect Income effect Horizontal summation Change in quantity demanded Change in demand Normal goods Inferior goods Substitutes Complements Law of supply Change in quantity supplied Change in supply Taxes Subsidies Equilibrium Excess supply Surplus Excess demand Shortage Comparative statics analysis Consumers’ surplus Producers’ surplus Total surplus Price ceiling Deadweight loss Price floor Effective or binding (price ceilings and price floors) Market failure Public goods Free rider effect Externalities Marginal private cost (MPC) Marginal social cost (MSC) Marginal private benefit (MPB) Pigouvian tax Marginal social benefit (MSB) Problems for Review 1. Suppose the price of peanut butter falls. If P1 and Q1 are the current equilibrium price and quantity of jelly, then how will the jelly market be affected by the drop in the price of peanut butter? Analyze this case in three steps. 2. Suppose the unit tax on gasoline is reduced. If P1 and Q1 are the current equilibrium price and quantity of gasoline, then how will the gasoline market be affected by the drop in the unit tax? Analyze this case in three steps. 3. Suppose consumers of an inferior good experience a rise in their incomes. If P1 and Q1 are the current equilibrium price and quantity of this good, then how will the market be affected by the rise in incomes? Analyze this case in three steps. 4. Suppose the demand rises for a good while the supply falls. Which conclusions can be drawn about the overall effect on equilibrium price and quantity exchanged? How would you draw the graph of this case? 5. Suppose the price of the good in Figure 3.24 is$5 per unit. Calculate the consumers’ surplus using the information in the graph.
6. Suppose the price of the good in the graph below is \$5 per unit. Calculate the producers’ surplus using the information in the graph.
1. Samuelson, Paul. 1957. “Wages and Interest: A Modern Dissection of Marxian Economic Models.” American Economic Review, 47: 884, 894.
2. This notation follows notation that Prof. David Ruccio used in his undergraduate economics principles class at the University of Notre Dame during my years as his teaching assistant in the early 2000s.
3. The reader should note that a movement along the demand curve does not occur in this case because the price of gasoline has not yet changed. It is only the expected future price of gasoline that has changed.
4. McConnell and Brue (2008), p. 52, recognize both possible outcomes whereas many authors of neoclassical textbooks only emphasize the case of current storage.
5. I believe that I first encountered this example in Prof. Kevin Quinn’s introductory economics class at BGSU.
6. For a nice summary of how externalities violate the neoclassical efficiency theorem and different approaches to resolving them, see Rosser and Rosser (2004), p. 32-36.
7. Evans, Nick. “Whitehaven tips steadier coal price as high-cost producers exit.” The Australian. Australian edition. 12 July 2019. | textbooks/socialsci/Economics/Principles_of_Political_Economy_-_A_Pluralistic_Approach_to_Economic_Theory_(Saros)/01%3A_An_Introduction_to_Economic_Theory/03%3A_The_Neoclassical_Theory_of_Supply_and_Demand.txt |
Goals and Objectives:
In this chapter, we will do the following:
1. Explore the early history of Marxian economics
2. Describe a Marxian circular flow model
3. Identify the characteristics of commodities and money within the Marxian framework
4. Explain how to represent the circulation of commodities in Marxian economics
5. Define the concept of capital within Marxian economics
6. Examine the commodity labor-power and the determination of its value
7. Illustrate the division of the working day and the production of surplus value
The Early History of Marxian Economics
In this chapter, we will explore Marxian economics. As we learned in the last chapter, the neoclassical contribution to the discourse of economics places heavy emphasis on the roles of supply and demand in the marketplace as determinants of product and resource prices. Neoclassical economists also emphasize that free and competitive markets lead to economic efficiency. In contrast, Marxian economists place primary emphasis on human labor as the source of commodity value and assert that competitive capitalism leads to class exploitation. Before we explore the Marxian perspective in greater detail, we should briefly consider its origins.
In Chapter 1, we discussed the decline of feudalism and the transition to capitalism as it occurred in England and Europe during the eighteenth and nineteenth centuries. Indeed, the distinct discourse of political economy was born due to this transition. Classical political economists generally viewed the rise of capitalism as a positive development, but many critics of the new economic system also arose.
The most famous of these critics was Karl Marx (1818-1883). Marx was a man of many hats. He was a philosopher by training but was also an historian, an economist, a radical journalist, and a revolutionary political activist. At times, he even fancied himself a mathematician and a poet! He was born and raised in Germany, obtained his doctorate in philosophy, and participated in the revolutions of 1848 in Europe, during which time he wrote The Communist Manifesto with his collaborator and friend Frederick Engels. The Manifesto was essentially a call to workers throughout the world to resist the changes that were taking place in the global economy, which Marx considered to be detrimental to the well-being of workers. Despite his emphasis on the exploitation of workers, Marx did recognize that the economic transition was contributing to rapid economic development like nothing the world had ever seen. Marx was driven into exile due to his political activities. He moved to France and then Belgium, before settling with his family in England.
Once he settled in London, Marx began to concentrate on intellectual work, but political resistance was always a part of his life. In the late 1850s, Marx completed a work titled, Grundrisse, which means “Foundations.” This work served as a rough draft for Marx’s most famous intellectual work, Das Kapital or Capital. This three-volume work contains Marx’s theory of how capitalism functions as well as his detailed critique of classical political economy. The first volume of Capital, published in 1867 and subtitled The Process of Production of Capital, is the only one that was published during Marx’s lifetime. The second and third volumes, titled The Process of Circulation of Capital and The Process of Capitalist Production as a Whole, were published posthumously by Engels in 1885 and 1894, respectively. Another work titled Theories of Surplus Value was also published after Marx’s death. It contains Marx’s critical analysis of the history of economic thought and is sometimes regarded as the fourth volume of Capital. Because the foundation of Marx’s theory of capitalism is developed in volume 1, it is our exclusive focus in this chapter.
Marx’s theory of capitalism represents the merger of several complex bodies of thought.[1] Marx was inspired by the German philosopher G.W.F. Hegel. Hegel’s theory of history was based on a kind of logic referred to as dialectical idealism. According to this manner of reasoning, all historical change is driven by the conflict between mutually antagonistic opposites.[2] Marx transformed this logic into one that emphasized material relations as the driving force in history rather than ideas as Hegel had done. It was later dubbed dialectical materialism for this reason. At the same time, Marx also borrowed the emphasis on the conflict between the bourgeoisie (capitalist class) and the proletariat (working class) from French political theorists.[3] Finally, he incorporated the theory that labor is the sole source of the value of commodities into his theory of capitalism.[4] Marx’s theory of capitalism is somewhat unique in that it is an impressive blend of descriptive analysis and normative critique. Marx’s concepts allow him to describe the workings of capitalism in detail, but the concepts inevitably lead to normative criticism. In this respect, his theory is sharply different from neoclassical theory, which aims to separate positive and normative analysis.
A Marxian Circular Flow Model
In the last chapter, we analyzed the neoclassical circular flow model, which shows how businesses and households interact through voluntary exchange in the product and factor markets. That model presents market relationships as harmonious, efficient, and consistent with Adam Smith’s Invisible Hand of the market. We will now consider a Marxian circular flow model of a market capitalist economy that assigns a central place to the class struggle, which Marxian economists claim is the defining feature of market capitalism. A Marxian circular flow model, developed by Prof. Ed Nell, is shown in Figure 4.1.[5]The major difference between the Marxian circular flow model and the neoclassical circular flow model from Chapter 3 is that the Marxian model includes a well-defined social class hierarchy. That is, most of the members of this society are workers. A minority of the population consists of owners of the means of production, and this group has a higher place in the social hierarchy than workers. Beneath the workers is another large group of unemployed workers that does not contribute to the circular flow of the economy. In Marxian economics, this last group is referred to as the reserve army of the unemployed. The reader should recall that in the neoclassical model, all resource owners are lumped together in the household sector. Neoclassical economists do not find it necessary to distinguish between the owners of capital, labor, and land in their model.
Another major difference between the neoclassical and Marxian models is that in the Marxian model, the working class contributes to industry something that is fundamentally different from the capitalist class. That is, the working class contributes work to industry and the capitalist class contributes investment funds (or money capital), which are used to purchase new capital goods (i.e., means of production) to be used in industry. Each receives a different kind of income based on these different contributions to industry. Workers receive wages in return for their work, and capitalists receive profits as a return on their investments.
Another important difference between the two models is that in the Marxian model, capitalists and workers consume two different classes of goods and services. That is, the working class enters the retail markets to purchase necessities whereas the capitalist class enters the retail markets to purchase relatively more expensive luxuries. Because owners receive profit income, they can afford luxuries, like mansions, yachts, rare artwork, fine clothes, fancy automobiles, pricey jewelry, and catered meals. Because their wage incomes do not allow them to purchase luxuries, workers must be content with necessities, such as rental units, cheap clothing, used automobiles, inexpensive jewelry, and microwave dinners. It should also be noted that the sales of these goods and services generate monetary receipts for industry, which are used in the payment of wages and profits. In addition, only the net social product is sold in the wholesale and retail markets because a part of the product of industry is consumed during the production process. That is, industry uses up some of the means of production in the production of products and services.
Now that we have analyzed the neoclassical and Marxian circular flow models and considered the similarities and differences between the two models, the reader might like to know which of the two models is correct. That is, which model should the reader accept as the true representation of how market capitalist economies work? The answer is that we cannot settle this question for the reader. The reader must choose the model that he or she finds to be most convincing. The reader may even reject both models because neither model emphasizes those features of market economies that the reader finds to be most central. Remember that economics is a discourse with many competing opinions and viewpoints. If we identify one of these two models as containing the “Truth” about economics, then we have abandoned the notion that economics is a discourse and have returned to the conventional view that economics is a science that can provide final answers to descriptive questions.
To make the point in another way, we can see that neoclassical economists do not incorporate the potential for conflict between resource owners in their model. We can also see that Marxian economists do not incorporate the possibility of class mobility in their model. That is, can’t a worker save enough money to join the class of capitalists? Each type of economist might be willing to admit these possibilities if asked, but the point is that they have excluded these possibilities because of all the infinite material that could be included in the models, they have chosen to include only those features that they consider to be the most important for understanding market capitalism. Consequently, their efforts to describe the functioning of economies have led them to evaluate that functioning from a normative standpoint at the same time. This inability to separate descriptive analysis from normative analysis is what makes economics a discourse at its core.
Commodities and Money
We can now begin to explore the theory of capital that Marx developed in volume 1 of Capital. Just like neoclassical economics, Marxian economics has its own language. Therefore, we will spend a great deal of time on its foundational concepts in this chapter just as we did when we explored the neoclassical theory of supply and demand. Once we have a solid grasp of the different components of Marxian theory, we can bring them together in a manner that provides a different conception of market capitalism than the one that neoclassical economists have developed.
Marx begins volume 1 of Capital by considering the form that wealth takes within the capitalist mode of production. He argues that wealth takes the form of an “immense collection of commodities.” Because Marx regarded the commodity as the basic cell of capitalist wealth, it served as the starting point of his analysis. Marx next defines the commodity as consisting of two essential components. First, a commodity is a use value. That is, a commodity has a value in use. It serves some useful purpose for the user. We are surrounded by use values in our daily lives. For example, a chair allows one to sit rather than stand; a cell phone allows one to call or text one’s friends; an automobile allows one to transfer one’s self and one’s belongings over long distances relatively quickly. This characteristic of a commodity is entirely qualitative in nature. To be a commodity, however, a thing must also be an exchange value. That is, the thing must also have a value in exchange. In other words, it must be possible to exchange the thing in the marketplace for so much of another commodity. This property of a commodity is entirely quantitative in nature. If a thing has both properties, it is a commodity. If it has neither property, or only has one of these properties, then it is not a commodity.
In capitalist societies, commodities are everywhere. All the use values mentioned above are commodities because they are also exchange values. It should be noted that a thing need not be a material object to qualify as a commodity. For example, a haircut is something bought and sold in a marketplace. It is also useful to the person consuming it because that person walks away with a nice, neat haircut. Still, it is not a material object but because it is a use value and an exchange value, it is a commodity. All services sold to consumers may be regarded as commodities for this same reason. It should also be pointed out that some things do not qualify as commodities. In the United States, for example, it is illegal to own slaves. Although slaves have a use value, they do not have an exchange value due to the absence of an organized market. People are, therefore, not commodities in the United States, except where the practice continues as criminal activity. On the other hand, millions of people continue to live as slaves in parts of Africa and Asia. Where slaves are still bought and sold, people continue to exist as commodities.
Marx next turns to the question of what determines the exchange value of a commodity. Marx encounters two related questions when trying to explain the exchange value of a commodity:
1. How is it possible to equate two qualitatively different commodities through market exchange? Isn’t this like saying apples and oranges are equal when apples are traded for oranges in the marketplace even though they are clearly different things?
2. What determines the rate at which two commodities exchange? Why does 1 desk exchange for 5 books rather than 4 books or 6 books?
Marx solves this problem and answers these questions by arguing that a common element must exist within each commodity to make the equation of exchange possible. This common element, he argues, is human labor.[6] That is, even though the books and the desk are qualitatively different items, they both require human labor for their production. As a result, it is this hidden element that is equated in the process of exchange. Marx recognized, however, that the labor embodied in commodities has a dual character. On the one hand, the books and the desk each require a different type of labor for their production. The act of producing books is obviously very different from the act of producing a desk. These specific forms of labor Marx referred to as concrete, private labor. Because of the qualitative differences between these kinds of labor, we do not appear to have solved the problem of how qualitatively different commodities may be equated in exchange. On the other hand, Marx argues that the different production processes do have something in common. Each production process involves the generalized expenditure of human brains, muscles, nerves, hands, and so on. It is this homogenous human labor that is embodied in commodities and which is revealed when the exchange of two commodities takes place. Marx referred to this generalized human labor as abstract, social labor. It is the common element that makes it possible to equate the books and the desk in the process of exchange. Furthermore, because labor time is a measurable concept, we also may use it to answer the second question above. That is, 5 books exchange for 1 desk because the 5 books and the 1 desk require the same amount of abstract, social labor for their production.
Marx’s solution, therefore, suggests that a commodity will be more valuable when it requires more abstract, social labor for its production. A commodity will be considered less valuable when it requires less abstract, social labor for its production. Marx did recognize one potential problem with this explanation of exchange value. The solution appears to suggest that producers that are lazy and take longer to produce will produce commodities that are more valuable than efficient producers who complete production in a much shorter period. To resolve this problem with his theory, Marx concludes that only socially necessary labor contributes to the production of value. That is, the only labor that counts in exchange is the labor that is required under the conditions that are normal for a given society and that uses the average degree of skill and intensity prevalent in that society at a point in time. According to Marx’s theory then, the value of a commodity depends directly on the amount of socially necessary abstract labor time (SNALT) required for its production. It follows that if only 10 hours of SNALT are required to produce a desk, then a producer that spends 15 hours of concrete, private labor on the production of a desk will have wasted 5 hours of labor time and only the 10 hours of SNALT will be realized in exchange. Similarly, a highly efficient producer that produces a desk with only 5 hours of concrete, private labor will be able to realize 10 hours of SNALT in exchange and so enjoys an extra bonus for this efficiency. Socially necessary abstract labor is, therefore, the substance of commodity value, and SNALT is its measure.[7] The claim that a commodity’s value depends upon the SNALT required for its production, we will refer to as the law of value.
Another issue arises when we consider the concept of money. After all, when we go to the store to purchase a pair of shoes, we do not see on the price tag a specific amount of SNALT. The prices of commodities are stated in terms of money, not SNALT. As a result, Marx’s next step is to explain why it is that commodity values are expressed in terms of money.
When Marx considers primitive economies in which commodity exchange only occurs sporadically and peripherally, he explains that value expressions can be represented with what he calls the simple form of value as shown in Figure 4.2.
Notice that the market price fluctuates considerably, however, in response to changes in the supply and demand for linen. The value of the linen represents the center of gravity around which the market price fluctuates and represents an average price over relatively long periods of time. It is here that we observe an important distinction between neoclassical and Marxian theory. Neoclassical economists only refer to market prices and the concept of value does not exist for them. Marxian economists recognize both concepts and consider the concept of value to be the more important object of analysis. As Marx wrote:
“[I]t is not the exchange of commodities which regulates the magnitude of their values, but rather the reverse, the magnitude of the value of commodities which regulates the proportion in which they exchange.”[8]
Throughout this chapter, we will follow Marx’s assumption throughout volume 1 of Capital in assuming that market prices are equal to values. That is, supply and demand do not force any significant deviations of price from value.
The Circulation of Commodities and the Meaning of Capital
In commodity exchange societies, commodities are constantly being bought and sold for money, which serves as the universal equivalent for the expression of value. Each sale and subsequent purchase can be represented as a commodity circuit through which the socially necessary labor of one commodity owner is equated with the socially necessary labor of another commodity owner. Indeed, Marx argued that all exchange within a commodity exchange society can be represented with a vast collection of interlocking commodity circuits. Marx chose to represent an individual commodity circuit symbolically as in Figure 4.9.
$M'=M+\Delta M$
That is, M’ is larger than the original sum (M) by the amount ∆M. This increment (∆M) is what Marx calls surplus value. When one uses money in this manner, Marx writes that money is transformed into capital. What then is capital? Capital in Marxian theory is money and it is commodities, but only when they take part in this specific movement. More generally, we can say that money is value in search of a greater value. Because capitalists are constantly striving to expand their capital in the endless search for surplus value, this movement never ceases in capitalist societies. The reader should notice how different this definition of capital is from the neoclassical definition of capital. For neoclassical economists, capital is only physical goods used to produce other goods. For Marxian economists, capital is the movement represented by M – C – M’.
Of course, if the person who advances the initial money capital ends up with a larger sum of money capital at the end of this process, then it might seem that we no longer can assume the exchange of equivalent values. For example, assume again that $100 representing 10 hours of SNALT buys a desk that requires 10 hours of SNALT for its production. This time, however, we will assume that when the desk is resold, it is sold for$120 representing 12 hours of SNALT. The surplus value in this case is $20, but the desk sells for more than it is worth. Commodity owners no longer exchange equivalent values. It might seem that the exchange of unequal values must be the source of surplus value in capitalist societies. Marx, however, strongly rejects this explanation. According to Marx, if a seller of a commodity manages to sell a commodity at a price that exceeds its value (e.g., a$100 desk is sold for $120), then that individual seller manages to obtain a surplus value. The problem is that the buyer experiences a loss of value. What occurs then is a redistribution of value throughout society. The total value produced has not changed at all. As a result, Marx concludes that the answer to the question of where surplus value originates must lie outside the sphere of circulation. To find his answer, Marx looks to the sphere of production to unlock the mystery of surplus value creation. Specifically, what if production makes it possible to enhance the value of the desk before the owner sells it? Once again, suppose that$100 representing 10 hours of SNALT buys the desk, which requires 10 hours of SNALT for its production. If the value of the desk somehow increases from 10 hours of SNALT to 12 hours of SNALT during the production process, then the owner can sell it for its equivalent value of $120. This example suggests that owners can exchange equivalent values in the sphere of circulation even as one owner realizes surplus value in exchange. The circulation of capital can now be represented in a slightly expanded form as follows: $M-C...C'-M'$ In this expanded formula for capital, a change occurs to the original commodity (C) to transform it into a new commodity (C’). The question that we must ask is how this increase in the value of the commodity is possible. The Commodity Labor-Power and the Determination of its Value Marx explains that this expansion of the value of the commodity in the production process is possible because a very peculiar commodity is available in the marketplace that has a unique property. This commodity Marx calls labor-power. Labor-power is the capacity to perform work during a specific period (e.g., one hour, one day). Like any commodity, it has a use value and an exchange value. Even though it is not a tangible commodity, like a desk, a worker can sell it to a capitalist for a sum of money (i.e., a wage) and so it has exchange value. Its use value, however, is what is truly unique. It is unlike any other commodity that exists in a capitalist society because when it is used, it creates new value. Think about it for a moment. When a person buys a desk and consumes it over time, its value does not increase. If anything, when the person tries to sell it as a used item later, the price that it fetches will likely be below its initial value. When a capitalist buys labor-power and consumes it, however, she orders the worker to complete a specific type of work. As the worker performs this work, the worker performs socially necessary abstract labor. The SNALT performed adds value to the materials that the worker uses in production. It was this key insight that allowed Marx to explain the origin of surplus value. Before we delve deeper into the details of how capitalists use labor-power to produce surplus value, we need to discuss the historical roots of this peculiar commodity. Labor-power is not a commodity that has always existed in human societies. In fact, it is specific to the capitalist mode of production. In ancient slave societies, for example, the enslaved people themselves were commodities. The slaves did not sell their ability to work for a specific period. Slaves possess no ownership rights themselves. Similarly, in feudal Europe, the serfs did not sell their labor-power to feudal lords in exchange for a wage. Serfs were bound to specific lands by tradition and custom. They handed a portion of their produce to the lords in exchange for protection and a place to live and work. It was only with the decline of feudalism and the spread of private ownership in land that landowners separated the serfs from the means of production and transformed them into wage laborers. For this reason, Marx identifies two key historical conditions that were required before labor-power became widely available as a commodity. First, workers needed to be free to enter into voluntary labor contracts and for that to happen, the legal system needed to recognize them as the rightful owners of their labor-power. Second, workers needed to be forcedto have this freedom in the sense that if they did not sell their labor-power to capitalists, they would not be able to survive. In fact, as the serfs were forced from the land with the decline of feudalism in Europe, they had little choice but to migrate to the cities in search of wage work. Marx thus asserts that workers became free in a double sense.[9] Even though we take this socioeconomic relationship between workers and employers for granted as a natural and eternal relation, Marx insists that this socioeconomic relationship is historically specific. In Marx’s words: “[N]ature does not produce on the one hand owners of money or commodities, and on the other hand men possessing nothing but their own labor-power.”[10] The widespread availability of labor-power is the defining feature of the capitalist mode of production. As we will see, capital cannot survive without it. Because labor-power is a commodity with a use value and an exchange value, the quantity of SNALT required for its production must determine its value. It is clear what we mean when we state that a desk requires 10 hours of SNALT for its production, but what does it mean to state that one day’s worth of labor-power requires 10 hours of SNALT for its production? Because labor-power is an intangible commodity, it is more difficult to imagine that it requires 10 hours of SNALT to produce it. What then determines the value of labor-power? Marx explains that for a worker to perform work during the working day, he must have access to some essential commodities. For example, the worker requires food, clothing, housing, fuel, medical care, and possibly additional commodities each day. Each of these commodities requires SNALT for its production. Therefore, the value of the commodities that the worker requires each day to produce and reproduce her labor-power is what determines the value of labor-power. In other words, the value of labor-power depends on the value of the means of subsistence that are necessary to maintain the worker in her normal state as a working person. Marx argues that the value of labor-power must also account for the dependents of the owner of labor-power because without such an allowance, future labor-power will not exist. He is also careful to point out that the value of labor-power contains an “historical and moral element,” which means that the specific commodities that are regarded as the necessary means of subsistence are specific to time and place. In the United States in the twenty-first century, the necessary means of subsistence might include an automobile, cell phone service, and a health insurance policy. In the U.S. during the nineteenth century or in many parts of the developing world in the present day, none of these elements would be included. Marx provides a precise formula for the value of one day’s labor-power as follows:[11] $The\;Value\;of\;One\;Day's\;Labor-Power=\frac{365A+52B+4C+...}{365}$ In this formula, A represents the value of the commodities that the worker requires daily, B represents the value of the commodities that the worker requires weekly, and C represents the value of the commodities that the worker requires quarterly. We multiply each value by the number of periods within a year. The numerator, therefore, represents the annual value of labor-power. If we divide the annual value of labor-power by the number of days in the working year (assumed to be 365 days), then we obtain the daily value of labor-power. We could further divide this amount by the number of working hours in the workday to obtain the hourly value of labor-power. For example, suppose that A represents the value of food required daily, B represents the value of fuel required weekly, and C represents the value of the rent for housing required quarterly. We may express these values in terms of SNALT or in dollar terms. If we assume that A equals$10 of food per day, B equals $73 of fuel per week, and C equals$3,650 of housing per quarter, then we have the following results assuming an 8-hour workday:
$Annual\;Value\;of\;Labor-Power=365(10)+52(73)+4(3650)=\22,046\;per\;year$ $Daily\;Value\;of\;Labor-Power=\frac{\22,046\;per\;year}{365\;days\;per\;year}=\60.40\;per\;day$ $Hourly\;Value\;of\;Labor-Power=\frac{\60.40\;per\;day}{8\;hours\;per\;day}=\7.55\;per\;hour$
We will continue to assume that prices equal values at this stage. That is, we assume that the price of labor-power equals the value of labor-power. In other words, we are ruling out the possibility at this stage that fluctuations in the supply and demand for labor-power might cause the price of labor-power to rise above or fall below its value.
T he Length of the Working Day and the Production of Surplus Value
Before we can unlock the secret of surplus value production, we must introduce a few more concepts. Labor-power has taken its place within the world of commodities that are available in the marketplace. Despite its peculiar characteristic, its value is determined like that of all the other commodities. Figure 4.11 shows one day’s labor-power as a single commodity among many other commodities.
In this example, we assume that 6 hours of SNALT are required to produce and reproduce a day’s worth of labor-power. It sells for $90, which represents an equivalent amount of SNALT. Therefore, if labor-power sells at its full value of$90, then a capitalist fully compensates a worker for the commodity she sells. This point is important. If we make this assumption, we cannot draw the conclusion that the worker is exploited in the realm of commodity circulation. An additional important assumption is that $90 represents 6 hours of SNALT. This ratio allows us to represent any amount of SNALT in monetary terms. In the equation below, we simplify this ratio, which Marxian economists refer to as the monetary expression of labor time(MELT). $MELT=\frac{\90\;per\;day}{6\;hours\;per\;day}=\15\;per\;hour\;(of\;SNALT)$ The reader should be aware that the MELT is not the same as the hourly value of labor-power (i.e., the wage). The MELT only tells us that$15 represents 1 hour of SNALT because the amount of gold that $15 represents (under the gold standard) requires 1 hour of SNALT for its production. We only have a few more concepts to introduce and then we can bring together our concepts in an example to reveal how capitalist production produces surplus value. When a capitalist advances a specific amount of money capital (M), the capitalist advances a portion of it for the purchase of the means of production. The means of production in a specific production process include the instruments of labor (e.g., tools, machinery, and specialized equipment) and the objectsof labor (e.g., raw materials, ingredients, component parts). Neoclassical economists refer to all these means of production simply as capital. The portion of the money capital that capitalists advance for the purchase of means of production, Marxian economists refer to as constant capital(c). The other part of the money capital that is advanced purchases labor-power. This part of the capital, Marxian economists refer to as variable capital(v). The reason for these labels will become clearer after we have worked through an example in which capitalist production produces surplus value. The money capital (M) may then be expressed as follows: $M=c+v$ As in neoclassical theory, we will make certain assumptions, and then analyze the situation given the restrictions that we have defined. We will assume that a capitalist hires one worker to work a 10-hour workday. The capitalist advances$300 of constant capital for means of production and $90 of variable capital for labor-power. That is: $M=c+v=300+90=\390$ We will also assume that the MELT is$15 per hour of SNALT as above and that the worker will produce a total product (TP) of 225 lbs. of sugar during the workday. With this information, we can uncover the origin of surplus value.
Figure 4.12 shows a timeline representing the length of the working day for this example.
Each of these monetary amounts corresponds to an equivalent value in terms of labor time. For example, the SNALT embodied in the means of production is referred to as dead labor (DL). The SNALT required to produce a value equivalent to the variable capital we call necessary labor (NL). We call this labor necessary labor because it is the amount of SNALT necessary to produce a value equivalent to the required means of subsistence, and we should not confuse it with the concept of socially necessary labor.[12] Finally, the SNALT that the worker performs over and above the necessary labor, we refer to as surplus labor (SL). The entire amount of labor that the worker performs during the workday is called living labor (LL). It follows that:
$LL=NL+SL$
Because the MELT makes it possible to convert between monetary values and labor time equivalents, we can work through this problem as follows:
Determine the amount of necessary labor time.
• $NL=\frac{v}{MELT}=\frac{\90}{\frac{\15}{hour}}=6\;hours$
Determine the amount of surplus labor time.
• $SL=LL-NL=10\;hours-6\;hours=4\;hours$
Determine the amount of surplus value (s) produced.
• $s=SL \cdot MELT=4\;hours \cdot \frac{\15}{hour}=\60$
Determine the amount of dead labor time embodied in the means of production.
• $DL=\frac{c}{MELT}=\frac{\300}{\frac{\15}{hour}}=20\;hours$
We can now see that the total value(TV) of the sugar produced in the day and the total labor(TL) embodied in the final product for the day are calculated as follows:
$TV=c+v+s=300+90+60=\450$ $TL=DL+NL+SL=20+6+4=30\;hours$
It should be noted that $450/30 hours equals$15 per hour, which is also the MELT.
We can also calculate the monetary value or price (p) of one pound of sugar by dividing the total value of the sugar by the total product as follows:
$p=\frac{TV}{TP}=\frac{\450}{225\;lbs.}=\2\;per\;lb.$
Just like the constant capital, the variable capital, and the surplus value correspond to the dead labor, necessary labor, and surplus labor, respectively, they also correspond to the specific parts of the total product. That is, the constant capital corresponds to what we can call the dead product(DP), the variable capital corresponds to the necessary product(NP), and the surplus value corresponds to the surplus product(SP), as shown in Figure 4.14.
To calculate each of the components of the total product, it is only necessary to divide each of the monetary magnitudes by the price of sugar as follows:
$DP=\frac{c}{p}=\frac{\300}{\2\;per\;lb.}=150\;lbs.$ $NP=\frac{v}{p}=\frac{\90}{\2\;per\;lb.}=45\;lbs.$ $SP=\frac{s}{p}=\frac{\60}{\2\;per\;lb.}=30\;lbs.$
The total product should be simply the sum of these component parts. That is:
$TP=DP+NP+SP=150+45+30=225\;lbs.$
We now have a complete picture of the process by which surplus value is created. We can also expand the circuit of capital to gain a clearer picture of the entire process as shown in Figure 4.15.
This expanded version of the circuit of capital shows that the commodities (C) that are purchased using the initial money capital at the beginning of the circuit include means of production (mop) and labor-power (Lp). The circulation process is then interrupted with the production phase (P). Once production is complete, a new commodity (C’) emerges that contains surplus value. It then sells for an amount of money (M’), and the capitalist realizes the surplus value. The capital has expanded. Marx’s theory suggests that surplus value exists because the capitalist exploits the worker in the production phase of the circuit. Even though the worker is responsible for the entire new value created, the capitalist owns the final product and decides how the proceeds from its sale are used. Therefore, exploitation within the capitalist mode of production refers to the production of surplus value by workers and its appropriation and distribution by capitalists. It is here that we see why Marx’s theory is an impressive blend of positive and normative analysis. The reference to this process as one involving exploitation indicates Marx’s condemnation of it. At the same time, it has a technical meaning that describes how a worker produces more value then she receives in the form of a wage.
The reader should be able to understand more clearly now why the labels constant capital and variable capital have been used. The reason for this distinction is that labor-power has the peculiar property that it creates new value when consumed. It alone is responsible for the expansion of the capital value, and so Marxian economists regard the capital advanced for the purchase of labor-power as variable in nature. By contrast, the value of the means of production is only preserved and transferred to the final product. As a result, their value does not expand and so this part of the capital Marxian economists regard as constant in nature.
The reader might object to this entire analysis because capitalists do not pay workers one lump sum for the day but rather pay workers for each hour worked. It should be noted, however, that in this case, the hourly wage would be $9 per hour (=$90 per day/10 hours per day) so even though it looks like the worker is compensated for every hour she works, this appearance is a false one. The worker works only part of the hour for herself and the other part for the capitalist. Remember, each hour worked creates the value equivalent of $15, according to the MELT. Hence,$9 of value created in an hour corresponds to necessary labor whereas the other $6 of value created in an hour corresponds to surplus labor when we view the problem in this manner. Hourly wages rather than daily wages do nothing to change the fact that the capitalist appropriates a part of the value that the worker produces. The Rate of Surplus Value and the Rate of Profit Marx also introduces two important measures that correspond to this analysis. The first measure he calls the rate of surplus value or the degree of exploitation of labor-power. This measure is of great importance to the worker because it measures the extent to which the capitalist exploits the worker in the production process. Marx defines it as follows: $Rate\;of\;surplus\;value=\frac{s}{v}=\frac{SL}{NL}=\frac{\60}{\90}=\frac{4\;hours}{6\;hours}=66.67\%$ The rate of surplus value measures the degree to which the worker works for the capitalist rather than for herself. The higher is the rate of surplus value, the higher is the degree of exploitation. A second measure of importance is the rate of profit. The rate of profit measures the rate at which the capital value has expanded during the production process. It is of greatest interest to the capitalist because it is how the capitalist measures the profitability of her investment. Marx defines it as follows: $Rate\;of\;profit=\frac{s}{c+v}=\frac{\60}{\390}=15.38\%$ The higher is the rate of profit, the more profitable is the investment. That is, a higher rate of profit indicates a more rapid expansion of the capital value. The Production of Absolute Surplus Value and Relative Surplus Value Because the capitalist is interested in extracting as much surplus value as possible from the worker, it is important to consider which measures the capitalist can take to increase the amount of surplus value produced. One way to increase the amount of surplus value produced is through an extension of the length of the working day. Marx refers to an increase in the production of surplus value due to an extension of the workday as an increase in absolute surplus value. Figure 4.16 shows the modifications to our example that stem from a lengthening of the workday. In this case, the variable capital has declined from$90 per day to $75 per day due to the reduction in the value of labor-power. The necessary labor time falls to only 5 hours (=$75/$15 per hour). Due to the reduction in the necessary labor time to 5 hours and the fact that the workday is fixed at 10 hours, the surplus labor time performed rises from 4 hours to 5 hours. The surplus value also rises then to$75. In this example, the rate of surplus value rises to 100% (= $75/$75) for the twofold reason that more surplus value is produced and less variable capital is advanced. In addition, the rate of profit increases in this example to 20% (= $75/$375). The increase in the rate of profit is due to the increase in surplus value, but it is also due to the reduction in the amount of capital that must be advanced.
Of course, changes do not always work in the favor of capitalists. If workers form a union and demand shorter working hours, then the rates of surplus value and profit will decline. In addition, if the means of subsistence rise in value, then the capitalist will appropriate less surplus value because she must pay the worker a higher wage. As a result, the rates of surplus value and profit will fall. In this case, the worker is no better off despite the higher wage, however, because the higher wage is paid solely to allow the worker to buy the same quantity of the means of subsistence as before.
As we conclude this chapter, we should place special emphasis on the uniqueness of the capitalist process of production. In all human societies, the production of use values is essential. Indeed, in Marxian economics, the labor process refers to any purposeful activity aimed at the production of use values. In addition to purposeful productive activity, Marx explains that the labor process includes the object of labor and the instruments of labor. The labor process is an important element within the capitalist mode of production as well, but within capitalism it overlaps with another process that Marx calls the valorization process. The valorization process refers to the process by which surplus value is created. As we have seen, the capitalist owns labor-power, the means of production, and the commodity that is ultimately produced. The goal of the capitalist then is not to produce use values but rather commodities containing surplus value. As this chapter has demonstrated, the origin of surplus value rests in the productive consumption of labor-power, which leads to the creation of new value that exceeds its own value. It is this valorization process that gives the capitalist production process its uniqueness and that is the defining characteristic of the capitalist mode of production.
F ollowing the Economic News [13]
Marxian economists argue that wage workers in general are exploited in capitalist societies. At the same time, specific circumstances can render some workers more vulnerable to exploitation than others. For example, natural disasters have created the conditions for heightened degrees of exploitation in the United States. For example, Jessica Kutz describes the aftermath of the fire that destroyed most of the town of Paradise in Northern California in November 2018. In addition to long working hours and low pay, immigrant workers are often hired to perform dangerous and hazardous work in the aftermath of a natural disaster. For example, workers performing cleanup operations might be subjected to “asbestos and mold, toxins that can have long-term health effects.” She reports that although laws are in place to protect workers, a lack of government resources devoted to the task leads to improper enforcement, and businesses would rather skimp on protective gear and training programs to keep costs down. Kutz also explains that the undocumented status of many immigrant workers discourages workers from reporting workplace safety violations. These circumstances suggest that these disaster workers experience an additional negative aspect of exploitation that goes beyond the discussion in this chapter. That is, they are performing surplus labor that capitalist firms appropriate, but they are also being subjected to harsh conditions that may lead to illness or even death. Furthermore, undocumented workers are more likely to have their wages stolen from them. Kutz explains that sometimes they are not paid their final wages, they are given bad checks, or they are given debit cards that turn out to be scams. According to one research study, “over a quarter of immigrant day laborers … were victims of wage theft after Hurricane Harvey.” In these situations, the rate of exploitation of labor-power (s/v) becomes infinite as the variable capital falls to zero.
Summary of Key Points
1. Marx’s theory of capitalism represents a merger of Hegelian philosophy, French political theory, and British political economy.
2. The Marxian circular flow model is different from the neoclassical circular flow model in that the Marxian model emphasizes a social class hierarchy, persistent unemployment, inequality in consumption, and the distinctive nature of work as a factor contributed to industry.
3. For a thing to be considered a commodity, it must be both a use value and an exchange value.
4. The value of a commodity depends directly on the amount of socially necessary abstract labor time (SNALT) required for its production.
5. Commodities exchange for units of paper money in Marxian economics because the units of paper represent definite quantities of gold that require equivalent amounts of SNALT for their production.
6. Commodity circuits are represented as C-M-C’ whereas the circuit of capital is represented as M-C-M’.
7. Labor-power is a special commodity that can create more value than it is worth when it is consumed.
8. The value of labor-power depends on the SNALT required for its production and reproduction (i.e., the SNALT embodied in the means of subsistence).
9. The monetary expression of labor time (MELT) makes possible the conversion of any amount of SNALT into its equivalent in money.
10. The exploitation of labor-power may be increased either through an extension of the working day or through a cheapening of the value of labor-power.
List of Key Terms
Dialectical idealism
Dialectical materialism
Bourgeoisie
Proletariat
Marxian circular flow model
Reserve army of the unemployed
Necessities
Luxuries
Net social product
Wealth
Commodity
Use value
Exchange value
Concrete, private labor
Abstract, social labor
Value
Socially necessary abstract labor time (SNALT)
Law of value
Simple form of value
Expanded form of value
Universal equivalent
General form of value
Money form of value
Fiat money
Market price
Commodity circuit
Surplus value
Capital
Labor-power
Free in a double sense
Value of labor-power
Annual value of labor-power
Daily value of labor-power
Hourly value of labor-power
Monetary expression of labor time (MELT)
Instruments of labor
Objects of labor
Constant capital (c)
Variable capital (v)
Dead labor (DL)
Necessary labor (NL)
Surplus labor (SL)
Living labor (LL)
Total value (TV)
Total labor (TL)
Dead product (DP)
Necessary product (NP)
Surplus product (SP)
Exploitation
Rate of surplus value (or degree of exploitation)
Rate of profit
Absolute surplus value
Relative surplus value
Labor process
Valorization process
Problems for Review
Assume the following initial conditions for problems 1-7. Be sure to include the proper units in each of your answers.
• The working day is fixed at 11 hours.
• The capitalist hires one worker for the day for which the worker is paid $63. • The capitalist buys the means of production (tools, raw materials) for$189.
• The worker produces 950 lbs. of sugar during the working day.
• The worker consumes (i.e., uses up) all the means of production.
• The monetary expression of labor time is $7 per 1 hour of SNALT. That is, it takes one hour to produce the gold that the$7 represents under the gold standard.
Complete the following problems:
1. Draw a timeline representing the length of the working day in this example.
2. Identify the necessary labor, the surplus labor, and the dead labor.
3. Identify the constant capital, the variable capital, and the surplus value.
4. What is the total (monetary) value of the day’s product? What is the (monetary) value (or price) of each pound of sugar?
5. What is the rate of surplus value? What is the rate of profit?
6. If the working day increases to 12 hours, calculate the new rate of surplus value and the new rate of profit? What happened to each (increased, decreased, constant)?
7. Returning to the initial conditions when the working day is set at 11 hours (that is, disregarding the change that occurs in problem 6), calculate the new rate of surplus value and the new rate of profit when the wage paid to the worker rises to $70 for the day. What happened to each (increased, decreased, constant)? 8. If a worker requires$12 worth of food per day, $28 worth of clothing per week, and$985 of rent per month, calculate the following:
• The annual value of labor power
• The daily value of labor power (assuming a 365-day working year)
• The hourly value of labor power (assuming an 8-hour working day)
1. For a helpful overview of the way in which Marx’s thought represents a synthesis of three major bodies of European thought, see Rosser and Rosser (2004), p. 56-59.
2. Ibid. p. 56.
3. Ibid. p. 57.
4. Ibid. p. 58.
5. Figure 4.1 is a slightly modified version of Prof. Nell's original figure.
6. Marx reasoned that because the concept of use value is entirely qualitative in nature, it cannot explain the quantitative relationship of a commodity to other commodities (i.e., exchange value).
7. See Marx (1990), p. 131.
8. Marx (1990), p. 156.
9. Marx (1990), p. 272.
10. Ibid. p. 273.
11. Marx (1990), p. 276.
12. Marx offers a cautionary note to this effect. See Marx (1990), p. 325, footnote 5.
13. Kutz, Jessica. “After natural disasters, workers face exploitation.” High Country News. Paonia, CO. 21 Jan. 2019: 5,7. | textbooks/socialsci/Economics/Principles_of_Political_Economy_-_A_Pluralistic_Approach_to_Economic_Theory_(Saros)/01%3A_An_Introduction_to_Economic_Theory/04%3A_The_Marxian_Theory_of_Class_Exploitation.txt |
Goals and Objectives:
In this chapter, we will do the following:
1. Define the neoclassical concept of price elasticity of demand and explain its importance
2. Calculate and interpret the price elasticity of demand
3. Learn how and when to use the arc elasticity formula and the point elasticity formula
4. Identify key determinants of the price elasticity of demand
5. Explain the relationship between the price elasticity of demand and sales revenue
6. Define, calculate, and interpret other key measures of elasticity
The Need for a Measure of Consumer Responsiveness
In Chapter 3, we spent a great deal of time discussing the law of demand, which states that, other things equal, as the price of a good declines, the quantity demanded rises, and vice versa. In this chapter, we are interested in more than the direction of the change in quantity demanded when the price changes. That is, we wish to know the magnitude of the change in quantity demanded when the price changes. As a result, we require a measure of the change in quantity demanded when the price changes by some amount. This measure of the responsiveness of the consumer to a change in price is known to neoclassical economists as the price elasticity of demand.
The reader may wonder why neoclassical economists require this special measure of consumer responsiveness to a price change. After all, the slope of the demand curve tells us the change in quantity demanded for a specific change in the price of the good. Figure 5.1 illustrates how to calculate the slope of a linear demand curve.
Calculating and Interpreting the Price Elasticity of Demand
The price elasticity of demand is a measure that avoids the shortcomings of the slope of the demand curve as a measure of consumer responsiveness. It is calculated in the following way, where ED refers to the price elasticity of demand:
$E_{D}=\frac{\%\Delta Q^D}{\%\Delta P}$
For example, when the price of a good rises by 6% and the quantity demanded of the good falls by 12%, then the price elasticity of demand is equal to -2 as shown in the following calculation:
$E_{D}=\frac{\%\Delta Q^D}{\%\Delta P}=\frac{-12}{6}=-2$ The careful reader will notice two important differences between this measure and the slope of the demand curve. First, the price elasticity of demand places Q in the numerator and P in the denominator, which suggests that this measure will be inversely related to slope. Second, the price elasticity of demand includes percentage changes as opposed to absolute changes in P and Q.
The next question we must ask, however, is whether this measure of consumer responsiveness is unit-free. Only then will it be possible to make comparisons of consumer responsiveness across markets. It turns out that it is unit-free. Consider, for example, a child that begins the month weighing 100 lbs. At the end of the month, the child weighs 105 lbs. Because the child’s original weight (W) is 100 lbs. and the change in the child’s weight (∆W) is 5 lbs., the percentage change in the child’s weight (∆W/W) is 5 lbs./100 lbs. or 5%. The reader can easily see that the units cancel out in this calculation, leaving us with a pure or unit-free number. It is the same way with all calculations involving percentages. In the case of the price elasticity of demand, we can rewrite the formula in the following way:
$E_{D}=\frac{\%\Delta Q^D}{\%\Delta P}=\frac{\frac{\Delta Q}{Q}}{\frac{\Delta P}{P}}$
The reader should note that cancellation of the units in the numerator and denominator of this fraction leads to the calculation of a unit-free measure of consumer responsiveness.
If we return to the example in which the price elasticity of demand was calculated to be -2, it is natural to wonder why the result has included a negative sign. This result should come as no surprise because the law of demand states that price and quantity demanded are inversely related, other things held constant. In fact, we should almost always expect a negative sign when we calculate the price elasticity of demand. For this reason, neoclassical economists typically omit the negative sign when referring to the price elasticity of demand and instead refer to its absolute value. A neoclassical economist would state then that the price elasticity of demand is 2 even though she really means -2. Our formula for the price elasticity of demand can be modified as follows, and the previous calculation would be carried out as shown:
$|E_{D}|=|\frac{\%\Delta Q^D}{\%\Delta P}|=|\frac{-12\%}{6\%}|=|-2|=2$
The absolute value of the price elasticity of demand is used then as a kind of shorthand. It is useful as well for another reason. When the absolute value of the price elasticity of demand is equal to 2, it can be interpreted to mean that a 1% rise in price causes a 2% reduction in quantity demanded, other things equal. If the absolute value is equal to 3, then a 1% rise in the price causes a 3% reduction in quantity demanded. In the latter case, we observe a larger response from consumers given a 1% rise in price. When consumers are more responsive to a price change, it is said that demand is more elastic. Because we are referring to the absolute value, the larger the number is, the more elastic the demand will be. If we were using the negative values, then we would be forced into the less natural position of claiming that the lower the value, the greater the elasticity of demand.
More generally, the price elasticity of demand may take on any value from zero to positive infinity (in absolute value terms). Depending on the specific value, different language is used to refer to the elasticity of demand. Below are the phrases used for each possible range of values. The symbol “$\Longleftrightarrow$” indicates that the two statements are logically equivalent.
$|E_{D}|>1\Longleftrightarrow Demand\;is\;elastic$ $|E_{D}|=1\Longleftrightarrow Demand\;is\;unit\;elastic$ $|E_{D}|<1\Longleftrightarrow Demand\;is\;inelastic$ $|E_{D}|=0\Longleftrightarrow Demand\;is\;perfectly\;inelastic$ $|E_{D}|=\infty\Longleftrightarrow Demand\;is\;perfectly\;elastic$
It has already been emphasized that a larger price elasticity of demand implies greater responsiveness on the part of consumers. Nevertheless, more must be said to explain why a value of 1 is so important to the interpretation of this value. To understand the reason, we return to the definition of the price elasticity of demand and observe the following:
$|\frac{\%\Delta Q_{D}}{\%\Delta P}|=1\Rightarrow |\%\Delta Q_{D}|=|\%\Delta P|\Rightarrow Demand\;is\;unit\;elastic$
That is, when demand is unit elastic, a 5% rise in price leads to a 5% reduction in quantity demanded. The consumers, in other words, respond by an equal percentage amount to a price change. For this reason, the value of 1 is important for the purposes of interpreting the price elasticity of demand.
When the price elasticity of demand exceeds 1, we have the following:
$|\frac{\%\Delta Q_{D}}{\%\Delta P}|>1\Rightarrow |\%\Delta Q_{D}|>|\%\Delta P|\Rightarrow Demand\;is\;elastic$
This result indicates that demand is elastic whenever the consumers respond by a greater percentage amount than the price change (in absolute value terms).
When the price elasticity of demand is less than one, we have the following:
$|\frac{\%\Delta Q_{D}}{\%\Delta P}|<1\Rightarrow |\%\Delta Q_{D}|<|\%\Delta P|\Rightarrow Demand\;is\;inelastic$ This result indicates that demand is inelastic whenever the consumers respond by a smaller percentage amount than the price change (in absolute value terms).
When the price elasticity of demand is equal to 0, we have the following:
$|\frac{\%\Delta Q_{D}}{\%\Delta P}|=0\Rightarrow |\%\Delta Q_{D}|=0\Rightarrow Demand\;is\;perfectly\;inelastic$ This result indicates that demand is perfectly inelastic whenever the consumers do not respond at all to a given percentage change in the price of the good.
Finally, when the price elasticity of demand is equal to ∞, we have the following:
$|\frac{\%\Delta Q_{D}}{\%\Delta P}|=\infty\Rightarrow |\%\Delta P|=0\Rightarrow Demand\;is\;perfectly\;elastic$
Division by zero causes the fraction to be undefined. In this case, however, we can imagine a very tiny percentage price change such that it approaches 0 and the entire fraction, therefore, approaches infinite. In other words, even for the smallest (nearly zero) change in price, we obtain an opposite change in quantity demanded. That is consumers are perfectly responsive to any price change at all, and demand is said to be perfectly elastic.
Notice that with this measure we can now compare the responsiveness of orange consumers and apple consumers if we know the price elasticity of demand for each. If the price elasticity of demand for oranges is 2 and the price elasticity of demand for apples is 3, then we conclude that apple consumers are relatively more responsive than orange consumers to price changes. In a sense, we are free to compare apples and oranges, which was not possible when we only knew the slopes of the demand curves.
The Arc Elasticity and Point Elasticity Formulas
When we know the percentage changes in price and quantity demanded, it is very easy to calculate the price elasticity of demand. We simply use the definition of the price elasticity of demand that was provided in the previous section. At times, however, we might find ourselves only knowing the absolute changes in price and quantity demanded. Without direct knowledge of the percentage changes in price and quantity demanded, we must find some way of obtaining this information from the information we do have. For example, consider the graph in Figure 5.3.
In this case, we know that the price of the good rises from $4 per unit to$5 per unit and that the quantity demanded subsequently falls from 22 units to 18 units. That is, we know only the absolute changes in price and quantity demanded. To convert our formula for the price elasticity of demand from one that uses percentage changes to one that uses absolute changes, we need to return to our initial definition and make the conversion as follows:
$E_{D}=\frac{\%\Delta Q^D}{\%\Delta P}=\frac{\frac{\Delta Q}{Q}}{\frac{\Delta P}{P}}=\frac{\frac{Q_{2}-Q_{1}}{Q}}{\frac{P_{2}-P{1}}{P}}$
This formula appears to solve our problem because we can now use absolute quantities and prices to carry out a calculation of the price elasticity of demand. Unfortunately, the formula has one major defect. The problem with this formula is that it is not immediately clear which Q and P should be used in the denominator of each fraction. When neoclassical economists first considered this problem, they decided that it would be completely arbitrary to use Q1 and P1 as opposed to Q2 and P2. The issue is important because the calculation is different depending on the choice that is made. As a result, they concluded that it made the most sense to use the average quantity demanded and the average price when carrying out the calculation. As a result, the formula changes to the following:
$E_{D}=\frac{\%\Delta Q^D}{\%\Delta P}=\frac{\frac{\Delta Q}{Q}}{\frac{\Delta P}{P}}=\frac{\frac{Q_{2}-Q_{1}}{Q}}{\frac{P_{2}-P{1}}{P}}=\frac{\frac{Q_{2}-Q_{1}}{\frac{Q_{1}+Q_{2}}{2}}}{\frac{P_{2}-P{1}}{\frac{P_{1}+P_{2}}{2}}}$
If we write the arc elasticity formula in terms of its absolute value and carry out the calculation using the information provided in Figure 5.3, then we obtain the following:
$|E_{D}|=|\frac{\frac{Q_{2}-Q_{1}}{\frac{Q_{1}+Q_{2}}{2}}}{\frac{P_{2}-P{1}}{\frac{P_{1}+P_{2}}{2}}}|=|\frac{\frac{18-22}{\frac{22+18}{2}}}{\frac{5-4}{\frac{4+5}{2}}}|=|\frac{\frac{-4}{20}}{\frac{1}{9/2}}|=|\frac{-1}{5} \cdot \frac{9}{2}|=|-\frac{9}{10}|=\frac{9}{10}$ The reader should note that the average quantity demanded of 20 units and the average price of $4.50 per unit (= 9/2) is in Figure 5.3 at the midpoint between the two points on the demand curve that we have been considering. Another point to notice is that it is possible to conclude that demand is inelastic in this case because 9/10 is less than 1. Therefore, consumers are relatively unresponsive to price changes, at least between these two points on the demand curve. The arc elasticity formula works well when we wish to calculate the price elasticity of demand between two points on the demand curve as in Figure 5.3. At other times, we might wish to calculate the price elasticity of demand at a single point on the demand curve. It might seem like an impossible task given that our initial formula depends upon changes in price and quantity demanded. It is still possible, however, to calculate the price elasticity of demand in such situations if we know that the demand curve is linear and we can determine the slope. For example, if we have the information given in Figure 5.4, then we can calculate the price elasticity of demand at a specific point. To understand how this information can be used to calculate the price elasticity of demand, we can convert our original formula in the following way: $E_{D}=\frac{\%\Delta Q^D}{\%\Delta P}=\frac{\frac{\Delta Q}{Q}}{\frac{\Delta P}{P}}=\frac{\Delta Q}{Q} \cdot \frac{P}{\Delta P}=\frac{P}{Q} \cdot \frac{\Delta Q}{\Delta P}=\frac{P}{Q} \cdot \frac{1}{\frac{\Delta P}{\Delta Q}}$ The final expression is the point elasticity formula. It is now possible to calculate the price elasticity of demand for a given P and Q on the demand curve. The reader should also note that ∆P/∆Q represents the slope of a linear demand curve. If we use the information in Figure 5.4 to calculate the absolute value of the price elasticity of demand using the point elasticity formula, then we obtain the following result: $|E_{D}|=|\frac{P}{Q} \cdot \frac{1}{\frac{\Delta P}{\Delta Q}}|=|\frac{13}{44} \cdot \frac{1}{\frac{-24}{96}}|=|\frac{13}{44} \cdot \frac{1}{\frac{-1}{4}}|=|\frac{13}{44} \cdot -4|=\frac{13}{11}$ In this case, the price elasticity of demand is greater than 1. Therefore, we conclude that demand is elastic at this point on the demand curve. That is, consumers are relatively responsive to the price change. The reader might expect the price elasticity of demand to be the same at every point on this linear demand curve. After all, the slope is constant at every point on the demand curve. This conclusion is incorrect, however, as can be shown by calculating the price elasticity of demand at another point on the demand curve. For example, we might calculate the price elasticity of demand at a second point on the linear demand curve we just considered as shown in Figure 5.5. If we calculate the price elasticity of demand when the price is equal to$9 per unit and the quantity demanded is equal to 60 units, then we obtain the following result:
$|E_{D}|=|\frac{P}{Q} \cdot \frac{1}{\frac{\Delta P}{\Delta Q}}|=|\frac{9}{60} \cdot \frac{1}{\frac{-24}{96}}|=|\frac{9}{60} \cdot \frac{1}{\frac{-1}{4}}|=|\frac{9}{60} \cdot -4|=\frac{36}{60}=\frac{3}{5}$
In this case, we conclude that demand is inelastic because the price elasticity of demand is less than 1. It should also be noted that the slope of -1/4 remains the same in this calculation. The only change in this calculation compared with the calculation when the price is equal to $13 per unit is the specific P and Q that we use as we move down the demand curve. What we observe is that the price elasticity of demand declines as we move down the linear demand curve. This general result can be explained intuitively. That is, consumers are less responsive to price changes at lower prices than at higher prices. In other words, a 5% price reduction when the price is very high has a greater impact on the consumer’s quantity demanded than a 5% price reduction when the price is very low. We thus obtain a major result: the price elasticity of demand falls as the price falls along a linear demand curve. The point elasticity formula can also be used to divide a linear demand curve into elastic and inelastic sections as shown in Figure 5.6. For example, we can calculate the price elasticity of demand where the demand curve intersects the vertical axis as follows: $|E_{D}|=|\frac{P}{0} \cdot \frac{1}{\frac{\Delta P}{\Delta Q}}|=|-\infty|=\infty$ In this case, for any price and slope, the price elasticity of demand will be (or will approach) infinity. We can also calculate the price elasticity of demand where the demand curve intersects the horizontal axis as follows: $|E_{D}|=|\frac{0}{Q} \cdot \frac{1}{\frac{\Delta P}{\Delta Q}}|=0$ In this case, for any Q and slope, the price elasticity of demand will be zero. Furthermore, the point elasticity formula indicates that as the price falls and the quantity demanded rises along a linear demand curve, the ratio of P to Q (that is, P/Q) will decline causing the price elasticity of demand to fall. Therefore, the price elasticity of demand falls continuously from its highest value of infinity to its lowest value of zero as we move down along the linear demand curve. Due to the continuous decline in the price elasticity of demand, at some point, the price elasticity of demand will equal 1. That is, demand will be unit elastic. This point marks the separation between the elastic portion of the demand curve (where |ED|>1) and the inelastic portion of the demand curve (where |ED|<1). Cases of Extreme Elasticity In certain situations, demand may become perfectly elastic or perfectly inelastic at every price on the demand curve. These situations are unusual but theoretically possible. For example, a consumer might become perfectly unresponsive to price increases if she is in desperate need of a life-saving medication. No matter how high the price rises, the consumer will pay the price and not reduce her quantity demanded. Of course, even this case has limits because the consumer will eventually become unable to make the purchase even if she is still willing to do so. (The reader will recall that both ability and willingness to pay are required for the demand for a product to exist.) Nevertheless, in this case, the demand curve becomes perfectly vertical as shown in Figure 5.7. As the reader can see, even when the price rises from P1 to P2, the quantity demanded remains unchanged at Q1. Because the slope of the demand curve is infinite in this case, the use of the point elasticity formula yields the following result: $|E_{D}|=|\frac{P}{Q}\cdot\frac{1}{\frac{\Delta P}{\Delta Q}}|=|\frac{P}{Q}\cdot\frac{1}{\infty}|=0$ It is clear then that demand is perfectly inelastic when the slope of the demand curve is infinite. It should also be clear that the slope of the demand curve and the price elasticity of demand are inversely related. A second extreme case arises when consumers become perfectly responsive to price changes. That is, the smallest rise in price may lead consumers to reduce their quantity demanded to 0. Alternatively, the smallest reduction in price might lead consumers to increase their quantity demanded to infinity (or a very large quantity, at least!). This might occur when a consumer knows that a perfectly good substitute product is available at the same price. As soon as the price of the product the consumer is buying rises at all, he switches immediately to the other product and his quantity demanded of the first product falls to zero. This situation is depicted in Figure 5.8 as a horizontal demand curve. As the reader can see, for any price above P1 the quantity demanded will equal zero and for any price below P1 the quantity demanded will soar to infinity. Because the slope of the demand curve is zero in this case, the price elasticity of demand can be calculated as follows: $|E_{D}|=|\frac{P}{Q}\cdot\frac{1}{\frac{\Delta P}{\Delta Q}}|=|\frac{P}{Q}\cdot\frac{1}{0}|=\infty$ Demand is perfectly elastic then when the slope of the demand curve is equal to 0, and we again see that the slope of the demand curve and the price elasticity of demand are inversely related. Key Determinants of the Price Elasticity of Demand At this point, we have considered several ways to calculate the price elasticity of demand, but it is also necessary to consider the factors that cause the demand for a product to be more (or less) elastic. The key determinants of the price elasticity of demand include the following: The nature of the good: Is it a luxury or a necessity? If the good is a luxury item then consumers can do without it. If the price rises, consumers will be highly responsive to the price change. Similarly, if the price falls, consumers will be eager to enter this market. On the other hand, if the good is a necessity, like the life-saving medication described above, then consumers will not be able to reduce their purchases very much when the price rises. Alternatively, if the price falls, consumers will not expand their purchases much because they were already purchasing the amount required before the price fell. In general, the price elasticity of demand for luxuries tends to be greater than the price elasticity of demand for necessities, other things the same. The budget share devoted to the purchase of the good If consumers spend a large percentage or share of their budgets on a good, then the demand for the good tends to be more elastic, other things the same. The reason is obvious. Consumers will feel a greater pinch from a rise in the price of an automobile than they will feel from the rise in the price of chewing gum. Consumers of automobiles are, therefore, more responsive to price changes than consumers of chewing gum. The time span during which the good is purchased The reader should recall from Chapter 3 that the quantity demanded of a product is a flow variable. That is, it is defined per period, such as a day, a week, a month, or a year. If the period is very short, such as a day, then the demand for a good tends to be inelastic, other things the same. For example, when the price of gasoline rises sharply, consumers are often slow to reduce their purchases. Consumers still need to drive to work and to school. Over long periods, however, consumers can begin to seek out substitute forms of transportation. For example, they can carpool, ride the bus, or ride a bike. As a result, consumers are more responsive to price changes over longer periods than over shorter periods. In general, the demand for a good is more elastic in the long run than in the short run, other things the same. The existence of substitutes Finally, if many close substitutes for a good exist, then consumers tend to be more responsive to price changes. For example, if the price of apple juice rises sharply, consumers can substitute towards grape juice. As a result, the quantity demanded of apple juice drops sharply. On the other hand, if the price of juice in general rises, then consumers can substitute towards milk or soda, but these alternatives are not very good substitutes for juice. As a result, the demand for juice is much more inelastic than the demand for apple juice. In general, when more close substitutes for a good exist, demand tends to be more elastic, other things the same. Below are a few examples of demand elasticities in different industries.[2] Example 1: The price elasticity of demand for restaurant meals has been estimated to be 2.27. Example 2: The short run price elasticity of demand for gasoline has been estimated to be 0.3. Example 3: The price elasticity of demand for premium white pan bread has been estimated at 1.01. The high demand elasticity of restaurant meals can be attributed to the perception among many consumers that they are luxury goods. The low demand elasticity for gasoline can be attributed to the short period and the perception that gasoline is a necessity. Finally, the relatively elastic demand for premium white pan bread may be attributed to the existence of many close substitutes. The Relationship between the Price Elasticity of Demand and Sales Revenue When a firm sells a particular product, its sales revenue, or total monetary receipts, depends on two important variables: the price per unit and the number of units sold. In other words, a firm’s revenue depends on price and quantity demanded. Specifically, we can calculate a firm’s revenue by multiplying the product price by the quantity demanded. If we consider a linear demand curve, like the one shown in Figure 5.9, then it is possible to represent total revenue (TR) as the product of P and Q, or as the area of the box under the demand curve. $TR=PQ$ In this case, the total revenue is$50 or $5 per unit times 10 units. A manager of a firm now faces a difficult task. If the manager aims to increase revenue, it might seem logical to raise the price of the good. The problem is that the quantity demanded will fall as the price rises, according to the law of demand. Therefore, we observe two conflicting effects on total revenue when the price changes, as shown below, leaving the overall effect an open question. $? \;\;\;\;\;\;\;\;\uparrow \; \downarrow$ $TR=PQ$ The manager must ask which factor has the greater impact on revenue. In other words, what is the net effect of a change in price? The answer to this question, it turns out, depends on the price elasticity of demand. Let’s consider a price reduction that leads to a rise in quantity demanded. Although we do not provide a rigorous proof of this result, we can provide an intuitive explanation for these changes. If the price falls by the same percentage as the rise in quantity demanded, then the net effect on total revenue is zero. On the other hand, if the price falls by a greater percentage than the rise in quantity demanded, then the net effect on total revenue is negative.[3] Finally, if the price falls by a smaller percentage than the rise in quantity demanded, then the net effect on total revenue is positive. These results and the implications for demand elasticity are shown below with larger arrows indicating larger percentage changes.[4] $P\downarrow \; and \; Q\Big\uparrow \; then\; TR \uparrow \Rightarrow Demand\; is\; elastic$ $P\downarrow \; and \; Q\uparrow \; then\; \overline{TR} \Rightarrow Demand\; is\; unit\;elastic$ $P\Big\downarrow \; and \; Q\uparrow \; then \; TR\downarrow \Rightarrow Demand\; is\; inelastic$ Because we identified the elastic and inelastic portions of a linear demand curve earlier in this chapter, we can now use that information to determine the shape of the total revenue curve. Figure 5.10 reveals that as the price falls from its peak, total revenue rises because demand is elastic. Once we reach the point where demand is unit elastic, total revenue does not change (the meaning of the overbar above TR in the unit elastic case shown above). Finally, if price falls far enough, then total revenue declines because demand is inelastic. The reader can see that when the price elasticity of demand is infinite, total revenue is equal to 0. Although the price is high, the quantity demanded is zero. Similarly, when the price is set at 0, total revenue is equal to 0 even though the quantity demanded is high at Q2. In between these two extremes, the total revenue rises and then falls as the price declines. Because total revenue rises prior to the point of unit elasticity and falls after the point of unit elasticity, it follows that total revenue reaches its peak at the point of unit elasticity. Although total revenue reaches its maximum at Q1, the reader should not assume that this level of output is the optimal choice for the firm. The firm must also consider production cost, which is a concept that is discussed at great length in Chapter 7. Other Measures of Elasticity: Supply, Cross-Price, and Income The price elasticity of demand is a widely used concept among neoclassical economists, in part because of its connection to sales revenue. Several other elasticity concepts are also useful, namely the price elasticity of supply, the cross-price elasticity of demand, and the income elasticity of demand. This section only provides a brief overview of these concepts. The Price Elasticity of Supply Just as consumers are responsive to changes in price, so are sellers. To measure the responsiveness of sellers to price changes, neoclassical economists use the price elasticity of supply defined below: $E_{S}=\frac{\%\Delta Q^S}{\%\Delta P}$ The formula for the price elasticity of supply (ES) measures the percentage change in the quantity supplied for a given percentage change in price. For example, if the price of a product increases by 8% and the quantity supplied rises by 24%, then the price elasticity of supply equals 3. It should be noted that it is not necessary to calculate the absolute value of the price elasticity of supply as we did earlier with the price elasticity of demand. The reason is that the price elasticity of supply will virtually always be a positive number due to the law of supply. That is, price increases will lead to increases in quantity supplied and price reductions will lead to reductions in quantity supplied. When the price elasticity of supply equals 3, it may be interpreted to mean that a 1% rise in price leads to a 3% rise in quantity supplied, or a 1% reduction in price leads to a 3% reduction in quantity supplied. The interpretations of price elasticity of supply are also like the interpretations of the price elasticity of demand. For example, if the price elasticity of supply equals 1, then supply is unit elastic. If it is greater than 1, then supply is elastic. If it is less than 1, then supply is inelastic. If it is infinite, then supply is perfectly elastic. If it is equal to 0, then supply is perfectly inelastic. The primary determinant of the price elasticity of supply is the time frame. If the price of apples rises in a very short period such as a month, for example, then producers of apples cannot expand production very quickly. They can hire more workers to pick more apples, but they cannot grow more apples in a month’s time. The price elasticity of supply in the short run tends to be very low, as a result. Over a longer period, it may be possible to purchase additional orchards or even to grow more trees. Supply then becomes much more elastic. That is, producers can expand production as the price rises over long time periods. Figure 5.11 shows an inelastic short run supply curve and a much more elastic long run supply curve. The Cross-Price Elasticity of Demand The cross-price elasticity of demand (or simply, cross elasticity) allows us to measure the percentage change in the quantity demanded of a product for a given percentage change in the price of a different product. For example, the cross elasticity of demand between goods A and B can be written as follows: $E_{A,B}=\frac{\% \Delta Q_{A}^D}{\% \Delta P_{B}}$ If the price of good B rises by 4% and the quantity demanded of good A rises by 2%, then the cross elasticity is equal to +1/2. In this case, the sign is important. The fact that the consumer purchases more of good A when the price of good B rises indicates that the consumer considers good A to be a substitute for good B. Similarly, if the price of peanut butter rises by 6% and the quantity demanded of jelly falls by 2%, then the cross elasticity is -1/3. Because the consumer reduces purchases of jelly when the price peanut butter rises, it suggests that the goods are often consumed together. In other words, the two goods are complements. Finally, the two goods are regarded as unrelatedgoods if the quantity demanded does not change at all when the price of the other good changes. That is: $E_{A,B}=\frac{\% \Delta Q_{A}^D}{\% \Delta P_{B}}>0 \Rightarrow\;Substitutes$ $E_{A,B}=\frac{\% \Delta Q_{A}^D}{\% \Delta P_{B}}<0 \Rightarrow\;Complements$ $E_{A,B}=\frac{\% \Delta Q_{A}^D}{\% \Delta P_{B}}=0 \Rightarrow\;Unrelated\;Goods$ The reader should notice that a positive value for the cross elasticity may be obtained either with a +/+ or a -/-. Similarly, a negative value for the cross elasticity may be obtained either with a +/- or a -/+. The cross elasticity has an important application in antitrust law. Consider two firms that are trying to initiate a merger. If the merger reduces competition and leads to higher prices, then the merger will harm consumers. Antitrust laws are in place to prevent such mergers, but it is not always obvious whether two goods are substitutes for one another. If they are, then the merger will reduce competition. As a result, the U.S. Justice Department, which enforces the nation’s antitrust laws, may ask an expert to testify in antitrust cases that two goods have a positive cross elasticity. Such evidence supports the claim that the goods are substitutes and that a merger of the two firms will harm American consumers. The Income Elasticity of Demand One final elasticity measure that we will consider is the income elasticity of demand. This elasticity concept measures the responsiveness of consumers to a change in income. That is, it measures the percentage change in the quantity demanded of a product given a percentage change in income (Y). It can be written as follows: $E_{Y}=\frac{\% \Delta Q^D}{\% \Delta Y}$ For example, if a 3% rise in income leads to a 12% rise in quantity demanded, then the income elasticity of demand is equal to +4. The sign of the income elasticity of demand is also important. The positive sign in this case indicates a positive relationship between income and quantity demanded. In Chapter 3, we explained that such goods are called normal goods. Alternatively, if a 3% rise in income leads to a 6% drop in quantity demanded, then the income elasticity of demand is -2. Such goods are called inferior goods because a negative relationship exists between income and quantity demanded. Finally, if the quantity demanded does not change at all when income changes, then the income elasticity of demand is equal to 0. Such goods are said to be neutral with respect to income. That is: $E_{Y}=\frac{\% \Delta Q^D}{\% \Delta Y}>0\Rightarrow\;Normal\;Goods$ $E_{Y}=\frac{\% \Delta Q^D}{\% \Delta Y}<0\Rightarrow\;Inferior\;Goods$ $E_{Y}=\frac{\% \Delta Q^D}{\% \Delta Y}=0\Rightarrow\;Neutral\;\;Goods$ The reader should note that a positive income elasticity of demand may be obtained with either a +/+ or a -/-. The reader should also note that a negative income elasticity of demand may be obtained with either a +/- or a -/+. Do Marxian Economists Use Elasticity Measures? Before concluding this chapter, it is worth noting that Marxian economists do not make much use of elasticity measures. One reason is that the price elasticities of supply and demand are measures that relate to market supply and demand curves. For neoclassical economists, supply and demand provide the best explanation of market prices. For Marxian economists, supply and demand influence market prices, but these laws are subordinate to the law of value. That is, socially necessary abstract labor time governs commodity values and so it is the law of value that receives the attention of Marxian economists. Similarly, Marxian economists are interested in the class dynamics of capitalist societies. How consumers respond, and to what extent they respond, to price changes is not a major concern of Marxian economists. A second reason is that the two primary measures that Marxian economists use to draw comparisons across industries are unit-free measures. Recall that the rate of surplus value and the rate of profit measure the degree of exploitation of labor-power and the rate of self-expansion of capital in different industries, respectively. Both measures are already expressed in percentage terms and so direct comparisons across industries are possible. In Chapter 8, we will see that such comparisons across industries play an important role in the Marxian theory of industrial competition. Following the Economic News [5] Business executives are very aware of the issue of consumer responsiveness to price changes. For example, the Chief Executive of Hershey Co., Michele Buck, explained in an interview that Hershey recently increased the prices of its products but that she does not expect people to reduce their candy purchases in response to the higher prices. In other words, Ms. Buck believes that the demand for Hershey products is relatively inelastic. She anticipates a rise in sales as Hershey introduces new “stand-up pouches” for its candy bags, which “look more appealing on shelves.” If sales revenues rise even as prices are increased, then that result would certainly be consistent with Ms. Buck’s contention that the demand for Hershey’s candy is relatively inelastic (i.e., less than one in absolute value). Innovation is used to justify the price increases for food products with inelastic demands. In addition to Hershey’s new packaging, it also is introducing a “thinner Reese’s peanut butter cup … that it hopes will appeal to calorie-conscious Americans.” Gasparro likens this new product to Oreo Thins, which Mondelez International, Inc. introduced in 2015. Because of these kinds of innovations, Hershey managed to increase total sales by 2.5% to$1.99 billion in the fourth quarter of 2018. Although a rise in total revenue does not necessarily correspond to an increase in total profit, in this case, profits did rise in the fourth quarter by 24%. The implication is that the price increases are not only boosting sales revenue, they are part of an overall profit-maximizing strategy as well.
Summary of Key Points
1. The price elasticity of demand measures the responsiveness of consumers to price changes.
2. Unlike the slope of the demand curve, the price elasticity of demand is a unit-free measure.
3. A larger absolute value of the price elasticity of demand implies that demand is more elastic.
4. The arc elasticity formula is used to calculate price elasticity of demand when moving between two points on a demand curve; the point elasticity formula is used to calculate the price elasticity of demand at a single point on the demand curve.
5. The price elasticity of demand depends on the nature of the good, the time span, the budget share, and the existence of substitutes.
6. Whether total revenue rises, falls, or remains the same when price changes, depends on whether demand is elastic, inelastic, or unit elastic.
7. The price elasticity of supply measures the responsiveness of sellers to price changes.
8. The cross-price elasticity of demand measures the responsiveness of consumers to a change in the price of a different good.
9. The income elasticity of demand measures the responsiveness of consumers to a change in their incomes.
10. We do not use the absolute value of supply elasticity, cross elasticity, and income elasticity because the signs of these values are highly significant.
List of Key Terms
Price elasticity of demand
Elastic
Unit elastic
Inelastic
Perfectly inelastic
Perfectly elastic
Arc elasticity
Point elasticity
Total revenue
Price elasticity of supply
Cross-price elasticity of demand
Substitutes
Complements
Unrelated goods
Income elasticity of demand
Normal goods
Inferior goods
Neutral goods
Problems for Review
1. Suppose the price of a good rises by 6% and the quantity demanded falls by 30%. What is the price elasticity of demand (in absolute value terms)? Also, interpret your answer.
2. Suppose the price of a good falls from $62 to$58 and the quantity demanded rises from 1,760 units to 1,910 units. Calculate the price elasticity of demand using the arc elasticity formula. Also, interpret your answer.
3. Suppose the price of a good is \$45 and the quantity demanded is 500 units. If the slope of the linear demand curve is -3, then what is the price elasticity of demand, according to the point elasticity formula? Also, interpret your answer.
4. If the price of gasoline rises and the total revenue received by sellers decreases, then what can you conclude about the relationship between the percentage change in quantity demanded relative to the percentage change in price (in absolute value)? What can you conclude about the price elasticity of demand?
5. If the price of cereal rises by 2% and the quantity demanded of milk falls by 0.5%, then what is the cross elasticity between the two products? Also, interpret your answer. Is your interpretation consistent with your expectations?
6. If your income rises by 10% and your quantity demanded of used goods falls by 20%, then what is the income elasticity of demand? Interpret your answer. Is your answer consistent with your expectations?
1. I wish to acknowledge Prof. John Hoag for first emphasizing to me the units in which slope is measured.
2. Keat et al. (2013), p. 84-85.
3. Recalling that the %∆xy ≈ %∆x+%∆y, we can write that %∆PQ ≈ %∆P+%∆Q. If revenue falls, then %∆P+%∆Q < 0, and %∆Q < -%∆P. In the case of a price decrease and an increase in quantity demanded, it follows that the percentage change in price exceeds the percentage change in quantity demanded (in absolute value terms). Hence, demand is inelastic.
4. It is left to the reader to consider how to analyze the three cases when the price increases.
5. Gasparro, Annie. The Wall Street Journal (Online); New York. 31 Jan. 2019. | textbooks/socialsci/Economics/Principles_of_Political_Economy_-_A_Pluralistic_Approach_to_Economic_Theory_(Saros)/02%3A_Principles_of_Microeconomic_Theory/05%3A_The_Neoclassical_Concept_of_Elasticity.txt |
Goals and Objectives:
In this chapter, we will do the following:
1. Outline the history of utility theory
2. Describe the traditional and modern neoclassical theories of utility maximization
3. Explain how to derive the demand curve using utility maximization
4. Explore criticisms of the neoclassical measure of welfare
5. Learn two competing solutions to the “paradox of value”
6. Analyze the complications that arise when preferences are endogenous
The Utilitarian Roots of the Theories
The theories that we will explore in this chapter have their roots in a philosophy called utilitarianism that developed in the nineteenth century. Utilitarianism is primarily a moral philosophy. According to its British founder, Jeremy Bentham (1748-1832), we ought to judge all social and economic policies according to the consequences that they carry for human happiness. If policies promote human happiness then they are morally right. If they diminish human happiness, then they are morally bankrupt. In other words, we ought to pursue the greatest happiness of the greatest number. Utilitarianism is mostly a normative theory, as defined in chapter 1. Its focus is primarily on what ought to be. John Stuart Mill is another famous thinker whose ideas on economics and politics utilitarianism greatly influenced, and the theory continues to have great influence among moral philosophers as well as economists.
By the late nineteenth century, many economists were beginning to reject the labor theory of value, arguably because its implications served critics of market capitalism more than it served its defenders. The notion that workers might be creating more value in production than they received in compensation was too threatening to those who wished to maintain the present social order. In its place, they discovered a theory of value that appeared to shift the focus back to the value that consumers obtain from consumption and away from labor content or cost of production. It was this discovery that gave rise to a school of economic thought that was so far removed from the classical economics of Smith and Ricardo that it was given the new title of neoclassical economics.
In the 1870s, three economists working independently co-discovered a concept that would form the basis of neoclassical microeconomics for the next century and a half. Leon Walras in France, William Stanley Jevons in Britain, and Carl Menger in Austria each developed the concept of marginal utility and identified an economic law to which they claimed all consumers are subject. They shifted the emphasis from the normative idea inherent in traditional utilitarianism (that we should pursue the greatest happiness of the greatest number) to a positive idea that economic agents, acting in a world of scarce resources, seek to maximize their own happiness. As economic agents go about maximizing their happiness, the economic law to which each is subject governs and determines their behavior in the marketplace.
The Concept of Utility in the Traditional Theory of Utility Maximization
Before we define this economic law with precision, we must first define the concept of utility more carefully. The early neoclassical economists aimed to shift the focus of value theory back to the consumption side, but they did not wish to use the classical notion of use value. The use value of a commodity refers to the useful properties of a good or service. Utility, on the other hand, refers to the satisfaction that the user experiences in consumption.
One reason neoclassical economists define utility in terms of satisfaction is that they recognize that the experience of consumption is highly subjective. How useful the properties of a good or service are perceived to be depends on the user’s subjective mental experience. For that matter, an item might seem to an external observer to be useless. For example, in 1975 an entrepreneur had the idea to sell ordinary rocks as pets. These Pet Rocks had no function at all. They were simply good for a laugh. Nevertheless, the owner of the business became a millionaire before the item fell out of fashion. In addition, the good or service might not always appear to lead to pleasure. For example, if you go to the doctor for a shot, it might be painful rather than pleasurable. Nevertheless, on some level, you recognize that it is good for you to have it, and so you receive satisfaction despite the sting.
One of the strangest properties of utility according to the traditional theory of utility maximization is its quantifiable nature. Early neoclassical economists assumed that they could measure utility in terms of a standardized unit called utils. For example, you might obtain 25 utils of satisfaction from eating a bowl of cereal. This claim might seem silly, but remember that it is only an assumption for model building. Early neoclassical economists did not literally believe that satisfaction was a peculiar substance in the brain. Instead, they regarded it as a useful theoretical tool that would yield useful results. In other words, if we assume that satisfaction is measurable, does that assumption help us to explain and predict the behavior of individual consumers? Early neoclassical economists believed that it was so.[1]
The Law of Diminishing Marginal Utility
We next introduce a very important distinction between two key variables in the traditional theory of utility maximization: total utility and marginal utility. Total utility (TU) refers to the overall amount of satisfaction derived from the consumption of a good or service. For a certain period, we measure TU in utils. Marginal utility (MU) refers to the additional satisfaction obtained from the consumption of an additional unit of a good or service. We measure MU in utils per unit as follows:
$MU=\frac{\Delta TU}{\Delta Q}$
For example, six mozzarella sticks might give you a total utility of 65 utils, but the third mozzarella stick might only give you a marginal utility of 12 utils for that unit consumed. More generally, as an individual consumes more of a good, a clear pattern begins to emerge, argues the neoclassical economist. Table 6.1 shows what might happen to the total utility and marginal utility of a consumer as she consumes more mozzarella sticks.
As the table indicates, as the consumer consumes more mozzarella sticks, the TU rises quite a bit even though it eventually begins to decrease. MU, on the other hand, falls from the beginning and eventually becomes negative. We can also graph these relationships as in Figure 6.1 where only a few of the points on each curve have been included.
It is worth noting the relationship between the two graphs. Mathematically, the slope of the TU curve is MU (=∆TU/∆Q). It should come as no surprise then that when total utility reaches its maximum, marginal utility equals zero utils per unit. That is, the slope of the TU curve is zero at the maximum point on the TU curve.
The law of diminishing marginal utility is perfectly compatible with the law of demand. If a consumer experiences a reduction in marginal utility as he consumes more of a good, then he will need a lower price to justify the purchase of an additional unit. That is, he will only be willing to purchase another unit if the price falls because that additional unit offers less satisfaction than the previous unit he consumed. Interestingly, the law of diminishing marginal utility also appears to be compatible with the discovery we made in chapter 5 that the price elasticity of demand falls all the way down a linear demand curve. It makes sense that a consumer would be less responsive to price changes at lower prices because those units correspond to lower marginal utilities.
The Traditional Theory of Utility Maximization
The law of diminishing marginal utility tells us how each consumer responds to the increased consumption of a good, but it does not tell us much about the consumer’s choices. Consumers generally consume more than one good. Consumers also must purchase these goods at constant prices and with limited incomes. To understand how much of each good a consumer will choose to purchase, we need a model to assist us with the analysis. To create an environment in which a single consumer makes decisions about how much of each good to purchase, we will assume that the consumer aims to maximize her total utility. It is also assumed that the consumer has complete preferences for the two goods available in the market and is subject to the law of diminishing marginal utility. Finally, the consumer faces a constant money income and constant prices for the two goods.
The statement that a consumer has complete preferences means that he knows exactly how many utils he will obtain from the consumption of a specific quantity of a good or service. In addition, the reader should notice the neoclassical entry point of given individual preferences and a given resource (or income) endowment. Overall, these assumptions are enough to make possible an analysis of the consumer’s utility maximizing choice.
We should begin with a simple example involving two goods. The consumer is trying to decide between the purchase of a television and a computer. Figure 6.2 captures the economic problem facing this consumer.
If the television will give the consumer 400 utils and the computer will give the consumer 800 utils, then one might conclude that the consumer should purchase the computer to maximize total utility. The problem with this line of reasoning is that it completely fails to consider the prices of the products. The price of the television might be $100 and the price of the computer might be$400. It turns out that the consumer will choose to purchase the television even though it gives the consumer less utility because the price is so much lower than the price of the computer.
To prove this point, we need to compare the marginal utility per dollar spent on each good (MU/$) by dividing the marginal utility of each good by its price. For example, the MU per dollar spent on the television is 400 utils/$100 or 4 utils per dollar spent. Similarly, the MU per dollar spent on the computer is 800 utils/$400 or 2 utils per dollar spent. Because the MU per dollar spent on the television is greater, the consumer will get more bang for her buck when she buys the television. We may state the general rule as follows: The consumer will always purchase first the good that gives the higher MU per dollar spent. We are now able to derive a more general result about utility maximizing behavior. Let us consider an example in which an individual is trying to decide how much of good X and how much of good Y to purchase. We will assume that the consumer’s income (M) is$35, the price of good X (PX) is $5 per unit, and the price of good Y (PY) is$3 per unit. We also assume that the consumer has clear preferences and so he or she knows the TU and MU for each quantity of the two goods consumed. Table 6.2 represents this information.
As the table shows, the consumer knows her preferences, and the law of diminishing marginal utility holds for each of the goods. In both cases, the MU falls as the consumer consumes more of the good. To calculate MU per dollar spent, we simply divide each MU by the price of the good in question.
The next question we wish to ask is how much of each good the consumer will choose given the income and the prices of the two goods. Because the consumer aims to maximize utility, the consumer will always select first the good that gives her the highest marginal utility per dollar spent. For example, assume that the consumer has an empty shopping cart and is trying to decide whether to purchase the first unit of good X or the first unit of good Y. Because the MU per dollar spent on the first unit of Y (= 15) is so much larger than the MU per dollar spent on X (= 5), the consumer will buy the first unit of Y. Next, the consumer must decide between the second unit of Y and the first unit of X. Because the eight utils per dollar spent on the second unit of good Y exceed the five utils per dollar spent on good X, the consumer will purchase the second unit of good Y. We need to keep track of expenditure as we proceed. Thus far, the consumer has spent $6. Next, the consumer must decide between the third unit of good Y and the first unit of good X. In this case, either choice leads to five utils per dollar spent. The consumer will be completely indifferent in this case between the third unit of Y and the first unit of X. The reader might think that the consumer should choose the third unit of Y because it is cheaper but that would be a mistake. We already considered the fact that Y is cheaper than X when we divided the MU of each unit of each good by the appropriate price. Let us then assume that the consumer will choose the first unit of good X, bringing total expenditure to$11. Now the consumer must choose between the second unit of good X and the third unit of good Y. Because 5 > 4, the consumer will choose the third unit of good Y, bringing total expenditure to $14. The next choice is between the fourth unit of Y and the second unit of X. Since 4 > 3, the consumer chooses the second unit of X. Expenditure has now reached$19. Next, the consumer is indifferent between the third unit of X and the fourth unit of Y because each yields 3 utils per dollar spent. If the consumer buys the fourth unit of Y, then total expenditure is up to $22. Now the consumer compares the MU per dollar spent on the fifth unit of good Y with the MU per dollar spent on the third unit of good X. Since 3 > 2, the consumer chooses to buy X, bringing total expenditure up to$27. Finally, the consumer is indifferent between the fourth unit of X and the fifth unit of Y. If the consumer chooses the fifth unit of Y, then total expenditure is $30. With the remaining$5, the consumer can buy the fourth unit of X because the sixth unit of Y has a negative MU and would reduce total utility.
With that final purchase, the consumer has purchased five units of good Y and four units of good X. It is the utility-maximizing combination of the two goods. In addition, the consumer has spent the entire $35 of income. Because we have been assuming that only the consumption of goods and services generates utility, it follows that the consumer must spend all income. If some income is not spent (i.e., if saving occurs), then utility cannot be at its maximum. The reader might object that individuals do choose to save. Neoclassical economists do analyze saving from a microeconomic perspective, but it involves a utility maximizing choice between present and future consumption rather than between two present goods.[2] One other major result that deserves special attention is the fact that the MU per dollar spent on goods X and Y are the same when the consumer is maximizing utility. The final unit of each good yields 2 utils per dollar spent. It is possible to construct an example where the marginal utilities per dollar spent on each good are only approximately equal due to the consumer running out of money before the equality is reached. Nevertheless, the point remains that the consumer will continue to move back and forth between the two goods until the marginal utilities per dollar spent are nearly, if not exactly, equal. Excluding possible exceptions, we can sum up as follows: The consumer maximizes utility when the marginal utilities per dollar spent are the same for both goods and all income is spent . Algebraically, it is possible to write this condition as follows: $\frac{MU_{X}}{P_{X}}=\frac{MU_{Y}}{P_{Y}}\;(all\;income\;is\;spent)$ Furthermore, if all income is spent and $\frac{MU_X}{P_{X}}>\frac{MU_Y}{P_{Y}}$, then the consumer should buy more X and less Y. As more X is purchased, the MU of X falls due to diminishing marginal utility. Similarly, as less Y is purchased, the MU of Y rises due to diminishing marginal utility. These changes will continue until the marginal utilities per dollar spent are the same for the two goods. Similarly, if all income is spent and $\frac{MU_Y}{P_{Y}}>\frac{MU_X}{P_{X}}$, then the consumer should buy more Y and less X. As more Y is purchased, the MU of Y falls due to diminishing marginal utility. Similarly, as less X is purchased, the MU of X rises due to diminishing marginal utility. These changes will continue until the marginal utilities per dollar spent are the same for the two goods. The Traditional Derivation of the Individual Demand Curve The utility maximizing condition described in the last section can be used to derive the individual demand curve. That is, we can gain a deeper understanding as to why the individual demand curve slopes downward when we think in terms of utility maximizing behavior. Suppose, for example, that the price of good Y declines. The law of demand states that the quantity demanded of Y will rise, other things the same. This situation is depicted in Figure 6.3. Assume that the consumer is maximizing utility at the original price of PY. In other words, the initial condition when all income is spent is the following: $\frac{MU_X}{P_{X}}=\frac{MU_Y}{P_{Y}}$ Now suppose that PY declines to PY*. It follows that: $\frac{MU_X}{P_{X}}<\frac{MU_Y}{P_{Y}*}$ Because the MU per dollar spent on good Y is greater than the MU per dollar spent on good X, the consumer will purchase more Y. Because the price of good Y fell and the quantity demanded of good Y rose, we can conclude that the demand curve slopes downward. It is worth noting that the increase in the quantity demanded of Y will eventually cease (when Q reaches QY*) because the diminishing marginal utility of Y will restore the equality between the two marginal utilities per dollar spent. The Paradox of Value The traditional theory of utility maximization also helps to resolve a paradox in the history of economic thought. A paradox is a statement that appears to be false but that contains an element of truth. The paradox of value refers to the fact that many goods, like diamonds, appear to be not very useful even though they have high prices. Similarly, the most useful goods, like water, often have the lowest prices. The classical economists, like Smith and Ricardo, believed that they had successfully found the solution in the labor theory of value. That is, diamonds have a high price because they require a lot of labor time for their production. Similarly, water has a low price because it requires very little labor time for its production.[3] Early neoclassical economists in the 1870s offered a different solution to the paradox than that which the classical economists offered. Their discovery of the marginal utility concept allowed them to develop a different solution to the paradox that emphasized consumer satisfaction rather than production cost. Specifically, they pointed out that the proper resolution to the paradox requires the distinction between total utility and marginal utility. That is, goods that most people consider to be useful, like water, generate a great deal of total utility for consumers. The marginal utility of the last unit consumed, however, is very low due to the law of diminishing marginal utility and the fact that so many units are consumed. It is the marginal utility of the last unit consumed that governs its price, according to this solution. In other words, the low MU of water explains its low price. On the other hand, goods that most people regard as relatively useless, like diamonds, do not give consumers a great deal of total utility. The marginal utility of the last unit consumed, however, is very high due to the law of diminishing marginal utility and the fact that relatively few units are consumed. In this case, it is the high MU of diamonds that explains its high price. We can also graphically represent the marginal utility solution to the paradox of value as shown in Figure 6.4. The top graphs in the figure show that the total utility obtained from the consumption of water is very high due to the large volume consumed. The marginal utility of the last unit consumed is very low for that same reason. The bottom graphs in the figure show that the total utility obtained from the consumption of diamonds is very low because of the small amount consumed. For the same reason, the marginal utility of the last diamond consumed is very high. The reader should also observe the straight lines that are just tangent to the TU curves at the quantities consumed. The slopes of the tangent lines represent the marginal utilities. The relatively flat tangent line in the top left graph indicates a low marginal utility. The relatively steep tangent line in the bottom left graph indicates a high marginal utility. Table 6.3 summarizes all the information in this section, including the paradox of value itself as well as the classical and early neoclassical solutions to the paradox.[4] Criticisms of the Neoclassical Measure of Welfare The concepts of consumers’ surplus and producers’ surplus that are discussed in Chapter 3 are presented as being logically consistent with the rest of neoclassical microeconomic theory. The concepts, however, are subject to two serious criticisms that can only be understood once we have a firm grasp of the theory of utility maximization. The first major criticism is that the concepts implicitly assume a constant marginal utility of money. For example, suppose that I am willing and able to pay$5 for an ice cream sundae, but I only need to pay the market price of $2. I enjoy a consumer surplus of$3. Suppose further that I purchase a second ice cream sundae for $2 and that I am willing and able to pay$4 for the second one. I enjoy a consumer surplus of $2 on the second one that I purchase. My total consumer surplus is$5 (= $3+$2). This measure of my welfare only makes sense if the marginal utility of money is constant for me. That is, if the law of diminishing marginal utility applies to money, then the first dollar of consumer surplus that I receive will contribute more to my welfare than the last dollar that I receive. In other words, the yardstick by which we measure welfare must remain the same for consumers’ surplus to be regarded as an internally consistent measure of consumers’ welfare. The same criticism applies to producers’ surplus.
The second major criticism is that the concepts also implicitly assume that the marginal utility of money is the same for all buyers and sellers. This criticism becomes relevant when we attempt to aggregate the surpluses of different individuals. For example, suppose that my consumer surplus is a total of $75 and your consumer surplus is also$75. If we add our surpluses together, we obtain a total of $150. What if my marginal utility of money is much higher than your marginal utility of money? In that case, my surplus should count more in the aggregate measure than your surplus, but in this case, our surpluses contributed equally to this measure of consumer welfare. Both criticisms raise serious problems that have been recognized by neoclassical economists. Despite the difficulties, the concepts are still used and students are rarely encouraged to critically reflect on the problems inherent in the use of this welfare measure. The Modern Theory of Utility Maximization As we have seen, the early neoclassical economists assumed that utility was quantifiable and measurable. When utility can be quantified and measured, it is called cardinal utility. During the twentieth century, neoclassical economists realized their theory would be stronger if they abandoned an assumption as strict as this one. Their effort to rid consumer theory of this strict assumption is a good example of the application of a philosophical principle known as Ockam’s Razor. According to this principle, the strongest theory is the one based on the simplest assumptions, other things the same. This principle has been applied in many contexts, including in the natural sciences. For example, during the nineteenth century, Charles Darwin developed the theory of natural selection to explain how organisms adapt to their natural environments over long periods of time. According to Darwin, random genetic mutations cause variations in the physical characteristics among the members of a species. Those members that develop the most advantageous characteristics for survival will thrive and reproduce. Those members with the least advantageous characteristics will die and fail to reproduce. As a result, the most advantageous characteristics are passed down and the least advantageous characteristics disappear from the species. A little-known fact among non-scientists is that a competing theory of evolution also existed in the nineteenth century. According to a French anatomist by the name of Lamarck, the members of a species acquire advantageous characteristics during their lifetimes in response to their specific environments. For example, a giraffe stretches its neck to reach leaves further up on a tree, and thus acquires a longer neck, which it then passes down to its offspring. This claim, that an organism acquires traits that alter the genetic material passed down to its offspring, is an assumption of Lamarck’s theory that is much more complicated than Darwin’s assumption that random genetic mutations are the source of the advantageous characteristics. Because Darwin’s theory was based on a simpler set of assumptions, it was adopted and Lamarck’s theory was rejected. It should be emphasized that Darwin’s theory was not proven once and for all. It was accepted as the best theory due to the application of Ockam’s Razor. Similarly, neoclassical economists aimed to replace the less plausible assumption of quantifiable satisfaction with a simpler assumption. That is, they rejected cardinal utility and replaced it with a different kind of utility called ordinal utility in their models of consumer behavior. The ordinal utility concept implies that consumers receive satisfaction from the consumption of goods, but they are only able to create a ranking among alternative commodity bundles (i.e., combinations of the goods). For example, bundle 1 may consist of 2 apples and 1 banana whereas bundle 2 may consist of 1 apple and 2 bananas. If we use the notion of ordinal utility, then a consumer can only say one of three things: 1) Bundle 1 is preferred to bundle 2; 2) bundle 2 is preferred to bundle 1; or 3) bundles 1 and 2 are equally preferred (i.e., the consumer is indifferent between the two bundles). On the other hand, if we use the concept of cardinal utility, then it would be possible to state that bundle 1 creates 10 utils for the consumer and bundle 2 creates 5 utils for the consumer. In that case, bundle 1 is not only preferred to bundle 2, but it is exactly twice as preferred as bundle 2. That is, the cardinal utility assumption allows us to state how much more preferred one bundle is than another. With the ordinal utility assumption, it is only possible to state that one bundle is more preferred than another, but it is impossible to state how much more preferred that bundle is. The Implicit Ideological Significance of the Ordinal Utility Assumption Before we explore the modern theory of utility maximization at greater length, we should pause to consider the implicit ideological significance of the ordinal utility assumption. It will not be immediately obvious to the uninitiated reader what role this assumption plays in neoclassical theory, but it can be explained easily enough if one is willing to be direct about it. If cardinal utility is assumed, then satisfaction is quantifiable. Suppose person A has$1 million and person B has only $10,000. Suppose also that the MU of an additional$10,000 for person A is 10 utils, but the MU of an additional $10,000 for person B is 500 utils. If the law of diminishing marginal utility holds, then this assumption seems to make sense. That is, the relatively poor individual values the additional$10,000 much more than the wealthy individual. It seems that we might be able to make a case for a redistribution of wealth from person A to person B strictly on efficiency grounds. Society will enjoy a net gain of about 490 utils due to the transfer.[5]
On the other hand, if we assume ordinal utility, then all we can assert is that both individuals will prefer the larger sum ($1,010,000 for person A and$20,000 for person B) to the smaller sum ($1,000,000 for person A and$10,000 for person B). We cannot say how much more each person prefers the larger sum to the smaller sum. As a result, it is impossible to conclude that a redistribution of money will lead to a net welfare gain. With ordinal utility, interpersonal utility comparisons are impossible. That is, who is to say that the individual with $1 million will value an additional$10,000 less than the individual with only $10,000? Because we lack a common yardstick for the measurement of satisfaction, we cannot justify the redistribution of wealth on efficiency grounds. If any argument is to be made for the redistribution of wealth, it must appeal to our desire for greater equality or some standard of fairness. For those wishing to limit government redistributions of wealth and income, the ordinal utility assumption is a powerful one. The Assumptions of the Modern Theory of Utility Maximization Just as in the case of the traditional theory, it is necessary to specify the conditions in which the consumer makes decisions with the goal of maximizing utility. It is again assumed that the consumer is choosing between two goods, X and Y. The consumer also possesses a fixed money income (M) and faces a constant price for good X (PX) and a constant price for good Y (PY). The consumer also has given individual preferences. The only major difference between the two theories is that the consumer’s preferences must be represented differently because in the modern theory, utility is not quantifiable. Budgets, Preferences, and Utility Maximization To graphically represent the modern theory of utility maximization, we will be working in a two-dimensional space called the commodity space. An example is shown in Figure 6.5 where the quantities of goods Y and X are measured on the vertical and horizontal axes, respectively. Each point in the commodity space represents a commodity bundle, or a combination of the two goods. For example, the ordered pair (8, 6) represents a commodity bundle that includes 8 units of good X and 6 units of good Y. Our purpose is to determine which of the affordable bundles in the commodity space maximizes the consumer’s utility. We will approach this problem in three parts. First, we will determine the set of all affordable bundles in the commodity space for a given income level and prices. Second, we will explain how preferences may be represented when utility is ordinal using an analytical device designed for this purpose known as indifference curves. Finally, we will bring together the consumer’s budget with her preferences to determine the utility maximizing commodity bundle. In terms of the consumer’s budget, we know that the money income and the prices of the two goods are fixed. Let’s first see if we can determine all the commodity bundles that require the consumer to spend all her income. In other words, let’s assume the following condition: $Money\;Income = Consumer\;Expenditure$ If the consumer spends the entire money income, then no saving exists. This same condition can be written symbolically in the following way: $\overline{M}=\overline{P_{X}}X+\overline{P_{Y}}Y$ The overbars in the equation indicate that the prices and income are constant. Only the quantities of goods X and Y are variables in the equation because only they can be influenced by the consumer’s choices. To graph this equation in the commodity space, we need to solve for the variable on the vertical axis. If we solve for Y, we obtain the following result (omitting the overbars): $Y=\frac{M}{P_{Y}}-\frac{P_{X}}{P_{Y}}X$ This equation is in slope-intercept form and so it is now possible to graph this equation as a straight line in the commodity space. The vertical intercept is constant and is equal to M/PY. The slope is also constant and is equal to –PX/PY. The horizontal intercept can also be determined by setting Y equal to 0 and solving for X as follows: $0=\frac{M}{P_{Y}}-\frac{P_{X}}{P_{Y}}X\Rightarrow X=\frac{M}{P_{X}}$ All these results are captured in Figure 6.6: In economic terms, the vertical and horizontal intercepts refer to the maximum quantities of Y and X, respectively, that can be purchased if the consumer spends the entire money income on one or the other good. Each of the other points on the budget line represents a commodity bundle that requires the consumer to spend the entire money income. Bundles below the budget line are affordable but do not require the expenditure of the entire income. For example, if a consumer began at a bundle on the budget line and reduced the amount of Y by a small amount, then some income would be left over. Hence, that bundle would be affordable but would not require the expenditure of the entire income. All the bundles on the budget line and those below the budget line are affordable and are therefore considered part of the consumer’s budget set. Any bundle above the budget line is not affordable because the consumer would need more income than she possesses to make that purchase. The slope of the budget line is also important and can be written as follows: $\frac{\Delta Y}{\Delta X}=-\frac{P_{X}}{P_{Y}}$ The slope of the budget line represents the ability of the consumer to trade off one good for another in the marketplace at the current prices. That is, if the consumer would like to purchase one more unit of X, she will have to give up –PX/PY units of Y. The reader might be thrown off by the fact that PX is in the numerator and PY is in the denominator. It should be remembered that the units in which price is measured, however, are$ per unit. Therefore, PX is measured in $/X and PY is measured in$/Y. The division yields Y/X, which are the correct units attached to the slope of the budget line.
To make this discussion a bit more concrete, let’s consider a numerical example. Suppose M = $20, PX =$5, and PY = $4. We can write the budget equation and then solve for Y as follows: $20=5X+4Y$ $Y=5-\frac{5}{4}X$ This budget equation may be graphed as in Figure 6.7. As the figure shows, a rise in M will increase both intercepts proportionately, leading to an outward, parallel shift of the budget line. More income thus makes more bundles affordable. Similarly, a rise in the price of X leads to a rotation inwards of the budget line because the vertical intercept is unaffected. In this case, the budget set contracts because the higher price of X makes fewer bundles affordable. Finally, a rise in the price of Y also makes the budget line rotate inwards because the horizontal intercept is unaffected. The contraction of the budget set indicates that fewer bundles are affordable. The reader should work through what will happen when the consumer’s income or the prices of the goods fall. We now turn to the representation of preferences within the modern theory of utility maximization. The key analytical tool for this purpose is a device called an indifference curve. It is defined as follows: • An indifference curve through commodity bundle A is a line drawn through all the commodity bundles that the consumer considers to be equally satisfying in relation to commodity bundle A. An example of an indifference curve is given in Figure 6.9. All the bundles along indifference curve, U1, are equally preferred to all other bundles on that same indifference curve. It is also possible to identify regions that have more of both goods relative to bundle A, less of both goods relative to bundle A, more Y and less X relative to bundle A, and less Y and more X relative to bundle A. Our next task is to explain why the indifference curve through bundle A slopes downward as well as why it is bowed away from the origin (as opposed to a straight line or having some other shape). The downward slope indicates that the consumer is willing to trade off some of good Y for more of good X and vice versa. For example, if the consumer begins at bundle A, and she loses some of good Y, then the only way to restore her to the U1 level of satisfaction is to increase her consumption of good X. Therefore, the indifference curve slopes downward. The fact that the indifference curve is bowed towards the origin indicates something significant about the willingness of the consumer to trade off one good for another. To clarify this point, we will refer to the slope of the indifference curve as the marginal rate of substitution (MRS). Figure 6.10 shows clearly that the slope is very steep at low levels of X and becomes very flat at high levels of X. We want to determine what the utility maximizing commodity bundle is. We can begin by narrowing down the possibilities very quickly. The bundle that maximizes utility must be on the budget line. If it is not, then the consumer will have income left over. Because only the consumption of goods generates utility, the consumer cannot be maximizing utility unless she is consuming on the budget line. Suppose we consider a bundle on the budget line such as bundle B. Because this bundle is on the budget line, we know that all income is being spent. Does it maximize utility though? It does not. The reason is that the indifference curve through bundle B (U1) is lower than the indifference curve through bundle A (U2). Therefore, the consumer prefers bundle A to bundle B. Because bundle A is affordable, the consumer should buy less Y and more X until she reaches bundle A. Similarly, if the consumer is consuming bundle C, then it is possible to reach the higher indifference curve by reducing her consumption of X and increasing her consumption of Y until she reaches bundle A where she consumes X* units of X and Y* units of Y. At bundle A, the consumer is maximizing utility because all income is spent, and it is not possible to reach a higher indifference curve by choosing a bundle within the budget set. At that bundle, the budget line is tangent to the highest indifference curve passing through the budget set. Mathematically, the slope of the budget line must equal the slope of the indifference curve. We can express this condition symbolically as: $-\frac{P_{X}}{P_{Y}}=MRS$ This utility maximizing condition may be written another way as well. Let’s first recall that total utility remains constant as we move along an indifference curve. That is, ∆TU = 0. When moving along the indifference curve, we can assume that the consumer reduces her consumption of good Y (by ∆Y) and increases her consumption of good X (by ∆X). The change in total utility can now be divided up into the loss of utility from the reduced consumption of Y plus the gain in utility from the increased consumption of X. That is: $\Delta TU=\underbrace{MU_{Y} \cdot \Delta Y}+\underbrace{MU_{X} \cdot \Delta X}=0$ $.\;\;\;\;\;\;\;\;\;\;\;\;\;\;\;\;\;Loss\;\;\;\;\;\;\;\;\;\;\;\; Gain$ If we solve the above equation for ∆Y/∆X, we obtain the following result: $\frac{\Delta Y}{\Delta X}=-\frac{MU_{X}}{MU_{Y}}$ Even though utility is not measurable in the modern framework, the utils cancel out in the fraction and so the MRS is a ratio of the change in Y to the change in X. We include the marginal utilities because this new manner of expressing the MRS allows us to write the utility maximizing condition in the following way: $-\frac{P_{X}}{P_{Y}}=-\frac{MU_{X}}{MU_{Y}}$ By rearranging the terms and eliminating the negative signs, we obtain the same result that we obtained in the traditional theory of utility maximization. $\frac{MU_{X}}{P_{X}}=\frac{MU_{Y}}{P_{Y}}$ In other words, the marginal utilities per dollar spent must be the same for both goods for utility to be maximized. This result was a remarkable outcome for neoclassical economists. They obtained precisely the same result that they had obtained with the traditional theory, but they did so without the less realistic assumption of cardinal utility. Other things the same, the theory with the simplest assumptions became the chosen theory. Ockam’s Razor had been successfully applied. The Modern Derivation of the Individual Demand Curve The modern theory of utility maximization also allows us to derive the downward sloping individual demand curve. Figure 6.13 provides the graphical analysis by which the demand curve is derived within a utility maximizing framework. In Figure 6.13, the price of good X rises from P1 to P2, causing a rotation inward of the budget line. The consumer moves from one utility maximizing point to another. In this case, he reduces the quantity demanded of X from X1 units to X2 units. The result is a movement up the individual demand curve. Because the consumer moves to a lower indifference curve, it is apparent that the consumer’s level of satisfaction has diminished as he moves up the demand curve. This conclusion makes sense because the consumer now faces a higher price for good X and nothing else has changed about his situation. This analysis could easily be reversed with a decline in the price of good X and a rise in the quantity demanded of good X. Theories of Endogenous Preferences Throughout this discussion of consumer behavior, we have been treating preferences as given or fixed in accordance with the neoclassical entry point. When preferences are treated as given or fixed, they are said to be exogenous. That is, they are determined by external factors, and their determination is not explained within the model. Heterodox critiques of neoclassical theory often focus on the assumption of exogenously determined preferences. Many critics argue that preferences should be treated as endogenously determined because often the variables that do change in neoclassical models can be argued to have a direct effect on preferences. One reason neoclassical economists have generally avoided making preferences endogenous in their models is that it becomes very difficult mathematically to incorporate this assumption into formal models. Furthermore, the assumption of endogenous preferences makes it impossible to derive the demand curve using the modern approach to utility maximization. To understand how the assumption of endogenous preferences interferes with the derivation of the demand curve, consider the case of conspicuous consumption first analyzed in detail by the great American social theorist Thorstein Veblen (1857-1929). According to Veblen, the upper classes would place their acts of consumption and leisure on display for all to observe. Examples include mansions, yachts, luxury vehicles, expensive art works, jewelry, fine clothes, and servants. According to the description of two historians of economic thought: For the wealthy, the more useless and expensive a thing was, the more it was prized as an article of conspicuous consumption. Anything that was useful and affordable to common people was thought to be vulgar and tasteless.[6] The term Veblen Good is sometimes used to refer to goods for which the quantity demanded rises as the price increases. A wealthy person thus wishes to purchase more of an item as its price rises rather than less because of the message it conveys to others about that person’s ability to buy expensive items. What this possibility implies is that the consumer’s preferences change because the price rises. Therefore, preferences are endogenous. To illustrate this point, consider Figure 6.14, which shows how a consumer’s utility maximizing choice of jewelry changes as the price falls. According to Figure 6.14, as the price of jewelry falls, the budget line rotates outward as usual. If preferences are given, then the quantity of jewelry that the consumer chooses increases from J1 to J2, and the consumer’s utility level rises from U1 to U2. In this case, however, preferences are endogenously determined. Because the price of jewelry has fallen, this wealthy consumer’s preferences change such that she prefers to purchase less jewelry rather than more. The indifference curves move such that the utility maximizing choice of jewelry is J3 at the lower price, and the utility level is U3.[7] Of course, less wealthy consumers might not experience any change in preferences when the price of jewelry falls, and they will purchase more. One might think that the lower price of jewelry and the smaller quantity purchased suggests an upward sloping demand curve. That is, price and quantity demanded appear to be positively related in this case. The problem is that the demand curve shows the relationship between price and quantity demanded when everything else is held constant, including preferences. Because the preferences change when the price changes, it is impossible to derive the individual demand curve for a Veblen good. The Veblen Good is not the only example where preferences are likely to be endogenously determined. Consider the case of cigarettes. According to data available from the Centers for Disease Control and Prevention (CDC), in 2006 cigarette companies spent$12.4 billion on advertising and promotional expenses in the United States. The CDC reports that specific populations have been the targets of these advertising campaigns, including young people, women, and racial/ethnic communities.[8]
Let’s consider an example in which a high school student experiences an increase in the price of cigarettes per pack. As usual, a rise in the price of cigarettes causes a rotation inward of the budget line as shown in Figure 6.15.
If preferences are exogenously determined, then the student will reduce his consumption of cigarettes from C1 to C2 and his utility will decline from U1 to U2. If preferences are endogenously determined, on the other hand, then it is possible that the rise in price will lead to greater profits for the tobacco companies. This increase in profits may be used to more aggressively advertise tobacco products to young people. The advertising campaign might change the preferences of the student so much that the student ends up purchasing more cigarettes even though the price rose. In Figure 6.15, the indifference curves move such that the final consumption of cigarettes is C3 and the student’s utility level is U3.
Even though the price of cigarettes rose, the student bought more. This positive relationship might lead one to expect an upward sloping demand curve. As in the case of the Veblen Good, it is impossible here to derive the individual demand curve because preferences have not remained constant. These two examples demonstrate how serious the complications are that arise from the assumption that preferences are endogenous. Without the ability to derive an individual demand curve, the supply and demand explanation of market price completely collapses.
Following the Economic News [9]
The neoclassical assumption of given individual preferences implies that the causal factors responsible for preference formation are outside the scope of neoclassical theory. To understand how much is lost due to the exclusion of variables that influence consumer preferences, consider the recent increase in the consumption of e-cigarettes among young people. Bogusky states that “vaping rose by nearly 80 percent among high school students from 2017 to 2018,” according to the Centers for Disease Control and Prevention. Bogusky argues that the vaping industry has adopted the tactics of large tobacco companies. They provide nicotine in concentrations that are even higher than traditional cigarettes, which they “put in sleek packages and market … relentlessly.” It is the relentless marketing that shapes consumers’ preferences and creates the conditions for producers to later raise prices while increasing the quantity sold. The higher prices, of course, permit even more aggressive marketing efforts, which encourages greater sales and nicotine addiction throughout the population. The marketing campaign has targeted young people with a variety of tactics. Bogusky describes these techniques, which include the use of “fruity and minty flavors, ‘vaping trick’ competitions that resemble bubble gum blowing contests of yore and the range of custom colors to choose from.” Other attractive features of the e-cigarettes that Bogusky mentions is their inconspicuous appearance and lack of a foul odor. Young people are thus drawn to these products. Other tactics for selling e-cigarettes include advertisements “placed near kids’ eye level in stores.” A theory of endogenous preferences allows one to better understand the reasons for changes in preferences and how the law of demand can break down under conditions of aggressive marketing and addiction.
Summary of Key Points
1. The positive theory of utility maximization developed by neoclassical economists in the 1870s has its roots in the normative philosophy of utilitarianism.
2. The law of diminishing marginal utility states that the extra satisfaction, from the consumption of an additional unit of a good, declines as the amount consumed rises.
3. In the traditional theory of utility maximization, the consumer will spend all income such that the marginal utilities per dollar spent are the same for each good.
4. The paradox of value can be resolved using either the classical labor theory of value or the marginal utility concept.
5. Consumers’ surplus and producers’ surplus assume a constant marginal utility of money and one that is the same for all buyers and sellers.
6. Ockam’s Razor states that the simplest theory is the best theory, other things equal, and for that reason the ordinal utility assumption is superior to the cardinal utility assumption.
7. Changes in price cause rotations of the budget line whereas changes in income cause parallel shifts of the budget line.
8. Indifference curves slope downwards because consumers are willing to make tradeoffs, and they are bowed towards the origin because consumers experience diminishing marginal satisfaction as they consume more of a good.
9. Utility maximization in the modern theory requires that the slope of the budget line equal the marginal rate of substitution.
10. When preferences are endogenous, the individual demand curve cannot be derived because a change in price causes preferences to change.
List of Key Terms
Utilitarianism
Marginal utility
Utility
Utils
Total utility
Marginal utility
Law of diminishing marginal utility
Paradox
Cardinal utility
Ordinal utility
Interpersonal utility comparisons
Commodity space
Commodity bundle
Budget line
Budget set
Indifference curve
Marginal rate of substitution (MRS)
Diminishing marginal rate of substitution
Indifference map
Exogenous preferences
Endogenous preferences
Conspicuous consumption
Veblen Good
Problems for Review
1. Suppose Steve is currently spending all his money income on pencils and erasers. The price of a pencil is $.75 and the price of an eraser is$1.50. If the marginal utility that Steve derives from the last pencil purchased is 5 utils and the marginal utility of the last eraser purchased is 12 utils, then will Steve buy more pencils, fewer pencils, or the same number of pencils? Why?
2. Assume that the price of good A is $1 per unit and the price of good B is$2 per unit. Complete the rest of the table.
3. Using the information from problem 2, assume that John has $14 of money income to spend on the two goods. How many units of each good will John purchase? 4. Suppose Bill has an income of$26 and faces constant prices for yogurt and pudding. Yogurt is $4 per pack and pudding is$5 per pack. Derive Bill’s budget equation and draw it on a graph. Label both axes and both intercepts. Place yogurt on the vertical axis.
5. Consider the budget constraint shown in Figure 6.16. Suppose the price of cereal rises from $2.75 to$5.50 per box. What is the consumer’s income if the line represents the consumer’s initial budget line? Draw the new budget line on the same graph and label any new intercepts. Can you determine the price of milk (per gallon)?
6. Suppose the price of cigarettes (per pack) falls. How might the quantity purchased by a high school student be affected if her preferences are exogenously determined? How might her preferences be affected if her preferences are endogenously determined? Explain.
1. Samuelson and Nordhaus (2001), p. 85, encourage readers to “resist the idea that utility is a psychological function or feeling that can be observed or measured.” Instead, they regard it as a “scientific construct.”
2. It is possible to construct an example in which a consumer has some money left over if that amount is not sufficient to pay the price of an additional unit of either good.
3. The classical economists also recognized that the scarcity or abundance of a good would influence its price, but we can think of that characteristic as influencing the labor requirement. For example, if water is plentiful in a region, then the labor time required for its production will be lower.
4. Neoclassical textbooks frequently discuss this paradox, but they typically do not acknowledge that the classical economists possessed an internally consistent solution to the paradox. I would like to acknowledge Prof. David Ruccio, whose lecture on this topic in an introductory economics class at the University of Notre Dame in the early 2000s influenced my presentation of this topic. I served as a teaching assistant for Prof. Ruccio at the time.
5. The loss of utility for person A will probably be slightly more than 10 utils due to diminishing marginal utility.
6. Hunt and Lautzenheiser (2011), p. 338.
7. The reader should note that indifference curves with given preferences never cross. The only reason they appear to cross in this graph is because two different sets of indifference curves are being placed on the same graph.
8. Centers for Disease Control and Prevention, http://www.cdc.gov/tobacco/data_statistics/fact_sheets/tobacco_industry/marketing/index.htm
9. Bogusky, Alex. “Big Tobacco’s Latest Ploy.” The New York Times. The New York Times Company. 06 May 2019. | textbooks/socialsci/Economics/Principles_of_Political_Economy_-_A_Pluralistic_Approach_to_Economic_Theory_(Saros)/02%3A_Principles_of_Microeconomic_Theory/06%3A_Theories_of_Utility_Maximization.txt |
Goals and Objectives:
In this chapter, we will do the following:
1. Describe short run production technology in the neoclassical tradition
2. Define the law of diminishing marginal returns to a single input
3. Explain how short run production technology generates short run production cost
4. Analyze different kinds of long run production technologies in the neoclassical tradition
5. Derive long run production cost from long run production technology
6. Demonstrate the relationship between short run and long run production cost
7. Investigate Schumpeterian and Marxian theories of production technology and cost
Short Run Production Technology in the Neoclassical Tradition
In the neoclassical tradition, production technology is defined very broadly to include all of the accumulated knowledge and technical skills that are used in the production of goods and services. As we will see, the unidirectional logic that is so central to neoclassical thinking applies in this case in that technology is used to determine the cost structure that firms face.
We begin with a distinction between two periods. The short run is a period in which at least one factor of production is fixed. If a pizzeria uses only capital (K) and labor (L), for example, we might expect labor to be a variable input whereas capital is its fixed input. That is, it may be possible for the firm to hire anywhere from 0 to a very large (unspecified) number of workers. At the same time, the restaurant itself, which includes its dining area, kitchen, and other facilities, is fixed in size. If the firm is not able to build a new restaurant or to add on to the existing restaurant, the firm is operating in the short run. If it takes 6 months to construct a new restaurant, then the short run in this specific industry is 6 months. The long run then refers to a period during which all factors of production are variable. In this example, the long run refers to a period that is longer than 6 months because both capital and labor are variable.
It is worth noting that the specific periods corresponding to the short run and the long run vary by industry. It may take two years to construct a new production plant in one industry and only six months to construct a new factory in a second industry. The amount of time simply depends on how long it takes for all inputs to become variable. It should also be emphasized that production technology remains fixed in both the short run and the long run. The knowledge and skills related to production do not change in this analysis, which is a key entry point of neoclassical theory. Also, consistent with the neoclassical approach is the assumption of a fixed capital endowment in the short run, which is another key entry point.
We will now continue with the example of a pizzeria in the short run. To represent the firm’s short run production technology, we will introduce a few key short run product concepts. The first concept is total product (TP). The total product refers to the total physical output produced during a given period, in this case a specific number of pizzas. In earlier chapters, we referred to total output as Q, which has the same meaning. Therefore, we can write the following:
$TP=Q$
An additional product concept that is critical for representing production technology in neoclassical theory is the concept of marginal product (MP). When an additional worker is hired, that additional worker increases total pizza production by a specific amount. This amount is the marginal product of that worker. For example, if the third worker increases total pizza production from 11 to 14 pizzas, then the marginal product of the third worker is 3 pizzas. Formally, we write the marginal product in the following way:
$MP=\frac{\Delta TP}{\Delta L}=\frac{\Delta Q}{\Delta L}$
Finally, the concept of average product (AP) is important as well. In this example, the average product of labor refers to the average number of pizzas produced per worker. For example, if the total product is 30 pizzas and 10 workers are employed, then the average product is 3 pizzas per worker. It is important to understand the difference between average product and marginal product. Whereas marginal product only considers the addition to the total product of the last worker hired, average product spreads out the entire product evenly over the number of employed workers. The average product may be written as:
$AP=\frac{TP}{L}=\frac{Q}{L}$
Table 7.1 provides an example with some hypothetical data for our pizzeria operating in the short run. Let’s say the period we are considering is one business day.
Using the information in the table, the MP when 3 workers are employed is calculated in the following way:
$MP=\frac{\Delta TP}{\Delta L}=\frac{36-20}{3-2}=\frac{16}{1}=16\;pizzas\;per\;worker$
Similarly, the AP of the third worker is calculated as follows:
$AP=\frac{TP}{L}=\frac{36}{3}=12\;pizzas\;per\;worker$
We are now able to consider the patterns that emerge from these calculations. The MP appears to rise until it reaches its peak at L = 3 workers. Next it declines, eventually reaching 0, and then becomes negative. The range over which MP rises is called the range of increasing returns to labor. The question arises as to why MP rises as more workers are hired at these low employment levels. The answer is specialization and the division of labor. Just think about all of the tasks that are involved in the pizza business. If a single worker is hired, then that worker needs to make the dough, roll the dough, toss the dough, make the sauce, spread the sauce, add the toppings, bake the pizza, cut the pizza into slices, take customer orders, serve the pizza to customers, bus the tables, wash the dishes, operate the register, clean the kitchen, clean the dining area, and clean the restrooms! The worker needs to accomplish other tasks as well, including ordering more ingredients, maintaining financial records, and paying taxes. Clearly, if a second worker is hired, then the tasks can be divided up, allowing for a greater degree of specialization. These gains from specialization imply that the second worker increases the TP by 12 pizzas, which is more than the increase that resulted from the hiring of the first worker. When three workers are hired, the tasks can be further divided so that one worker can work in the kitchen, a second worker can handle customer service in the dining area, and a third worker can work the cash register and maintain the books. As a result, the MP continues to rise. The reader should be aware that the additional workers hired are not more skilled or more hardworking. In fact, we are assuming the opposite. That is, each worker is equally skilled and hardworking. These gains in MP are solely the result of the benefits of specialization and the division of labor. The AP rises as well for this same reason.
Once we move beyond the point where three workers are hired, we begin to see a decline in the MP of labor. The range over which MP falls is called the range of diminishing returns to labor. Why does this decline in MP occur? Imagine that the kitchen is very small at our restaurant and the fourth worker is asked to work in the kitchen with the cook already present there. The worker contributes to production and so TP rises. At the same time, the presence of the additional worker in the kitchen makes it somewhat more difficult for the original cook to work efficiently. The two cooks keep running into one another. At times, they bump elbows as one rolls the dough and the other spreads the sauce. Even though the fourth worker adds to production, TP only rises by 12 pizzas rather than 16 pizzas as a result of this “bumping elbows problem.” The more formal phrase that is used to refer to this phenomenon is the law of diminishing returns to labor. It should be noted that AP falls for the same reason.
The law of diminishing returns may be expressed in two different ways. It may be expressed as:
1. a decline in the marginal product of labor as employment increases
2. an increase in the total product of labor at a diminishing rate
The reader should refer to Table 7.1 to observe these two patterns. It should be noted that this problem of bumping elbows eventually becomes so serious that the TP begins to fall. In other words, the MP becomes negative as additional workers reduce the total production of pizzas. The range of negative MP is referred to as the range of negative returns to labor. The underlying reason for this pattern of diminishing returns and then negative returns to labor is that the capital input (i.e., the size of the restaurant, and the kitchen, specifically) is fixed in the short run. The same pattern would eventually result if we were to add additional workers in the dining area and in the finance area. Due to the importance of the fixed capital input in generating this result, the law of diminishing returns is a specifically short run phenomenon.
It really should be emphasized how extraordinary the claim is that neoclassical economists are making when they assert that the law of diminishing returns holds for production technologies in the short run. They are claiming that every single short run production process exhibits this same pattern. It does not matter whether we are discussing the production of commercial aircraft, high-tech computers, cheese pizzas, automobiles, or haircuts. All these production processes have this basic feature of their production technologies in common. It is a fundamental aspect of our economic existence.
It is also possible to represent these patterns graphically. The TP curve that corresponds to the data in Table 7.1 is represented in Figure 7.1. The MP and AP curves corresponding to these data are represented in Figure 7.2.
It is important to notice that MP and AP intersect in Figure 7.2 at L = 4 when both the AP and the MP are equal to 12 pizzas per worker. It turns out that MP always intersects AP at the peak of AP. Why? It helps to consider a non-economic example first. Suppose that the total weight of everyone in a classroom of 30 people is 4,200 lbs. The average weight of a person in the room is then equal to 140 lbs. (= 4,200 lbs. / 30 people). Next let’s consider what would happen if we bring in a marginal person (person A) from outside the room. Person A is a football player who weighs 300 lbs. Notice that the total weight in the room is now 4,500 lbs. and the number of people in the room is 31 people. In that case, the new average weight will be approximately 145 lbs. (= 4,500 lbs. / 31 people). Because the marginal weight exceeded the average weight, the average weight rose. It follows that if the marginal contribution exceeds the average, the average will rise. In the case of MP and AP, if the MP exceeds the AP, the AP will rise.
If instead we had brought in a marginal person (person B) with a weight of 100 lbs., then the average weight of a person in the room would be approximately equal to 139 lbs. (= 4,300 lbs. / 31 people). Because the marginal weight is below the average weight in this example, the average weight falls. It follows that if the marginal contribution is below the average, the average will fall. In the case of MP and AP, if the MP is below the AP, the AP will fall.
In Figure 7.2, the reader can see that at low employment levels, the MP exceeds the AP causing the AP to rise. At higher employment levels, the MP falls below the AP causing the AP to fall. It follows that the MP must intersect the AP at the peak of the AP curve. To the left of the peak, the higher MP pulls the AP up and to the right of the peak, the lower MP pulls the AP down.
Short Run Production Cost in the Neoclassical Tradition
Our next task is to explain the cost structure that firms face in the short run. We will differentiate between two types of short run cost. First, total variable cost (TVC) refers to the total monetary cost of the variable input, which in this case is labor. If we assume a constant wage rate (w), measured in terms of dollars per worker, then TVC may be calculated as follows:
$TVC=wL$
Because L can be measured in terms of the number of workers employed during this period, TVC is measured in dollars of labor cost incurred during this period. TVC can change in the short run because L is a variable input.
The other major type of cost is total fixed cost (TFC). TFC refers to the total monetary cost of the fixed input, which in this case is capital. If we assume a constant price of capital (PK), measured in terms of dollars per unit of capital, then TFC may be calculated as follows:
$TFC=P_{K}K$
Because K is measured in terms of the number of units of capital employed during this period, TFC is measured in dollars of capital cost incurred during this period. With both K and PK fixed, the TFC is also fixed in the short run.
The firm’s total cost (TC) is simply the sum of TVC and TFC. It can be expressed as:
$TC=TVC+TFC=wL+P_{K}K$
TC is measured in terms of dollars of cost incurred during this period.
For example, we can select some hypothetical cost data for a pizzeria operating in the short run as shown in Table 7.2.[1]
If the numbers in Table 7.2 correspond to one business day, then the capital cost or TFC (i.e., the rent for the building) is fixed for all levels of output at $150 per day. The labor cost or TVC, on the other hand, rises with output because increased employment of the variable input is what makes possible the rise in output. Finally, total cost rises because the TVC is rising even though the TFC remains fixed. It should also be noted that TVC is$0 when 0 units of output are produced because no workers are hired, but TFC is still $150 because the rent must be paid regardless of whether pizzas are produced. It is possible to say more about this pattern of short run production cost. In fact, we can use the short run production technology concepts already developed to derive a specific pattern of short run production cost. It is easiest to understand this derivation by considering the similarities between the TP curve and the TVC curve as shown in Figure 7.3. Because the TFC is fixed at$150 for all levels of output, the TFC curve is simply a horizontal line. The TC curve, however, has the same shape as the TVC curve because TC only changes due to changes in TVC (since TFC is fixed). In addition, the TC curve is shifted upwards by the amount of the TFC. As a result, the distance between the TVC and TC curves is always equal to the TFC. Because the TFC is reflected in the distance between these two curves, it is not necessary to include the TFC curve when we wish to represent the three total cost measures on a single graph. For that reason, the TFC curve has been included here as a dotted line. Also, because all three concepts are measured in dollars, the “$” symbol has been placed on the vertical axis. Next, we need to introduce several unit cost concepts. Often managers of firms think in terms of production cost per unit of output produced, particularly when they are considering whether to increase or decrease production by a small quantity. We will define four key unit cost concepts, and then we will consider the pattern these unit cost measures exhibit as output changes in the short run. The first unit cost concept that we will define is average variable cost (AVC). The AVC is the variable cost per unit of output produced. If labor is the variable input, then the AVC is per unit labor cost. If total wages amount to$1000 and 100 units of output are produced, then the AVC is $10 per unit (=$1000/100 units). It is defined in the following way:
$AVC=\frac{TVC}{Q}$ Another unit cost concept that we will define is average fixed cost (AFC). The AFC is the fixed cost per unit of output produced. If capital is the fixed input, then the AFC is the per unit capital cost. If total capital cost amounts to $4500 and 100 units of output are produced, then the AFC is$45 per unit (= $4500/100 units). It is defined in the following way: $AFC=\frac{TFC}{Q}$ A third unit cost concept that we will define is average total cost (ATC). The ATC is the total cost per unit of output produced. It is simply the sum of the AVC and the AFC. If the AVC is$10 per unit and the AFC is $45 per unit, then the ATC is$55 per unit (= 10+45). Alternatively, if total cost is $5500 and total output is 100 units, then ATC is$55 per unit (= $5500/100 units). It is defined as follows: $ATC=\frac{TC}{Q}=\frac{TVC+TFC}{Q}=\frac{TVC}{Q}+\frac{TFC}{Q}=AVC+AFC$ The final unit cost concept that we will define is marginal cost (MC). The MC is the additional total cost per additional unit of output produced. For example, if total cost rises by$200 and total output rises by 50 units, then MC is $4 per unit. Furthermore, because total cost can only rise due to a rise in variable cost (since TFC is fixed), the MC can also be defined as the additional variable cost per additional unit of output produced. It is thus defined as follows: $MC=\frac{\Delta TC}{\Delta Q}=\frac{\Delta TVC}{\Delta Q}$ Using the total cost information presented in Table 7.2, we can now calculate all these additional unit cost measures for our pizzeria operating in the short run. Table 7.3 combines the total cost information from Table 7.2 with the corresponding unit cost calculations. Clear patterns emerge for each of the unit cost concepts. The AFC, for example, declines continuously as total product rises. This reduction in AFC occurs because the fixed cost is spread over a larger and larger quantity of output. Businesspeople refer to this phenomenon of a falling AFC as “spreading one’s overhead.” Figure 7.5 shows a graph of the AFC curve. As Figure 7.5 indicates, the AFC curve possesses horizontal and vertical asymptotes. That is, at very low output levels, the AFC soars because the denominator approaches zero while the numerator remains fixed (equal to TFC). As output rises, on the other hand, AFC declines due to the spreading of overhead. That is, output becomes increasingly large while the numerator remains fixed. The curve will never cross the horizontal axis though because some fixed cost will always exist no matter how thinly it is spread across the existing output. It should also be noted that$/Q has been placed on the vertical axis because the unit cost concepts are measured in dollars per unit of output.
In addition, Table 7.3 shows that the AVC, ATC, and MC measures all decrease at low output levels and then rise at higher output levels. Because they are derived from the total cost measures, the reductions in AVC and MC can be attributed to specialization and division of labor. The ATC falls at low output levels for two reasons. As the sum of AVC and AFC, it falls due to specialization and division of labor (falling AVC) and due to the spreading of overhead (falling AFC). All three measures begin to rise at higher output levels due to diminishing returns to labor.
As Figure 7.6 shows, the AVC, ATC, and MC curves are all U-shaped.
Furthermore, because the ATC is equal to the sum of AFC and AVC, it follows that AFC = ATC – AVC. Therefore, the difference between the ATC and AVC curves will always equal the AFC. As a result, we do not need to include the AFC curve when we wish to graphically represent the four unit-cost measures. For that reason, the AFC curve has been omitted in Figure 7.6. It should also be noticed that the AVC and ATC curves grow closer together as Q rises. The reason is that AFC is declining due to the spreading of overhead.
An additional point that must be made is that MC intersects AVC and ATC at the minimum points on the AVC and ATC curves. The reason is the same as that used to explain why MP intersects AP at the maximum AP. That is, when MC is below the AVC, the AVC falls. When the MC is above the AVC, the AVC rises. Therefore, the MC intersects the AVC at the minimum AVC. The same argument can be used to explain why MC intersects ATC at the minimum ATC. In terms of Table 7.3, we can see that MC changes from being below AVC to being greater than AVC between 30 and 40 units of output. The intersection of the two curves, therefore, occurs within that range. Similarly, MC changes from being below ATC to being greater than ATC between 60 and 70 units of output. The intersection of the MC and ATC curves must occur within that range as well.
Finally, the relationship between the product curves and cost curves should be emphasized once more. Because production technology determines production cost in neoclassical theory, we should be able to identify some connection between the product concepts and the unit cost concepts. It turns out that the MP and AP curves are the mirror image of the MC and AVC curves, respectively. If we look at the definitions, this implication leaps out at us.
$MP=\frac{\Delta TP}{\Delta L}=\frac{\Delta Q}{\Delta L}\;and\;MC=\frac{\Delta TVC}{\Delta Q}=\frac{\Delta wL}{\Delta Q}=\frac{w \Delta L}{\Delta Q}$
Clearly, if ∆Q/∆L rises, then ∆L/∆Q falls. That is, if MP rises, then MC falls. The opposite also holds that if MP falls, then MC rises. We can make the same argument about the relationship between AP and AVC. That is:
$AP=\frac{TP}{L}=\frac{Q}{L}\;and\;AVC=\frac{TVC}{Q}=\frac{wL}{Q}$
It should be clear that if Q/L rises, then L/Q falls. Hence, a rise in AP coincides with a fall in AVC. The opposite also holds that if AP falls, then AVC rises. Figure 7.7 shows these curves side-by-side to emphasize the relationships between them.
Finally, we have been assuming the ceteris paribus condition throughout this analysis. That is, we have assumed that the wage rate, the price of capital, the quantity of capital, and the production technology have remained fixed. We should briefly consider what will happen to the unit cost curves if any of these factors changes. For example, a rise in wages will cause the AVC, ATC, and MC curves to shift upwards. The reason is that wages determine TVC, which influences the position of each of these curves. If wages rise, the firm faces higher unit costs. Second, a rise in the price of capital or in the quantity of capital employed will cause an upward shift of the ATC curve but will leave the AVC and MC curves unchanged. The reason is that these factors only affect the TFC, which influences the AFC but not the AVC or MC. Hence, the gap between the ATC and AVC curves will rise as AFC grows but otherwise nothing will change. Finally, a technological improvement will cause a reduction in the AVC and MC (and thus the ATC). Therefore, a downward shift of the AVC, MC, and ATC curves will occur. It is left to the reader to consider the consequences of a reduction in wages, the price of capital, or the quantity of capital employed. A loss of technological knowledge is also theoretically possible and should be considered.
A Short Run Technology and Cost Example Using Microsoft Excel
It is helpful to use a spreadsheet software program such as Microsoft Excel when analyzing the short run production technology and cost structure facing a firm. The reason is that it allows one to avoid performing all the calculations by hand, and so it saves the analyst a great deal of work. Let’s consider a simple example in which an analyst only has a small amount of information about a firm. Suppose the analyst only knows that the wage is $5 per hour and the price of capital (PK) is$2 per unit. That is, w = 5 and PK = 2. Suppose that the only other information the analyst possesses relates to total product and the capital stock as shown in Table 7.4.
In MS Excel, the columns are labeled with capital letters and the rows are numbered. The reader may be surprised to learn that the entire table can be completed with only the information that has been provided. To complete the entire table by hand would require 199 separate calculations! Fortunately, MS Excel allows us to use the definitions of each measure and then use cell references to complete the entire table in a small fraction of the time it would take to complete the table by hand.
Because the capital stock is fixed in the short run at all output levels, we can simply copy and paste that quantity of capital to every cell in column B. To carry out this operation quickly, it is only necessary to place the cursor over the lower right corner of the cell B2 until the cursor turns into a little black cross (+). The analyst may then drag the cursor all the way down the column until it is complete.
The other columns are a little more difficult to complete because it is necessary to insert a formula to ensure an accurate calculation. Whenever entering a formula in MS Excel, it is necessary to first include an “=” sign. For example, because the definition of AP is TP/L, the AP is calculated as =C2/A2 for L = 0. As with the capital stock, this formula can be dragged down to complete the rest of the cells in the column. The rest of the columns are completed in a similar fashion. It should be noted that the “*” symbol, which is used in the calculation of TVC and TFC, is used for the multiplication of terms in Excel.
Table 7.5 shows the complete table after all calculations have been performed.
A few points worth noticing include the fact that diminishing returns to labor first appear at L = 11 when MP shows a decline for the first time. Additionally, it is also at this employment level that MC begins to rise for the first time, which demonstrates the notion that the MP and MC are mirror images of one another. Finally, it is possible to locate the points of intersection of MC with AVC and ATC. MC intersects AVC between employment levels 13 and 14, whereas MC intersects ATC between employment levels 17 and 18. The reader might notice that MP intersects AP between employment levels 13 and 14, a fact which also reinforces the point that the MP and AP curves are mirror images of the MC and AVC curves.
It is also possible to generate graphs in Excel of the product and cost curves. To illustrate how these graphs may be created, we will create a graph of the TP curve and a separate graph containing the AP and MP curves. To create a graph, the analyst should select the following:
1. On the Insert Tab, choose “Line.”
2. From the options available, choose “Line” again.
3. A chart box should appear. Right click it and choose “Select Data.”
4. Next click “Add” and in the new box type “TP” for Series Name.
5. Where it says, “Series Values,” click the symbol to the right and then drag in the data for TP from the Excel table beginning with L = 0. Then click OK and click OK once more.
6. To add horizontal and vertical axis labels, you can use the Design and Layout Tabs.
Figure 7.8 shows the TP curve as generated in MS Excel.
The same procedure may be used to create the graph of the AP and MP curves. The only difference is that you need to return to step 4 to “Add” the second curve after the first has been created. Also, because the values are undefined for L = 0, it is best to omit these calculations when dragging in the data for these two curves. Figure 7.9 shows the AP and MP curves as generated in Excel.
L ong Run Production Technology in the Neoclassical Tradition
We now turn to production technology in the long run when all inputs are variable. In the case of the pizzeria, it is now technically possible for the firm to construct additional restaurants in addition to hiring additional workers. We will discuss three types of long run production technologies before we explain how these long run technologies determine long run production costs.
The first type of long run production technology is a technology that exhibits constant returns to scale (CRS). A CRS technology exists when a fixed percentage change in all inputs leads to the same percentage change in total output. For example, suppose that the amounts of capital and labor double (100% increases in each). In that case, the amount of output produced also exactly doubles, assuming a CRS technology. Using the pizzeria example, if 3 workers in one restaurant produce 10 pizzas in an hour, then 6 workers in two restaurants will produce 20 pizzas in an hour, assuming a CRS technology. The assumption of a CRS technology should seem reasonable enough. A firm should be able to perfectly duplicate its smaller scale operation when it doubles its inputs and so output should exactly double.
A second type of long run production technology is a technology that exhibits increasing returns to scale (IRS). An IRS technology exists when a fixed percentage change in all inputs leads to a greater percentage change in total output. For example, suppose that the amounts of capital and labor double (100% increases in each). In that case, the amount of output produced more than doubles, assuming an IRS technology. It may seem strange, given what was previously explained about the likely consequences of duplication, that output could more than double. It would be relatively easy to explain this possibility with an impure example. That is, we might argue that the quantities of labor and capital have exactly doubled but the qualities of the newly acquired capital and labor are superior to what was previously used, causing output to more than double.
It is possible, however, to provide a pure example of an IRS technology or one in which a doubling of the inputs leads to a greater than doubling of output even when the additional inputs are of the same quality as that which was previously used. Such cases arise when the production processes have certain geometric characteristics that make IRS technologies possible.[2] For example, consider an oil pipeline that transports oil over a long distance. To keep the example simple, we will focus on the opening at one end of the pipeline, which is assumed to form a perfect circle. The circumference of the circle (i.e., the distance around it) is directly related to the amount of material that is used to construct the pipeline. That is, a larger circumference implies a larger amount of material that is required to produce the pipeline. The circumference (C) is given by the following formula where r is the radius of the circle:
$C=2\pi r$
The area of the circle, by contrast, is directly related to the amount of oil that can pass through the pipeline. That is, a larger opening implies that a larger amount of oil can pass through the pipeline. The area of the circle is given by the following formula:
$A=\pi r^2$
Now consider what happens when we double the amount of material used in the construction of the pipeline. This doubling of the amount of material makes possible a doubling of the circumference of the circle. In Figure 7.10, the inner circle represents the original pipeline opening and the outer circle represents the new pipeline opening that uses twice as much material.
According to the figure, the doubling of the circumference doubles the radius of the circle. As a result, we can calculate the circumference of the larger opening (C’) as:
$C'=2\pi (2r)=4\pi r=2C$
In other words, the doubling of the radius has doubled the circumference, which indicates that the amount of material inputs has doubled. What effect does this doubling of the radius have on the area of the new opening? We can calculate the area of the larger opening (A’) as follows:
$A'=\pi (2r)^2=4\pi r^2=4A$
In other words, the doubling of the radius leads to a quadrupling of the area of the opening. That is, the material inputs in the production of the pipeline have doubled and yet the output that passes through the pipeline has more than doubled. It appears we have a pure example of an increasing returns to scale (IRS) technology.
The third and final type of long run production technology is a technology that exhibits decreasing returns to scale (DRS). A DRS technology exists when a fixed percentage change in all inputs leads to a smaller percentage change in total output. For example, suppose that the amounts of capital and labor double (100% increases in each). In that case, the amount of output produced lessthan doubles, assuming a DRS technology. It is difficult to provide pure examples of DRS technologies, although it is relatively easy to provide any number of impure examples. That is, we might argue that the quantities of labor and capital have exactly doubled but the qualities of the newly acquired capital and labor are inferior to what was previously used, causing output to less than double. More will be said about these issues when we discuss long run production cost.
Table 7.6 provides a summary of the three types of long run production technologies.
In each of the three cases (2A, 2B, and 2C), the quantities of capital and labor exactly double, but the output responds differently in each case. In the case of CRS, output exactly doubles. In the case of IRS, output triples. Finally, in the case of DRS, output only rises by 50%.
Long Run Production Cost in the Neoclassical Tradition
We are now able to draw some conclusions about long production cost based on our discussion of long run production technology. As in the short run, production technology determines the pattern of production cost that the firm faces. The most important long run cost concept that we will explore is long run average total cost (LRATC). As in the short run, average total cost in the long run is simply total cost per unit of output. The only difference is that LRATC may change due to a change in capital cost or due to a change in labor cost. It is defined as follows:
$LRATC=\frac{TC}{Q}=\frac{wL+P_{K}K}{Q}$
Let’s assume that the factor prices are constant in the long run such that w = 1 and PK = 2. We can now see clearly what the relationship is between the three types of long run production technology and LRATC. Table 7.7 shows the calculations for TC and LRATC for each of the three cases considered previously in Table 7.6.
What this example shows clearly is that total cost exactly doubles in all three scenarios because the inputs have exactly doubled. It is the changes in output that differ in all three scenarios, which causes the LRATC to be different in the three cases. Specifically, we see that an increase in the scale of production leaves LRATC unchanged at $0.05 per unit in the case of a CRS technology. Because TC and Q grow at the same rate, the ratio of the one to the other does not change. By contrast, an increase in the scale of production causes the LRATC to fall from$0.05 to $0.03 per unit in the case of an IRS technology. The reason is that TC grows more slowly than Q and so the ratio of TC to Q declines. Finally, an increase in the scale of production causes the LRATC to rise from$0.05 to $0.07 per unit in the case of a DRS technology. The reason is that TC grows more quickly than Q and so the ratio of TC to Q rises. The calculations from this example can be summarized as follows: $For\;CRS,\;LRATC=\frac{w(2L)+P_{K}(2K)}{2Q}=\frac{2TC}{2Q}=\frac{TC}{Q}\Rightarrow \overline{LRATC}$ $For\;IRS,\;LRATC=\frac{w(2L)+P_{K}(2K)}{3Q}=\frac{2TC}{3Q}=\frac{2}{3}\frac{TC}{Q}\Rightarrow LRATC \downarrow$ $For\;DRS,\;LRATC=\frac{w(2L)+P_{K}(2K)}{1.5Q}=\frac{2TC}{1.5Q}=\frac{4}{3}\frac{TC}{Q}\Rightarrow LRATC \uparrow$ Special phrases are used to describe changes in LRATC as the scale of production changes: 1. Economies of scale (EOS) refer to reductions in per unit cost as output rises. 2. Diseconomies of scale (DOS) refer to increases in per unit cost as output rises. When per unit cost does not change with an expansion in the scale of production, the firm is said to experience neither EOS nor DOS. Next, we should consider which of these cost patterns is most likely for an individual firm. Neoclassical economists argue that firms typically pass through all three phases as the scale of production grows. Specifically, firms experience scale economies at relatively low output levels, then they experience neither EOS nor DOS, and finally, they experience diseconomies of scale at relatively high output levels. Graphically, this pattern gives rise to a U-shaped LRATC curve like the one shown in Figure 7.11. Why do neoclassical economists assert that this pattern of unit cost is a typical one facing firms? They give several reasons for expecting scale economies at relatively low output levels.[3] The first is labor and managerial specialization. Unlike in the short run, these types of specialization require that all inputs be variable. For example, imagine a firm that carries out both production and distribution activities in a single facility. As it expands in the long run and increases its capital stock, it might be able to carry out production in one facility and distribution in another facility. The gains from specialization may be considerable. As a result, TC grows more slowly than Q and LRATC falls. Another reason for scale economies at relatively low output levels may be large startup costs. For example, in the automobile industry a huge outlay of financial capital is required to even begin operations. As more automobiles are produced, this initial outlay can be spread over a larger number of units and LRATC falls. Large startup costs in the long run operate in a similar manner to TFC in the short run. As firms become larger, they also frequently enjoy efficiencies that stem from expanded knowledge of the production process. That is, they simply become more efficient producers as the kinks in the production process are worked out. As a result, TC rises less quickly than Q and LRATC falls. Other factors that contribute to scale economies have more to do with input prices. For example, as firms expand they can take advantage of bulk discounts that suppliers offer. Another possibility is that they can borrow funds more cheaply in the stock and bond markets than smaller firms, which must rely on bank financing. As a result, output grows more quickly than cost and LRATC falls. On the other end of the spectrum are scale diseconomies, which can arise for a variety of reasons. First, corporate bureaucracies may become excessively large as the scale of production expands. If highly paid top executives are hired to prepare a lot of paper reports, the result may be a considerable rise in TC without much expansion of Q. In that case, LRATC rises. Communication problems are another potential source of DOS in large organizations. If managers have a difficult time coordinating production due to the large size, then further expansion may raise TC more than Q. The alienation that workers experience in the workplace in very large organizations may be another problem. Poor work performance may result when workers feel disconnected from one another and from their work. The sense of alienation may become so great that Q rises slowly even as TC increases with the purchase of additional inputs. The additional cost of hiring supervisors to monitor worker performance in these situations may also add to cost. Although Marxists tend to emphasize worker alienation to a much greater degree than neoclassical economists, neoclassical economists sometimes recognize that this factor contributes to DOS.[4] Finally, input prices may also be involved in creating DOS. For example, as firms expand to very large sizes, they may begin to push up input prices due to their increased demand for inputs. Similarly, if their large sizes necessitate transporting goods to more distant markets, then TC may rise more quickly than output.[5] The Relationship between Short Run and Long Run Average Total Cost The LRATC curve is sometimes described as the lower envelope of all short run average total cost (SRATC) curves. To understand the reason, consider Figure 7.12. Figure 7.12 shows a series of SRATC curves, each corresponding to a different production plant size. As production increases in the short run for a firm operating with plant size 1, unit cost declines due to labor specialization within the plant. Eventually, diminishing returns begin to set in as output expands due to the fixed amount of capital, and unit cost rises. In the long run, however, the firm has the option of building a larger production plant, which allows the firm to move to plant size 2. As a result, unit cost begins to decline again due to specialization within the larger plant. Eventually, however, diminishing returns result, and unit cost begins to rise. The firm can expand in the long run by building an even larger production plant, and the same process repeats itself. Due to this analysis, we can trace out the lower envelope of the SRATC curves to obtain the LRATC curve. Minimum Efficient Scale A final concept that deserves attention is what neoclassical economists call minimum efficient scale (MES). The MES refers to the lowest output level at which LRATC is minimized. Figure 7.13 shows the MES to be Q* because it is the lowest output level that minimizes LRATC. The MES varies by industry. For example, the MES has been estimated to be 10 million tons per year in the oil industry, 9 million tons per year in the steel industry, and at least 1 million barrels per year in the beer industry.[6] The MES in an industry may, therefore, be a large amount of output or a small amount of output. For example, Figure 7.14 contains examples of two LRATC curves. Each represents the LRATC of a firm in a different industry. Firm 1’s LRATC curve shows that the MES is very large due to large economies of scale in this industry. Only large firms in this industry will be able to minimize unit cost. Firm 2’s LRATC curve suggests a very small MES due to significant diseconomies of scale in this industry. Only small firms will be able to minimize unit cost in this industry. Furthermore, a firm may have multiple production levels that are consistent with minimum LRATC. For example, the firm’s LRATC curve shown in Figure 7.15 indicates that Q1 is the minimum efficient scale, but Q2 represents the maximum efficient scale. That is, Q2 is the largest output level that still manages to keep unit cost at its minimum. In this industry, small firms, large firms, and medium-sized firms can operate at minimum unit cost. The Schumpeterian Approach to Technological Change The neoclassical theory of production technology and cost of production that we have been considering treats technology as completely static. Almost no emphasis is placed on technological change. Granted, neoclassical economists have more to say about technological change in macroeconomics, but in microeconomics it plays essentially no active role at all. For this reason, many heterodox economists challenge the neoclassical treatment of production technology. One important example of an economist with a different approach to production technology is the famous economist Joseph Schumpeter, who is best known for his book, The Theory of Economic Development, first published in 1913. According to Schumpeter, technological change is the driving force in economies that creates economic growth, unstable and uneven as it is. Meghnad Desai provides a nice overview of Schumpeter’s theory: Innovations often clustered together and made for an Industrial Revolution. But they came only periodically and discontinuously, in waves. One wave of innovations would break the mould of the old stationary economy. The pioneers would borrow money and launch their innovations. They would enjoy a temporary monopoly, and make immense profits (if, that is, they were successful, since there are also failures in this life). These innovations would launch the economy on a growth path with an upswing that might last twenty to twenty-five years. But imitators would soon come in and erode the entrepreneurs’ excess profits. Output would multiply, but prices would start falling and profits would go down. A downswing would set in until another wave of innovations hit the economy.[7] According to Schumpeter, innovation would lead to long periods of growth and progress followed by periods of falling prices and sluggish growth until a new series of innovations revived the growth of capitalism. When innovation does occur, it generates growth in the innovating sectors but leads to “creative destruction” for the sectors made obsolete by the new technology. Clearly, Schumpeter’s theory shifts our focus to macroeconomics and away from microeconomics, but his theory also reveals just how static and unhelpful the microeconomic theory of production technology is when it comes to explaining technological progress. A Marxian Approach to Technological Change Much can be said regarding Marx’s thoughts about the role of technological change in capitalist economies and its ability to revolutionize the means of production. Indeed, Marx was a major influence on Schumpeter. When considering the specifically microeconomic aspects of production technology on which neoclassical economists focus, however, we will also find it helpful to contrast with those aspects the competing theory of production technology that is found in Marx’s work. In chapter 3, it was explained that a commodity’s value is determined by the socially necessary abstract labor time (SNALT) required for its production. John Eatwell refers to Marx’s concept as one of “socially necessary technique.”[8] Some producers will devote more labor to production than is socially necessary. Other producers will devote less labor to production than is socially necessary. All producers, however, will receive a value in exchange that is based on the average degree of skill and intensity of labor prevailing in the industry at that point in time. Therefore, producers that use less labor than the social average will enjoy a surplus profit whereas producers that use more labor than the social average will experience a smaller than normal profit. Those producers that use an amount of labor that is exactly equal to the social average will enjoy a normal profit (determined by the amount of surplus value embodied in the commodity). Because of these discrepancies, the producers will try their best to imitate the techniques of the most efficient producers. The surplus profits will be too tempting. If some of the producers succeed in their imitation of the other producers, then the SNALT embodied in the commodity will decline over time and its value will fall as well. The value of the commodity is, of course, determined by the average producer. Over time, all producers manage to lower the SNALT that they must perform to produce the commodity as they try to imitate the lowest cost producer and as the lowest cost producer strives for even lower costs. The result is a steady decline in the value of the commodity. In this competitive environment, the surplus profits of the low-cost producer do not rise, even though she is innovating, because the value of the commodity is falling. Similarly, the lower-than-average profits of the high-cost producer persist, even though she is also innovating, because the value of the commodity is falling. Consider an example that includes a high-cost producer, a low-cost producer, and an average producer. The product of the high-cost producer has an individual, private value of$25 whereas the product of the low-cost producer has an individual, private value of $15. The product of the average producer, however, has an individual, private value of$20. Because the value of the product of the average producer governs the market value, all three producers sell their commodities for $20 each. The low-cost producer thus receives a surplus profit of$5. The average producer does not receive any surplus profit but rather just a normal profit. Finally, the high-cost producer receives $5 less than a normal profit. Over time, technological innovation might cause all the individual, private values to decline by$5. The result will be a reduction in the market value without any change to the surplus profits of each producer. If the degree of technological innovation among the firms differs, however, then the surplus profits of each firm may change.
F ollowing the Economic News [9]
The world is experiencing a serious food crisis as close to 1 billion people experience severe hunger and roughly an additional billion people are not receiving enough key nutrients. The problem is expected to worsen in the coming decades as the human population continues to increase. With a fixed amount of land for cultivation, the problem of diminishing returns to land makes it difficult to increase food production sufficiently to keep up with global needs. In the past, the problem of diminishing returns to land has not become too serious because of technological advances in agriculture. The problem is that climate change is now threatening to interfere with productivity in agriculture, especially in poor nations. According to Siddharth Chatterjee, “it is estimated that climate change could reduce yields from rain-fed agriculture by 50 percent by 2020, jeopardizing the welfare of seven in ten people who depend on farming for a living.” Chatterjee explains that when crops are lost, families lose their ability to earn a living, which leaves children vulnerable to a variety of health problems, including malnutrition and malaria. As Chatterjee argues, technological change will become more important in the future to increase the resilience to climate-related shocks and raise productivity in Africa’s agricultural sector. Still, the problem of global hunger exists for reasons that go beyond diminishing returns to land, the slow pace of technological change, and climate change. The persistence of mass hunger even when large food surpluses exist in some countries is the result of uneven economic development and problems with the distribution of food to poorer regions.[10] If the global food distribution system responds to market demand rather than human need, we have every reason to expect a continuation of the global food crisis.
Summary of Key Points
1. In the short run, at least one input is fixed whereas in the long run, all inputs are variable.
2. The increasing marginal product of labor is due to specialization and division of labor whereas diminishing returns to labor is due to the inefficiencies resulting from using too much of a variable input with a fixed input.
3. When a marginal contribution exceeds the average, the average will rise. When a marginal contribution falls below the average, the average will fall.
4. Short run unit cost curves fall initially due to the specialization and division of labor, and they rise eventually due to diminishing returns to labor.
5. Constant, increasing, and decreasing returns to scale are three long run technologies that specify how output changes when all inputs change by a given percentage.
6. Economies and diseconomies of scale describe how unit cost changes as the scale of production changes.
7. Schumpeter asserts that technological innovations are the driving force behind economic development, but this development is highly cyclical.
8. In Marxian theory, competition and technological imitation in an industry will reduce the SNALT required for production and cause the value of a commodity to decline over time.
List of Key Terms
Production technology
Short run
Long run
Total product (TP)
Marginal product (MP)
Average product (AP)
Increasing returns to labor
Specialization and division of labor
Diminishing returns to labor
Law of diminishing returns
Negative returns to labor
Total variable cost (TVC)
Total fixed cost (TFC)
Total cost (TC)
Average variable cost (AVC)
Average fixed cost (AFC)
Average total cost (ATC)
Marginal cost (MC)
Constant returns to scale (CRS)
Increasing returns to scale (IRS)
Decreasing returns to scale (DRS)
Long run average total cost (LRATC)
Economies of scale (EOS)
Diseconomies of scale (DOS)
Short run average total cost (SRATC)
Minimum efficient scale (MES)
Maximum efficient scale
Problems for Review
1.Is it possible for the marginal product of labor to fall while the average product of labor rises? Explain the reason for your answer.
2. The table below represents the short run technology available to a firm. Assume that L is the variable factor of production and K is the fixed factor of production. The price of labor is $6 per unit and the price of capital is$4 per unit. Using a spreadsheet computer program (such as Microsoft Excel), complete the rest of the table.
3. Using the spreadsheet program you created to fill in the table in problem 2, create the two graphs described below in MS Excel. Remember to label all axes and curves.
• The total product (TP) curve
• The average product (AP) and marginal product (MP) curves (on one graph)
4. In the table from problem 2, what is the level of employment at which diminishing returns begin? What happens to the marginal product of labor and to marginal cost at this employment level?
5. Using the table from problem 2, fill in the blanks. Marginal cost equals minimum AVC between employment levels ____ and ____. Marginal cost equals minimum ATC between employment levels ____ and ____.
6. Suppose a firm hires only labor and capital and that the price of labor is $8 and the price of capital is$12. In the long run, the firm doubles its workforce from 8 to 16 units and doubles its capital from 12 to 24 units. Its output subsequently increases from 100 to 210 units.
• What sort of technology is this firm using?
• Calculate the firm’s long run average total cost before and after it changes its inputs.
1. These data are not intended to be compatible with the data in Table 7.1.
2. See OpenStax College (2014), p. 170, for a similar application to the chemical industry. Examples of IRS technologies arising from these geometric properties are found in many neoclassical textbooks.
3. These reasons are commonly cited in neoclassical economics textbooks.
4. For example, see McConnell and Brue (2008), p. 393., and Lipsey and Courant, p. 179.
5. See Keat et al. (2013), p. 265.
6. Carlton and Perloff (2000), p. 42.
7. Desai (2004), p. 176-177.
8. Eatwell (1990), p. 342-343.
9. Chatterjee, Siddharth. “Global Hunger is Threatening Families because of Climate Change.” IPS – Inter Press Service. 15 May 2019.
10. Pindyck and Rubinfeld (2013), p. 214. | textbooks/socialsci/Economics/Principles_of_Political_Economy_-_A_Pluralistic_Approach_to_Economic_Theory_(Saros)/02%3A_Principles_of_Microeconomic_Theory/07%3A_Theories_of_Production_Technology_and_Cost_of_Production.txt |
Goals and Objectives:
In this chapter, we will do the following:
1. Define the key revenue and profit concepts that neoclassical economists use
2. Identify the defining characteristics of the neoclassical theory of perfect competition
3. Explain the two rules of short run profit maximization for perfectly competitive firms
4. Analyze five possible cases of short run profit maximization under perfect competition
5. Derive the short run supply curve using the rules of short run profit maximization
6. Investigate the dynamic adjustment in the case of long run profit maximization
7. Explore implications and criticisms of the perfectly competitive model
8. Examine Marx’s theory of profit rate equalization and the related transformation problem
Neoclassical Revenue and Profit Concepts
In chapter 7, we focused almost exclusively on the factors that determine production cost, or the outlays that are required for a firm to obtain inputs for production. To understand the concept of profit, we must also understand something about the monetary receipts from the sale of the firm’s product, also known as total revenue (TR). If a firm only sells a single product then we can write total revenue as we did in chapter 5 where P is the price of the product and Q is the quantity sold. That is:
$TR=PQ$
We need to define two other related revenue concepts. The first is average revenue (AR), which is the revenue per unit of output sold. It is defined as follows:
$AR=\frac{TR}{Q}$
For example, if a firm’s TR is $5000 and 1000 units of output are produced, then the AR is$5 per unit.
The other concept that we need to define is marginal revenue (MR). Marginal revenue refers to the additional revenue resulting from the sale of an additional unit of output. It is defined as follows:
$MR=\frac{\Delta TR}{\Delta Q}$
For example, if a firm’s TR rises by $600 and its output increases by 300 units, then the MR is$2 per unit.
We cannot say anything at this stage about the behavior of TR, AR, and MR because we need more specific information about the characteristics of the marketplace. These concepts are developed at greater length in the next section.
First, however, we must consider what neoclassical economists mean by the term “profit,” which brings together the revenue and cost concepts that we have been discussing. It turns out that accountants define profit very differently from neoclassical economists, and so it is important to contrast the two definitions of profit. Accounting profit refers to the difference between TR and explicit costs. Explicit costs include all out-of-pocket costs or monetary costs, such as the payment of wages, rent, and interest. We can write the definition as follows:
$Accounting\;Profit=TR-Explicit\;Costs$
By contrast, neoclassical economists argue that accountants do not account for all the costs of production because some costs are not associated with out-of-pocket, monetary payments. Costs that do not carry with them explicit, monetary payments are called implicit costs. For example, suppose that the owner of the pizzeria is also the cook. Because she is the owner, she does not pay herself a wage (although she hopes to keep any profit that her firm earns). Because her labor is a resource used in production, it could be used elsewhere for some productive activity. That is, the owner could earn a wage or salary elsewhere and so her labor has an opportunity cost. The neoclassical economist, therefore, wishes to include the cost of this labor even though it has no explicit payment associated with it. Similarly, if the owner uses her personal computer to maintain the financial records of the firm, then the cost of this self-owned resource should be included as well even though the business did not directly incur a cost to purchase the computer. Additionally, if the owner invested her own financial capital in the business, then she incurs an opportunity cost in the form of interest and dividend income that would have been earned from other worthy investments. All these implicit costs should be included in any profit calculation, according to neoclassical economists. Neoclassical economists, therefore, define economic profit in the following way:
$Economic\;Profit=TR-Explicit\;Costs - Implicit\;Costs$
Let’s consider an example in which the pizzeria earns $100,000 in revenue in one month. Table 8.1 contains three scenarios. All numerical values are in dollar terms. In each scenario the explicit costs are the same and only the implicit costs differ. Because the explicit costs are the same in all three scenarios, the firm earns$10,000 in accounting profit in all three cases. Because the implicit costs differ, however, the economic profit is different in each of the scenarios. Despite the positive accounting profit of $10,000 in Scenario 1, the economic profit is$0 due to the implicit cost of $10,000. An economic profit of zero might appear to be an unpleasant situation for the firm, but in fact it is the opposite. The firm is earning enough revenue to cover its explicit costs and the foregone salary and interest of the owner. That is, the owner could not earn more in any other line of business. It is said that the firm enjoys a normal profit equal to$10,000 in this case.
In Scenario 2, the economic profit is -$5,000. That is, the revenue the firm earns is not sufficient to cover both the explicit and implicit costs. Even though the firm earns a profit on paper (i.e., a positive accounting profit), in a real sense, the firm is losing money. If the owner shut down the business and took her next best opportunity, she would earn an additional$5,000. As a result, the firm earns less than a normal profit in this case.
In Scenario 3, the economic profit is $5,000. The firm earns enough revenue to more than cover all explicit and implicit costs. In this case, if the owner shut down the business to produce elsewhere, she would actually lose$5,000. The firm clearly earns more than a normal profit in this industry. It should now be clear why neoclassical economists focus exclusively on economic profit. Economic profit is ultimately what affects a firm’s decision to remain in an industry or to leave an industry. Since accounting profit is the same in all three scenarios, it is not a proper guide to managerial decision making.
Although it was not mentioned in Chapter 7, all the cost curves that we discussed in the last chapter include both explicit and implicit production costs. Unless otherwise noted, any reference to production cost in neoclassical theory should be understood to include both kinds of cost because those are the costs that influence firm behavior according to neoclassical economists.
The Concept of Market Structure and the Meaning of Perfect Competition
We now wish to take a closer look at how the revenue measures defined in the last section behave as output changes. To accomplish this task, we must first discuss the concept of market structure. Market structure refers to all the characteristics of the marketplace that shape and influence how firms interact with their customers and with their competitors. Three key dimensions are used to distinguish between the different types of market structure:
1. The number and size of sellers
2. The ease of market entry and exit
3. The degree of product differentiation
How these characteristics combine in a specific market determines the degree of market power that each firm has in that market. Market power refers to the ability of a firm to raise the price of its product without losing all of its sales. A firm’s market power is greater when the reduction in quantity demanded is smaller for a given increase in price. For example, Figure 8.1 shows two demand curves facing two different firms in two different markets for a similar good.
Each of these market structures is distinguished along the lines of the three dimensions mentioned previously. The only market structure that we will examine in this chapter is perfect competition. According to neoclassical economists, a perfectly competitive market structure has the following three characteristics:
1. A large number of sellers and buyers
2. No barriers restrict the freedom of buyers or sellers to enter or exit the market
3. Each firm produces a homogeneous or standardized product
We should consider a few examples of actual markets that closely resemble perfectly competitive markets. For example, agricultural markets are highly competitive. The markets for wheat or corn have many buyers and sellers, and these crops are found to be very similar when we compare the product of one seller with that of another. It is also relatively easy for buyers and sellers to enter and exit these markets. Other examples include the markets for precious metals (e.g., gold and silver) and markets for corporate stock. In these markets, the standardization of the thing being sold is plainly seen.
The implication is that no seller or buyer in a perfectly competitive market has any market power. That is, each seller (or buyer) is a price-taker, and so is powerless to change the market price. In all these markets, competition is so intense that no single buyer or seller has the power to raise or lower her price above or below the market price without reducing her sales to nothing (in the case of a price increase) or needlessly sacrificing revenue (in the case of a price decrease). The graphical analysis of a price-taking firm is taken up in the next section.
Neoclassical economists assert that the phrase “perfect competition” is entirely descriptive in nature. Indeed, these three characteristics appear to simply describe certain features of specific markets. It should be noted, however, that the perfectly competitive market structure is the normative standard in neoclassical economics as well. That is, it is the moral ideal toward which market capitalist economies should strive, according to this school of thought. The reason neoclassical economists are such strong advocates of perfect competition is that such markets can be shown to lead to economic efficiency, as defined in chapter 2. Later in this chapter, we will see how neoclassical economists arrive at this result.
The Revenue Structure of a Perfectly Competitive Firm
In order to determine a perfectly competitive firm’s revenue pattern, we must first analyze the demand curve facing such a firm. From Chapter 3, we know that the market demand curve is downward sloping due to the law of demand, but the demand curve facing the individual firm is horizontal, as shown in Figure 8.3.
The graph on the left in Figure 8.4 shows that the area of the box under the demand curve is equal to total revenue since it is calculated as the product of price and quantity demanded. Furthermore, an additional unit can be sold at a price of $3 because the firm is a price-taker. The graph on the right shows what happens to total revenue as the quantity sold rises. It increases in a linear fashion because with each additional unit sold, the TR rises by the amount of the price of that unit, which is constant since the firm is a price-taker. Hence, the 101st unit raises TR from$300 to $303. We can also see that the TR curve is linear because TR = Pq, and the price is constant. Hence, the TR curve will have a zero intercept and a constant slope. If the price rises, then the TR curve will still rise from the origin, but the line will become steeper. That is, TR will rise more quickly as quantity rises. On the other hand, if the price decreases, then the TR curve will become flatter, indicating that TR rises more slowly. In addition, a price increase will shift the demand curve facing the firm upwards, and a price reduction will shift the demand curve facing the firm downwards. Next, we wish to investigate the behavior of marginal revenue as the quantity sold changes. In the case of a price-taking firm, a unit increase in quantity always increases TR by the amount of the price. Hence, the MR is always equal to the price in the case of a perfectly competitive firm. That is: $MR=\frac{\Delta TR}{\Delta q}=P$ In Figure 8.4, for example, the MR of the 101st unit is$3 per unit. Also, the slope of the TR curve is equal to the constant price, which in turn is equal to ∆TR/∆q. Hence, mathematically, we can see that MR = P. The MR curve is, therefore, the same as the horizontal demand curve facing the firm.
We can also consider the behavior of average revenue as the price changes. The AR in the case of a perfectly competitive firm is equal to the price as shown below:
$AR=\frac{TR}{q}=\frac{Pq}{q}=P$
In Figure 8.4, for example, the AR when 100 units are sold is equal to $300/100 units or$3 per unit. Similarly, the AR when 101 units are sold is equal to $303/101 units or$3 per unit. Since AR = P, the AR curve is also the same as the horizontal demand curve facing the perfectly competitive firm. Figure 8.5 shows the MR and AR curves on a graph.
All the revenue measures can also be expressed in tabular form as shown in Table 8.2.
Methods of Profit Maximization in the Short Run
The behavioral assumption that neoclassical economists impose is that all firms seek to maximize economic profit. A considerable amount of disagreement exists as to whether profit maximization is the primary objective of firms. Some critics argue that managers of modern corporations pursue revenue growth and market share much more aggressively than maximum profits. Others argue that firms consider their broader sense of social responsibility, which includes a commitment to the firm’s stakeholders (e.g., customers, the community, employees) rather than simply a commitment to the firm’s shareholders. Finally, it might be argued that firms balance multiple and competing objectives in their operations and that no single goal should be elevated above the others. Whatever may be the case, we will assume that the firm strives only to maximize its economic profit, in accordance with the neoclassical theory of the firm.
Because the perfectly competitive firm takes the market price as given, it need not ask which price is the best price to charge. In the short run, the only decision the firm must make is how much output to produce to maximize its economic profit. One way for the firm to achieve this goal is to compare TR and TC at each output level. Because the difference is the total economic profit (π), the firm can simply select the output level that maximizes that difference. Table 8.3 provides an example of a firm that aims to solve this profit maximization problem in the short run.
Figure 8.6 shows that economic losses exist to the left of the first break-even point because TC exceeds TR. At the break-even point, TC = TR and so economic profit is $0. Earlier in the chapter, it was argued that an economic profit of zero is still acceptable to the firm because all costs are covered. Because the opportunity costs are covered as well, the firm earns a normal profit. In between the two break-even points, the firm’s revenues exceed its costs. Therefore, positive economic profits are earned over that range of output. At a single output level, however, the gap between the TR and the TC is maximized. At that point where Q = 600 units, the economic profit is at a maximum. The graph on the right represents the economic profit curve. It measures the difference between the TR and the TC, as shown in the graph on the left. The break-even points occur where the economic profit curve crosses the horizontal axis. Clearly, it reaches its maximum where Q = 600 units. A second way to determine the profit-maximizing approach is less obvious but more useful. Managers generally do not have access to information about TR and TC at every possible output level. Instead, they base their production decisions on how profits rise or fall with small adjustments to output. This information is contained in the MC and MR measures, which have been calculated and are shown in Table 8.4. As Table 8.4 shows, MR is constant and equal to the product price of$3 per unit. The MC, on the other hand, falls and then rises for reasons already explained in chapter 7. We might start by asking whether the firm would find it profitable to produce the 100th unit of output. Since the sale of that additional unit will generate $3 of additional revenue and its production will add only$0.40 to cost, that unit will clearly add to the firm’s economic profit. The 200th unit will also add to the firm’s economic profit because the MR of $3 per unit clearly exceeds the MC of$0.30 per unit. In fact, the firm will continue to increase its output as long as MR exceeds MC. Once the firm reaches the 600th unit, the MR of $3 just barely exceeds the MC of$2.90 per unit and so it will be produced. If the firm increases its output any further, however, the MC of $3.70 will exceed the MR of$3 per unit and so it will not be profitable to produce that unit. The firm should, therefore, stop production at 600 units.
Even though MR and MC are not exactly equal at 600 units, they are close to equal. If we were to show more data, we could imagine increasing the output level somewhat above 600 units (but not as high as 700 units) until we reach the point where MR exactly equals MC. We know that MC will continue to rise due to diminishing returns to labor. The law of diminishing returns is the reason that the firm ceases production at a specific level of output in the short run. Beyond a certain point, the upward pressure on unit cost simply becomes too great. Figure 8.7 provides a graphical representation of how marginal adjustments to output can be used to determine the profit maximizing level of output for a perfectly competitive firm in the short run.
We can summarize how these marginal adjustments lead to the profit-maximizing choice of output:
1. If MR > MC, then the firm should increase its output.
2. If MR < MC, then the firm should reduce its output.
3. If MR = MC, then the firm should neither increase nor decrease its output.
It should also be noted that P = MR in the case of the perfectly competitive firm. Therefore, the rule that MR = MC can be written as P = MC for the perfectly competitive firm. Indeed, this condition is the first rule of profit maximization when we use the marginal approach.
Although the first rule of profit maximization is a necessary condition to ensure that profits are maximized in the short run, it is not a sufficient condition. That is, some instances arise in which a perfectly competitive firm would earn a greater profit by shutting down and producing zero units of output than by producing at the output level at which P = MC.
When would the firm decide to shut down? The second rule of profit maximization states that a firm will shut down when the product price falls below the firm’s average variable cost (AVC). Another way of stating this rule is to state that the firm will only produce at the output level where MR = MC when the product price is at least as great as AVC. That is, the firm will only produce when P ≥ AVC. This rule might seem entirely arbitrary to the reader, but it can be proven with the help of a little basic algebra.
As we have seen, if the firm operates then its profits from operating (πo) are the following:
$\pi_{o}=TR-TC$ $\pi_{o}=TR-TVC-TFC$
On the other hand, if the firm shuts down then its profits from shutting down (πSD) are also:
$\pi_{SD}=TR-TC$
$\pi_{SD}=TR-TVC-TFC$
We can say more about the profits from shutting down. If the firm produces no output, then its revenues are zero. Furthermore, its variable costs are $0 because the firm will not purchase any labor. Hence, the profits from shutting down may be written as: $\pi_{SD}=Pq-wL-TFC=P(0)-w(0)-TFC$ $\pi_{SD}=-TFC$ We can now compare the firm’s profits from operating with the firm’s profits from shutting down. In fact, the firm will only operate if the profits from operating are at least as great as the profits from shutting down. That is, the firm should operate if and only if πo ≥ πSD. We can now derive the second rule of profit maximization as follows: $\pi_{o}\geq \pi_{SD}$ $TR-TVC-TFC\geq -TFC$ $TR-TVC\geq 0$ $TR \geq TVC$ $Pq\geq TVC$ $P\geq \frac{TVC}{q}$ $P\geq AVC$ What this condition means is that the firm must earn enough revenue to cover its variable costs. If it does not earn this much revenue, then it makes more sense for the firm to shut down. Shutting down will cause the firm to lose its revenue, but firing all the workers will also allow the firm to eliminate its variable costs. The firm’s loss will then be reduced to its TFC. Five Possible Cases of Short Run Profit Maximization Given the marginal approach to short run profit maximization, we can identify five possible cases that might arise depending on the magnitude of the product price. Each of these cases as well as their implications for profitability are as follows: 1. $P>ATC\Rightarrow\pi>0$ 2. $P=ATC\Rightarrow\pi=0$ 3. $ATC>P>AVC\Rightarrow0>\pi>-TFC$ 4. $P=AVC\Rightarrow\pi=-TFC<0$ 5. $P In each of the five cases, we will consider how the two rules of short run profit maximization influence the graphical analysis of the situation. Again, the firm should 1) produce where MR = MC conditional upon 2) P ≥ AVC. Otherwise, the firm should shut down and produce zero units of output. Case 1 is the case of a positive economic profit as shown in Figure 8.8. Case 2 is the case of an economic profit of zero as shown in Figure 8.9. That is, shutting down is an even worse option. Let’s see why. The intersection of MR and MC occurs at 100 units of output as before and P =$0.80 is clearly above AVC = $0.60 at that output level. Hence, the firm will operate. The firm’s TR is equal to$80 (= $0.80 per unit times 100 units) and the firm’s TC is equal to$100 (= $1.00 per unit times 100 units). The firm’s economic profit is, therefore, equal to -$20 (= $80 minus$100). This loss is represented in Figure 8.10 as the top shaded box.
Why would the firm operate in this situation in the short run? If the firm shuts down, we know that its economic profit is always equal to – TFC. We can show the TFC graphically as the product of AFC and q. The reason is that AFC = TFC/q. Therefore, TFC = AFC·q. Furthermore, since ATC = AFC+AVC, the AFC = ATC – AVC. Hence, we can calculate the AFC in this case to be $0.40 per unit (=$1.00 per unit – $0.60 per unit), and the TFC is then equal to$40 (= $0.40 per unit times 100 units). Therefore, the economic profit from shutting down (= – TFC) is -$40. Clearly, this loss is much greater than the loss from operating. The loss from shutting down is equal to the two shaded areas combined. It follows that the firm will operate to maximize its economic profit. Certainly, the two rules of profit maximization led us to this conclusion much more quickly!
Case 4 is the case of a firm that is indifferent between operating and shutting down because its profit/loss situation is the same in either case. Figure 8.11 represents this case.
In this case, the intersection between MR and MC occurs at 100 units of output as before. The price, however, is exactly equal to AVC at this output level. The second rule of profit maximization requires that price be greater than or equal to AVC for the firm to operate. This condition is fulfilled and so the firm will operate. We can also see that TR is equal to $80 (=$0.80 per unit times 100 units) and TC is equal to $100 (=$1.00 per unit times 100 units). The firm’s economic profit is, therefore, equal to -$20 (=$80 – $100). In addition, because the AFC =$0.20 per unit, the TFC = $20 (=$0.20 per unit times 100 units). If the firm shuts down then, its economic profit will be equal to -$20 (= –TFC). Clearly, the profit from operating is the same as the profit from shutting down. Because the firm is indifferent between operating and shutting down, by convention, we conclude that the firm will operate. Students of economics are often puzzled by the conventional conclusion that a firm operates even though its economic profit is the same whether it operates or shuts down. In other words, why doesn’t the owner just stay in bed if the profit/loss situation is the same either way? Although it may seem strange, the reader should remember that the revenue is sufficient to cover all costs, including the opportunity cost of operating the firm, which might include the value the owner places on additional sleep! Case 5 is the only case in which the firm decides to shut down and produce zero units of output as shown in Figure 8.12. Again, the MR = MC intersection occurs at 100 units of output, but this time, the price of$0.70 per unit is below the AVC of $0.80 per unit. The second rule of profit maximization indicates that the firm should shut down in this case. The economic profit in this case is equal to –TFC. Because the AFC is$0.20 per unit, the TFC equals $20 (=$0.20 per unit times 100 units). The economic profit is, therefore, -$20. The careful reader might wonder how we can calculate TFC at an output level of 100 units when the firm has opted to produce zero units. The reason is that TFC is the same at all output levels so if we determine the TFC at 100 units of output, we also know the TFC at zero units of output. It should also be noticed that if the firm had operated at 100 units of output, then its TR would equal$70 (= $0.70 per unit times 100 units) and its TC would equal$100 (= $1.00 per unit times 100 units). Its economic profit would then be -$30. That is, its economic loss from operating would exceed its economic loss from shutting down. In the graph, the economic loss from operating is equal to the sum of the two shaded regions. Only the top shaded region (equal to the TFC) is lost if the firm shuts down.
The Derivation of the Short Run Supply Curve
Now that we have shown how the perfectly competitive firm maximizes its economic profit in the short run, we can use the analysis to derive the firm’s short run output supply curve. Figure 8.13 shows a series of MR curves corresponding to different prices as determined in the competitive market for this product.
Long Run Profit Maximization
We now turn to an analysis of profit maximization in the long run when all inputs are variable. Because capital inputs are not fixed in the long run, firms will enter the industry if economic profits exist, and they will exit the industry if economic losses exist. For the purposes of this analysis, we will assume that all firms possess identical short run ATC curves. This assumption is reasonable so long as all firms have access to the same production technologies and face the same opportunity costs. At this stage, we will ignore the adjustments that firms make to their plant sizes and focus exclusively on the impact that the entry and exit of competing firms has on the profit/loss situations of firms in the industry.
It turns out that the long run equilibrium outcome for a firm in a perfectly competitive market is the break-even case we considered in our analysis of the short run. That is, the market price is determined competitively through the interaction of supply and demand, and each firm earns an economic profit of zero as shown in Figure 8.16.
Why does this case represent the long run equilibrium outcome? The reason is that short run deviations from this situation produce an inherent long run tendency to change in the direction of this outcome. For example, in Figure 8.17, the market price and quantity exchanged begin at P1 and Q1, and the firm produces q1 units of output.
This result is expected because, as we have seen, whenever a marginal contribution is below an average, the average falls and whenever the marginal contribution is above an average, the average rises.
The firm will maximize long run economic profits by equating P and LRMC. Now suppose that the profit-maximizing choice is such that price exceeds LRATC. Then economic profits are made and firms will enter, driving the price down. As the price falls, the firm will reduce its plant size. Alternatively, suppose the profit-maximizing choice is such that the price is below LRATC. Then economic losses exist, and firms will exit the industry pushing the price up. As the market price rises, the firm will increase its plant size. Eventually, the firm will produce at output level q* where the market price is equal to LRMC and LRATC. In that situation, the firm is breaking even in the long run. It should also be noted that the plant size that corresponds to this output level allows the firm to produce at minimum SRATC and minimum LRATC. That is, the firm exhausts the gains from specialization and the division of labor in this plant but does not increase production so much that diminishing returns to labor begin to drive up per unit cost. Furthermore, it exhausts the gains from economies of scale but does not enter the region of diseconomies of scale. It is the optimal plant size for this reason.
The Derivation of the Long Run Industry Supply Curve
We can use our analysis of long run profit maximization to derive the long run industry supply (LRIS) curve.[2] The LRIS curve may possess different shapes depending on the way in which input prices respond as additional firms enter the market. If an abundance of the necessary inputs exists, then input prices might remain constant as additional firms enter the market. This type of industry is referred to as a constant-cost industry. Figure 8.20 shows how long run profit maximization may be used to derive the LRIS curve in a constant-cost industry.
In Figure 8.20, a short run increase in demand from D1 to D2 causes an increase in the product price from P1 to P2. As a result, the firm expands its output in the short run from q1 to q2. The resulting economic profits cause competitors to enter the industry. As additional firms enter, they increase the demand for inputs, such as labor, but because input supplies are perfectly elastic (i.e., horizontal), input prices (e.g., wages) do not rise. As a result, the LRAC remains fixed. Market supply, therefore, increases from S1 to S2 until the price returns to its original level, and economic profits are again zero. Finally, we can connect the original equilibrium P1 and Q1 with the new equilibrium at P1 and Q3 with a straight line. This horizontal line is the LRIS curve for a constant-cost industry. It shows that the market can expand in the long run without any upward pressure on the product price, precisely because no upward pressure on the inputs prices occurs with the expansion.
If the necessary inputs are relatively scarce, then input prices are more likely to rise as additional firms enter the market. This type of industry is referred to as an increasing-cost industry. Figure 8.21 shows how long run profit maximization may be used to derive the LRIS curve in an increasing-cost industry.
In Figure 8.21, a short run increase in demand from D1 to D2 causes an increase in the product price from P1 to P2. As a result, the firm expands its output in the short run from q1 to q2. The resulting economic profits cause competitors to enter the industry. As additional firms enter, they increase the demand for inputs, such as labor, and because input supply curves are upward sloping, input prices (e.g., wages) rise. As a result, the LRAC shifts upward due to the rise in unit costs. Market supply, therefore, increases from S1 to S2 until the price declines to P3, at which point economic profits are again zero. Finally, we can connect the original equilibrium P1 and Q1 with the new equilibrium at P3 and Q3 with a straight line. This upward sloping line is the LRIS curve for an increasing-cost industry. It shows that the market can expand in the long run only by putting upward pressure on the product price because upward pressure on the input prices occurs during the expansion.
If significant economies of scale exist in the input markets, then input prices may decline as additional firms enter the market. This type of industry is referred to as a decreasing-cost industry. Figure 8.22 shows how long run profit maximization may be used to derive the LRIS curve in a decreasing-cost industry.
In Figure 8.22, a short run increase in demand from D1 to D2 causes an increase in the product price from P1 to P2. As a result, the firm expands its output in the short run from q1 to q2. The resulting economic profits cause competitors to enter the industry. As additional firms enter, they increase the demand for inputs, such as capital, but because input supply curves are downward sloping (reflecting scale economies), input prices (e.g., prices of capital goods) fall. As a result, the LRAC shifts downward due to the reduction in unit costs. Market supply, therefore, increases from S1 to S2 until the price declines to P3, at which point economic profits are again zero. Finally, we can connect the original equilibrium P1 and Q1 with the new equilibrium at P3 and Q3 with a straight line. This downward sloping line is the LRIS curve for a decreasing-cost industry. It shows that the market can expand in the long run even as the product price falls because downward pressure on the input prices occurs during the expansion. This situation has occurred, for example, in the market for desktop and laptop computers due to effective utilization of economies of scale in the production of computer components as the market for computers has grown.
Implications and Criticisms of the Neoclassical Model of Perfect Competition
The major implication of the neoclassical model of perfect competition is that this market structure achieves economic efficiency. In chapter 3, it was explained that competitive market equilibrium leads to the full employment of scarce resources and allocative efficiency. That is, all resources are fully employed and marginal benefit equals marginal cost for each good produced when all markets clear. In that discussion, it was explained that the demonstration of least cost production would be postponed until this chapter. We can now see that long run equilibrium in a perfectly competitive market will lead to least-cost production. The long run equilibrium outcome leads to a price that is just equal to minimum long run average total cost. Hence, productive efficiency is achieved. Because full employment, least-cost production, and allocative efficiency are all achieved in a perfectly competitive market economy, neoclassical economists conclude that this market structure achieves economic efficiency. It is, therefore, the normative standard in neoclassical economics.
Nevertheless, we need to reflect on several major criticisms of the neoclassical model of perfect competition and its efficiency conclusion. First, market demand reflects willingness and ability to pay for the good or service. An individual may desperately need a specific good (e.g., a medication) but at the same time, she cannot afford to purchase the good at the equilibrium price. Because she is at a point on the demand curve that is below the equilibrium price, she will remain in need even when the market clears. To call the outcome an efficient one suggests that it is the most desirable outcome, but it ignores the possibility that many in need will not be able to obtain the product. The reader should recall that neoclassical economists do not distinguish between wants and needs. This criticism of the model is, therefore, a criticism that only heterodox economists emphasize.
A second major criticism of the neoclassical model of perfect competition is that social welfare is defined entirely in terms of the efficient use of resources to satisfy consumer wants. The level of satisfaction derived from productive work is completely ignored. For example, workers may be efficiently employed, but what if they are working 14-hour days over hot stoves or in dangerous coal mines and hate their jobs? Their satisfaction from living in such a society is diminished regardless of how much satisfaction they may derive from consuming material goods. Many workers may prefer to reduce their working hours even if it means reducing their material consumption, but in capitalist economies that choice may not exist. For many workers, the choice is to work long hours or not work at all. Even if part-time work is available, it typically is offered at low pay and without key benefits such as health insurance.
A final criticism of the neoclassical model of perfect competition is that it ignores power relationships. Conflicts between social classes are not possible in the model, which only acknowledges individuals interacting voluntarily in the free market. The notion that the relationship between employer and employee is conflict-ridden is entirely absent. All resource owners compete on the same level. The owners of capital and the owners of labor confront one another as equals in the perfectly competitive marketplace. All take market prices as given and differences in relative power simply do not exist. As we will see in the next section, the Marxian analysis of intensely competitive markets disagrees sharply with these conclusions.
The Marxian Theory of Competitive Profit Rate Equalization
Our purpose in this section is to consider how Marxian economists think about intensely competitive market capitalist economies. As we saw in Chapter 4, Marxian economists place primary emphasis on class conflict in their analyses of capitalism. To understand how this feature of capitalism is emphasized in their analysis of capitalist competition, we must first introduce a new concept that Marxian economists call the organic composition of capital(OCC). The organic composition of capital refers to the degree of constant capital intensity present in a capitalist production process. That is, a capitalist production process that uses relatively more constant capital than variable capital has a higher organic composition of capital than another capitalist production process that uses relatively less constant capital compared with variable capital. To make this definition more precise, we can define the OCC as follows:
$OCC=\frac{c}{c+v}$
According to this definition, the OCC tells us the fraction of the total capital advanced that consists of constant capital. If the total capital advanced is $1000 and the constant capital advanced is$700, then the OCC is 70%. In the extreme case that no constant capital is advanced (c = 0), the OCC equals 0. On the other extreme, if the entire capital consists of constant capital (v = 0), then the OCC equals 1 or 100%.
We are now able to consider a simple example of a capitalist economy with only five industries. Table 8.5 contains hypothetical data for the five industries.
In this example, each of the firms advances $100 worth of capital, but the organic compositions of capital are very different. Industry 1 has a very high OCC of 80% whereas Industry 5 has the lowest OCC of only 20%. In neoclassical terminology, Industry 1 is very “capital-intensive” and Industry 5 is very “labor-intensive.” The rates of surplus value are also assumed to be the same across the industries. Specifically, the rate of surplus value (s/v) is assumed to equal 75% in each industry.[3] These assumptions of different OCCs and uniform rates of surplus value lead to differences in the rates of profit across the sectors. Why? Recall that labor-power is the only commodity that creates new value (and thus surplus value) in the Marxian framework. When an industry uses relatively more variable capital, it will necessarily produce more surplus value (assuming the same degree of exploitation or rate of surplus value) across industries. That is the reason that Industry 5 produces the most surplus value and has the highest rate of profit. Similarly, it is the reason that Industry 1 produces the least surplus value and has the lowest rate of profit. As the reader can see by looking at what happens to the OCC and the rates of profit from Industries 1 through 5, as the OCC falls, the rate of profit rises. Because capitalists measure the profitability of their activities using the rate of profit, this situation is highly unstable in a competitive capitalist economy. Think about it. Why would a capitalist want to invest$100 in Industry 1 and earn a 15% return when she can invest the same $100 in Industry 5 and earn a 60% return. Capital’s search for the highest rate of profit should cause it to exit industries that have low profit rates due to high OCCs and to enter industries that have high profit rates due to low OCCs. In everyday life, we do not observe profit rates that are much higher in industries that use relatively more variable capital (e.g., garment-making) and profit rates that are much lower in industries that use relatively more constant capital (e.g., the automobile industry). The problem we face then is to explain how the rates of profit equalize across industries so that the same amount of capital generates approximately the same return regardless of where it is invested. From a static perspective, the solution to this problem requires that we calculate the general rate of profit (r) for this capitalist economy. The general rate of profit that applies to all capital once the profit rates have equalized may be calculated by dividing the aggregate surplus value (S) for the entire economy by the aggregate capital advanced (C+V) for the entire economy. We can calculate the general rate of profit in this example in the following way: $r=\frac{S}{C+V}=\frac{187.50}{500}=37.50\%$ Because all capital should earn the same rate of profit in a competitive capitalist economy, we can multiply the amount of capital invested in each industry by r to obtain the averageprofit that will be appropriated in each industry. Because the capital invested in each industry is the same ($100) and the general rate of profit is the same (r), the profit appropriated in each industry is the same in this example. Table 8.6 adds two additional rows of information to the information from Table 8.5 that applies specifically to this question of profit rate equalization.
Table 8.6 shows that the profit in each industry is $37.50. The reader should notice that the concept of profit is one that we have not yet discussed in the Marxian framework. It is not the same as surplus value. In fact, the equalization of the profit rate has created a situation in which the profits received and the surplus values produced are different in most of the industries in the table. In addition, the selling prices of the commodities will now be different from the values of the commodities. That is, the prices of production in each industry are equal to the total capital advanced in that industry plus the profits received in that industry. From a dynamic perspective, we can say that capital flows out of low profit industries and into high profit industries. As capital moves, production in high profit industries increases. The increased production causes the market price of the commodities produced in those industries to fall below the market value of those commodities.[4] As a result, the profit rates fall in high profit industries. Similarly, production in low profit industries contracts as capital flows out of them. The decrease in production causes the market price of the commodities in those industries to rise above the market value of those commodities. As a result, the profit rates increase in low profit industries. Capital movements will continue to occur until the profit rates have equalized across all industries. In addition, we can see from Table 8.6 that prices of production rise above their values in low profit industries and fall below their values in high profit industries. Only Industry 3, which possesses the same OCC as the entire economy, earns a profit equal to the surplus value it produces and charges a price of production equal to the value of its commodities. It is important not to become lost in the details and miss the fact that this analysis of competitive capitalism assigns a central role to class exploitation. It is the working class that produces the surplus value. Even though each industry ends up earning an amount of profit that is different from the surplus value it produces (except for Industry 3), the aggregate surplus value for the entire economy ($187.50) is equal to the aggregate profit. In other words, the capitalist class shares equally in the mass of surplus value produced by the working class according to each capitalist’s share of the total capital. In addition, the aggregate value of the commodities produced depends upon the SNALT required for their production within the Marxian framework. As Table 8.6 shows, the aggregate value of $687.50 is the same as the aggregate production price of the commodities produced for the entire economy. Marx identified these two key aggregate equalities in volume III of Capital which we can summarize as follows: $Aggregate\;Surplus\;Value=Aggregate\;Profit$ $Aggregate\;Value=Aggregate\;Price\;of\;Production$ The major objection to this Marxian analysis has been dubbed the Transformation Problem. The problem is easy enough to grasp but has proven incredibly difficult to solve to the satisfaction of all those interested in this question. The problem is that the elements of constant and variable capital also have values that must be transformed into production prices. In our example, these values have been left in their original form, giving rise to the objection that the transformation of values into production prices is not complete. For example, in Industry 1 constant capital might be advanced for the purchase of iron ore to be used in production. It will be purchased at its value, but once the profit rate has equalized, it should be purchased at its production price rather than its value. Many proposed solutions to this problem have been put forward since the late nineteenth century. The problem is that no one has yet discovered a way to transform the input values into production prices while at the same time maintaining both of Marx’s aggregate equalities. This problem continues to be one of the most challenging problems in the history of economic thought. Despite this problem, Marxian analysis provides a powerful explanation for the equalization of profit rates in capitalist economies within the context of a framework that grants a central place to the class struggle between workers and capitalists. F ollowing the Economic News [5] For many sellers, a fall in the price of their product can create extreme economic hardship. For example, Kevin Sieff explains that the steep drop in the price of coffee in the past few years has placed coffee growers in Guatemala under great economic pressure. Consequently, Sieff reports that many farmers have decided to migrate to the United States, as they have been operating at a loss due to an approximately 60% drop in the price of coffee. The decision to operate at a loss suggests that the price is below average total cost but at least as high as average variable cost. In other words, coffee growers are earning enough revenue to cover their total variable cost of production and probably part, but not all, of their fixed cost of production. In other cases, coffee growers shut down entirely because prices are below their average variable cost of production. As Sieff explains, “[a]bandoned coffee farms lie fallow along the dirt roads that wind through the region.” Part of the problem facing Guatemalan coffee growers is a rise in production costs. Sieff explains that smaller coffee farmers have been required to purchase chemicals to address the problem of “coffee rust,” which is a fungus. The rise in costs pushes up average variable cost. At the same time, Sieff explains that coffee prices are falling due to increased production in Brazil, Vietnam, Honduras, and Colombia. The combination of rising average variable cost and falling product prices is responsible for many coffee growers operating at a loss or shutting down altogether. Because different coffee growers have different average variable costs, some can avoid shutting down, but others are not so lucky. Sieff reports that Guatemalan farmers have recently been paid a price of$1.20 per pound while their average total cost is estimated to be $1.93 per pound. Sieff explains that this situation represents a sharp break from 2012 when coffee prices were$2 per pound, and production was profitable. In that case, we can conclude that price had exceeded average total cost, but that lucrative scenario is now firmly in the past.
Summary of Key Points
1. Economic profit is typically smaller than accounting profit because economic profit subtracts both explicit costs and implicit costs from total revenue.
2. A firm earns a normal profit when its economic profit is zero.
3. Neoclassical economists regard perfectly competitive markets as the normative ideal among market structures.
4. Firms in a perfectly competitive market structure are price-takers, and so average revenue and marginal revenue are equal to price.
5. To maximize economic profit in the short run, a perfectly competitive firm must produce such that price equals marginal cost and should only produce a positive output level when price is greater than or equal to average variable cost.
6. The short run supply curve of a perfectly competitive firm is the marginal cost curve above the minimum average variable cost of production.
7. In the long run, economic profits will be driven to zero as firms enter due to positive short run economic profits and as they exit due to negative short run economic profits.
8. The long run industry supply curve may be positively sloped, negatively sloped, or horizontal depending on the way in which input prices react as new firms enter an industry.
9. Neoclassical economists conclude that perfect competition leads to economic efficiency, but they do not emphasize the distinction between market demand and needs, the power struggle between social classes, and the fact that people’s happiness might depend as much on the work that they do as on the material consumption they enjoy.
10. In Marxian analysis, rates of profit differ across industries due to differing organic compositions of capital.
11. Capital moves between industries in search of the highest profit rate until production prices are formed, and the general rate of profit is established across all sectors.
12. The Transformation Problem exists because many believe that the values of inputs must be transformed into production prices in the same way that the values of final commodities are transformed into production prices.
List of Key Terms
Average revenue (AR)
Marginal revenue (MR)
Accounting profit
Explicit costs
Implicit costs
Economic profit
Normal profit
Market structure
Market power
Market power spectrum
Perfect competition
Price-taker
Long run marginal cost (LRMC)
Optimal plant size
Long run industry supply (LRIS)
Constant-cost industry
Increasing-cost industry
Decreasing-cost industry
Organic composition of capital (OCC)
General rate of profit (r)
Average profit
Prices of production
Transformation problem
Problems for Review
1.Suppose the market for frozen pizza is perfectly competitive and the current market price of a frozen pizza is $5.75. On a graph, draw the total revenue curve facing one firm in the market as well as the new total revenue curve when the market price rises to$6.25 per frozen pizza. Place dollars (\$) on the vertical axis and quantity (q) on the horizontal axis.
• What is the profit-maximizing output level and price?
• What is total revenue?
• What is total economic cost?
• What is total economic profit?
• What is the total fixed cost?
4. Answer the following questions when the firm represented in Figure 8.25 maximizes its economic profit.
• What is the profit-maximizing output level and price?
• What is total revenue?
• What is total economic cost?
• What is total economic profit?
• What is the total fixed cost?
5. Complete the remainder of Table 8.7 using the given information. What is the general rate of profit? Do Marx’s two aggregate equalities hold?
1. Wolff and Resnick (2012), p. 38.
2. It was my experience as a teaching assistant for Prof. Thomas R. Swartz at the University of Notre Dame in the early 2000s that inspired my approach to the derivation of LRIS curves in this section.
3. In Table 8.5, the total surplus value may be calculated as the product of the rate of surplus value (s/v) and the variable capital (v). The rate of profit is calculated as s/(c+v) as in Chapter 4. Finally, the total value of the commodities produced in each industry is calculated as the sum of c, v, and s, which is also how the total value was calculated in Chapter 4.
4. Recall from Chapter 4 that fluctuations in supply and demand can cause the value of a commodity and its price to diverge.
5. Sieff, Kevin. “Falling Coffee Prices Drive Guatemalan migration to the United States.” The Washington Post. 11 June 2019. | textbooks/socialsci/Economics/Principles_of_Political_Economy_-_A_Pluralistic_Approach_to_Economic_Theory_(Saros)/02%3A_Principles_of_Microeconomic_Theory/08%3A_Theories_of_Intensely_Competitive_Markets.txt |
Goals and Objectives:
In this chapter, we will do the following:
1. Identify the defining characteristics of monopolies and barriers to the entry of competitors
2. Explain the nature of the demand facing a monopolist and its marginal revenue
3. Apply the rules of short run profit maximization for a monopolist to a variety of situations
4. Explore the implications of monopoly for efficiency and the long run
5. Analyze the special cases of natural monopoly and price discriminating monopoly
6. Investigate the Austrian and Randian critiques of neoclassical monopoly theory
7. Examine the Marxian theory of monopoly capital
Neoclassical Monopoly Theory: Defining Characteristics and Types of Entry Barriers
In the nineteenth century, competition in many American industries was quite fierce. As firms implemented new production technologies and new firms entered markets to capture a share of the profits, prices fell and the competitive struggle drove many firms out of business. In the iron and steel industry, for example, many iron and steel companies entered pricing pools in an effort to place limits on price competition. These agreements were not very stable, however, and by the late nineteenth century, a wave of mergers swept through American industry as firms strove for a way to stabilize their prices and profits. Out of this merger wave arose several giant corporations in a variety of different industries. These firms controlled such a large part of the total output of their industries that observers regarded them as monopolies. For example, the United States Steel Corporation (known simply as U.S. Steel) controlled most steel production in the United States after its formation in 1901. Other examples include International Harvester, which dominated the agricultural machinery market, and American Tobacco, which was dominant in the cigarette market. John D. Rockefeller established Standard Oil a few decades before the merger wave, and it was the dominant firm in the refining and transportation ends of the oil business.
Strictly speaking, a firm only qualifies as a monopoly firm if it is the only seller in a specific market. Technically, the firms that were born during the merger wave of the 1890s were not pure monopolies, but critics considered them monopolistic due to their dominance in their respective industries. The rise of large corporations encouraged neoclassical economists to develop an analysis of the behavior of the monopolistic firm. Before we examine this model of monopoly behavior in detail, we need to identify the defining characteristics of monopolies.
The first characteristic is that the seller must be the only seller in the entire market. On a related note, it is also important that no close substitutes exist for the product. If close substitutes do exist, then the market arguably has more than one seller because we should define the market broadly enough to include close substitutes. Finally, to ensure that the market remains dominated by a single seller, either natural or legal barriers must be in place to prevent potential competitors from entering the market. If all these conditions hold, then we regard the market as monopolistic.
It should now be clear that a monopoly market is the neoclassical antithesis of the perfectly competitive market. Without any competition from other sellers, the monopolist has the power to set the market price rather than taking it as given. It is a price-setter rather than a price-taker. Recall that market power is the power to increase the price of one’s product without losing all of one’s sales. The monopolist, therefore, has complete market power, limited only by consumer demand. That is, it can raise its price without the fear that competitors will charge lower prices, but it still must consider the fact that its customers will likely purchase less of its product at the higher price. In other words, the monopolist cannot subvert the law of demand.
Table 9.1 summarizes the differences between the perfectly competitive market and the monopolist market.
We need to explore the types of entry barriers that make monopolistic markets possible. Often the barriers are legal in nature. Legal barriers to entry include copyrights, patents, licenses, and the ownership of key inputs. We discuss each in turn.
A copyright refers to the exclusive right to reproduce materials (e.g., books, journals, magazines, musical recordings). Since 2003, copyright protection in the United States has been active during the life of the author plus 70 years. One widely cited example of copyright protection is Time Warner’s ownership of the copyright to the song “Happy Birthday.” As of 2004, Time Warner was earning about $2 million per year in royalties due to its ownership of this copyright.[1] It is the reason that the employees in many restaurants sing different songs rather than the song “Happy Birthday” to their customers when they learn that customers are visiting their restaurants on their birthdays.[2] Any public performance of the song without the payment of royalties to the owner of the copyright exposes the performer to a potential lawsuit. Another famous example is Michael Jackson’s purchase of the copyright to the Beatles’ songs in 1985 for$47.5 million.[3] Although it was a lot of money, the estimated value in 2006 was $1 billion![4] Patents are another kind of legal barrier to entry. A patent is the exclusive right granted to an inventor to produce and sell a product for a specific period. In the United States, the government grants patent protection for 20-year terms. Patents are particularly important in the pharmaceutical industry in which large corporations develop certain types of drugs and medications and possess the exclusive right to sell them during the term of the patent. The justification for patents and copyrights is that firms and individuals need incentives to incur the costs of developing inventions and creating artistic and professional work. If competitors could immediately duplicate and compete in the sale of the newly invented product or the newly created work, then the creator would not have an opportunity to recoup the costs. The consequence would be a lack of invention and artistic activity in our society. The downside, of course, is that competition in the protected area does not allow the price of the new product or material to decrease. As a result, a tradeoff exists between innovation and low product prices. For this reason, patent and copyright protection have limited terms. Licenses are another important type of barrier to entry. An occupational license is legal permission to conduct a specific line of business. For example, licenses are required to practice law and medicine. The belief is that some professions provide services that may harm consumers if unqualified individuals practice in those areas. The government uses licensing requirements then as a safeguard against the entry of unqualified service providers. Strictly speaking, we should not regard these markets as monopolistic. Those licensed to practice law jointly hold the monopoly power within the legal profession. Considerable competition exists between the many licensed professionals who sell legal services. The same applies to those who have licenses to practice medicine. Finally, the ownership and control of key inputs is another legal barrier to entry because it depends on property rights. That is, if a firm has a monopoly in a key resource market, then it also frequently has a monopoly in the product market. For example, the Aluminum Company of America (ALCOA) once had a monopoly in the market for bauxite, which is the critical input to produce aluminum. Its monopoly in the market for bauxite allowed it to monopolize the aluminum market.[5] Similarly, in the late nineteenth century, Standard Oil acquired all the major pipelines for the transportation of oil in the United States helping it to solidify its monopolistic control of the transportation side of the oil business. During this same period, Carnegie Steel acquired a controlling interest in a major producer of coking coal, which the company then used in the production of steel. This acquisition helped Carnegie’s company to dominate the steel market. Aside from legal barriers to entry, we can also identify one key economic barrier to entry that may lead to the formation of a monopoly market. In Chapter 7, we discussed the concept of economies of scale (EOS). This concept refers to the way in which per unit production cost declines as a firm expands in the long run. This phenomenon occurs for a variety of reasons, including the spreading of large startup costs over many units of output, labor and managerial specialization, and learning by doing. Economies of scale may give one firm such a large economic advantage over its competitors that it is able to completely monopolize a market even in the face of unrestricted competition. When a firm acquires a monopoly due to economies of scale, neoclassical economists refer to it as a natural monopoly. Consider the long run average cost (LRAC) curves of the two firms represented in Figure 9.1. Firm 1 enjoys considerable economies of scale as can be seen from the falling LRAC over a large range of output. Firm 2, on the other hand, experiences diseconomies of scale at relatively low output levels as indicated by the rapid increase in LRAC even while the firm is operating at a very low output level. The market demand is similar in each market. If Firm 1 charges a low price (P1) that just allows it to cover the minimum LRAC, then its production at the minimum efficient scale (MES) is sufficient to meet the entire quantity demanded in the market (Q1) at that price. The situation is different with Firm 2 if it also sets a price (P2) that just allows it to cover the minimum LRAC. Firm 2 will produce at MES, but this quantity (Q0) is not nearly enough to supply the entire quantity demanded in the market (Q2) at that low price. In this case, Firm 1 is the natural monopoly. The reason is that if multiple firms with the same LRAC curve were to produce only a fraction of the output, then the LRAC for each firm would be much higher than it is when a single firm produces for the entire market. A single firm in that case is the most efficient outcome from a cost-minimizing perspective, and the scale economies of the firm serve as a barrier to entry keeping out potential competition. On the other hand, if multiple firms produce in the industry in which Firm 2 operates, these firms can collectively produce enough to satisfy the entire quantity demanded in the market even as each produces at the MES. In that case, the most efficient outcome is to have multiple firms competing with one another, and this industry is not one in which a natural monopoly is likely to operate. T he Nature of Demand and Marginal Revenue in Neoclassical Monopoly Theory We are now to the point where we can begin to analyze the neoclassical theory of monopoly markets. We begin by considering the demand curve facing the monopolist. Because the monopolist is the only seller in the market, the monopolist faces the entire market demand curve. Furthermore, this demand curve that the monopolist faces is likely to be relatively inelastic. The reason is that no close substitutes for this product exist, and we learned in Chapter 5 that the availability of substitutes is a major determinant of the price elasticity of demand. When no close substitutes are available, consumers become much less responsive to changes in the price of the product. This aspect of the market demand curve in a monopoly market strengthens the market power of the monopolist. For the sake of comparison, we should consider how the demand curve facing the monopolist differs from the demand curve facing the perfectly competitive firm. Figure 9.2 shows the demand curves facing a monopolist and a perfectly competitive firm. The perfectly competitive firm faces a horizontal demand curve because the firm is small and only faces a segment of the market demand. As explained in Chapter 8, a perfectly competitive firm is a price-taker for this reason. Consumers are perfectly responsive to price changes and so demand is perfectly elastic. As when we investigated the revenue structure of the perfectly competitive firm, we will now consider the revenue structure facing the monopolist. It is assumed at this stage that the monopolist charges the same price for every unit sold. As a result, the firm’s total revenue (TR) may be represented in Figure 9.3 when the price charged is$5 per unit and the quantity demanded is 10 units.
Clearly, the firm’s TR in this case is $50 (=$5 per unit times 10 units) and is represented as the area of the rectangle in the graph. The average revenue (AR) can also be calculated as follows:
$AR=\frac{TR}{Q}=\frac{\50}{10\;units}=\5\;per\;unit$
It turns out that the AR in this case is the same as the price charged. This result will generally hold as can be seen below:
$AR=\frac{TR}{Q}=\frac{PQ}{Q}=P$
What this result implies is that at any level of output, we only need to look at the height of the demand curve to obtain the firm’s AR just as we look at the height of the demand curve to obtain the price at that output level. Therefore, the demand curve facing the monopolist is identical to the firm’s AR curve as indicated in Figure 9.3.
It should also be noted at this stage that the monopolist can set the product price or the quantity exchanged, but it cannot choose both variables independently. That is, if the monopolist selects the price, then the consumers will decide which quantity to demand at that price. Similarly, if the monopolist decides that it will sell a specific amount of its product, then the consumers will decide which price they are willing and able to pay to purchase that amount of the product.
We next turn to the monopolist’s TR curve. As the reader might recall from Chapter 5, the TR curve has a specific shape in the case of a downward sloping linear demand curve. It is shown in Figure 9.4.
In Figure 9.5, the price falls from $6 per unit to$5 per unit, and the quantity demanded subsequently rises from 3 units to 4 units. The TR increases from $18 to$20 indicating that the firm is selling in the elastic portion of the market demand curve. The MR of the fourth unit of output may be calculated as follows:
$MR=\frac{\Delta TR}{\Delta Q}=\frac{TR_{2}-TR_{1}}{Q_{2}-Q_{1}}=\frac{20-18}{4-3}=\2\;per\;unit$
In other words, the firm’s TR only rises by $2 due to the increase in output from 3 to 4 units. This result might seem surprising, especially given the fact that the fourth unit of output sells at a price of$5! What is the reason for this strange result? While it is true that the fourth unit sells at a price of $5, it was necessary to reduce the price from$6 to $5 for every unit sold to sell that fourth unit. Therefore, the firm gains$5 in additional revenue from the sale of the fourth unit even as it loses $3 due to the price cut (i.e.,$1 for each of the three units previously sold at a price of $6 each). The net change in revenue is$2 (= 5 – 3). The implication then is that the MR of the fourth unit is below the price of the fourth unit. This point is indicated in Figure 9.5 where the MR2 is equal to $2 and the quantity of output is 4 units. Because the MR is generally less than the price of the product, we can draw the MR curve as a downward sloping curve that falls faster than the demand curve, as shown in Figure 9.5. We have just seen that the MR curve for a monopolist falls faster than the demand curve facing the monopolist because the firm must reduce the price on all units sold when it wishes to sell an additional unit. It is helpful to contrast the MR curve facing the monopolist with the MR curve facing the perfectly competitive firm. If the perfectly competitive firm faces a constant market price of$5 per unit, then we can calculate the firm’s MR as shown in Figure 9.6.
Using the information in Figure 9.6, we can see that the MR is calculated as follows:
$MR=\frac{\Delta TR}{\Delta Q}=\frac{TR_{2}-TR_{1}}{Q_{2}-Q_{1}}=\frac{20-15}{4-3}=\5\;per\;unit$
Without the need to reduce price to sell an additional unit, the perfectly competitive firm’s MR is the same as the price charged.
We can also understand the shape of the MR curve facing the monopolist from a mathematical perspective if we consider the relationship between MR and TR. The MR is defined as ΔTR/ΔQ. If we consider the TR curve facing the monopolist, then we can see that the MR is nothing more than the slope of the TR curve. As Figure 9.7 shows, the slope of the TR curve at a given output level can be determined using the tangent line method.
It should be clear that in the elastic portion of the demand curve, the MR is positive because the slope of the TR curve is positive. Similarly, at the peak of the TR curve where demand is unit elastic, the MR is equal to zero because the slope of the TR curve is zero. Finally, in the inelastic portion of the demand curve where the TR is falling, the MR must be negative because the slope of the TR curve is negative.
We can also infer at this stage that the monopolist will never produce where demand is inelastic. If the monopolist produces in this region of the demand curve then MR will be negative, which means that TR will be falling. A firm can never increase its economic profits by producing in this region because its TR will be falling even as its total cost (TC) is rising due to the increase in production. At this stage, we have not even incorporated TC into the analysis of the pure monopolist, but it is certain that higher production increases TC. As a result, economic profit must fall if the firm produces where demand is inelastic. Therefore, the monopolist will only produce where MR is greater than or equal to zero. This result tells us that a monopolist will tend to produce relatively less output rather than more, but at this stage, we cannot draw a more precise conclusion about the profit-maximizing choice of the monopolist.
Short Run Profit Maximization: Rules and Cases
Now that we have fully explored the revenue structure of the pure monopolist, we can turn to the question of profit-maximization. That is, which output level will be chosen and which price will be charged to maximize the firm’s economic profit in the short run? To answer this question, we must introduce production cost into the analysis. We will assume that the cost structure facing the pure monopolist is identical to the cost structure elaborated in Chapter 7 and applied to the perfectly competitive firm in Chapter 8. It also turns out that the two rules of profit maximization in the short run that were applied in the case of a perfectly competitive firm are also applicable in the case of the purely monopolistic firm. That is:
1. The firm should produce where MR=MC.
2. The firm should only produce a positive output level when P≥AVC.
Table 9.2 provides detailed information facing a monopolistic firm.
The first two columns contain given information about the market demand schedule that the firm faces. Clearly, the market demand curve is downward sloping. TR is calculated as the product of price and quantity demanded in the market. MR is calculated in a manner just like that described earlier in this section. For example, we calculate the MR of the 20th unit of output as follows:
$MR=\frac{\Delta TR}{\Delta Q}=\frac{TR_{3}-TR_{2}}{Q_{3}-Q_{2}}=\frac{400-220}{20-10}=\18\;per\;unit$
The TC information in Table 9.2 is given, and the ATC, MC, and economic profit (π) calculations are all carried out as in earlier chapters.
A few details from Table 9.2 deserve special emphasis. The TR peaks at 60 units of output. At higher output levels, TR begins to fall and MR becomes negative. We can infer that demand becomes inelastic beyond 60 units of output. Because we are using discrete data for the level of output (e.g., 0, 10, 20, …), the MR is close to zero but not exactly equal to zero when the TR reaches its peak. As a result, we know that the firm must produce 60 units of output or less to maximize its economic profit since those output levels correspond to the elastic part of the demand curve. To be more precise, we can now apply the rule that the firm will produce where MR = MC (if P ≥ AVC). In the table, MR and MC are equal to $6 per unit at an output level of 50 units. We do not have specific information for AVC in the table, but since P > ATC at 50 units of output, P must necessarily exceed AVC. The firm earns its maximum economic profit of$300 at 50 units of output. It might be noticed that 40 units of output will also achieve this same amount of economic profit. Again, it is our use of discrete data that is responsible for this result, and so it is always best to focus on the rule that MR = MC.
Figure 9.8 shows how the monopolist’s situation appears graphically.
It is important to notice that even though the profit-maximizing output level is found directly below the MR = MC intersection, the profit-maximizing price that is charged is found above the intersection on the market demand curve. The area of the shaded box represents the firm’s economic profit of $300, which may be calculated as the product of the amount by which P exceeds ATC (=$6 per unit) and the quantity sold (= 50 units). Alternatively, TR is $700 (=$14 per unit times 50 units) and TC is $400 (=$8 per unit times 50 units). The economic profit of $300 is simply the difference between the two amounts. This analysis demonstrates that the goal of the monopolist is not to rip off the consumer. The monopolist aims to maximize economic profit. It could charge the consumer a higher price if it wished to do so, but a higher price would reduce its economic profit. We know that economic profit would be lost because at a higher price, the firm’s MR exceeds its MC. Similarly, the firm could increase the quantity sold by reducing its price, but this action too would fail to maximize economic profit because a lower price would cause MC to exceed MR. It is worth emphasizing that the monopolist does not have a supply curve like the perfectly competitive firm.[6] As we learned in Chapter 8, the perfectly competitive firm’s profit-maximizing quantity changes as the market price changes for reasons beyond the firm’s control. As the market price changes, we observe different quantities supplied by the perfectly competitive firm at each price. The monopolist, on the other hand, chooses the market price to maximize its economic profit. As a result, the price charged does not fluctuate for reasons beyond the monopolistic firm’s control. Therefore, the only relevant combination of output and price for a monopolist is the one that it chooses to maximize its economic profit. It is not possible to trace out a series of combinations of price and quantity supplied in the case of the monopolist. In addition, the economic profits that the monopolist earns may persist even in the long run due to the barriers to entry that prevent competitors from entering the market.[7] In the case of perfect competition, economic profits serve as a signal to firms outside the industry to enter. The lack of entry barriers leads to a rise in the market supply and a reduction in the market price until the economic profits are eliminated. No such elimination of the economic profits can occur in the case of pure monopoly. Although the monopolist is protected from competition, its economic profits are not guaranteed. If consumer demand falls then the market demand curve will shift to the left, which may eliminate the economic profits.[8] Similarly, a rise in production costs may occur, which would cause the ATC curve to shift upwards.[9] The result again would be a reduction in economic profits. These possibilities lead us to consider additional scenarios that may face the monopolist in the short run. Figure 9.9 represents the case where a monopolist is operating at the break-even point. In this case, the firm charges a profit-maximizing price of$8 per unit, which is also equal to the firm’s AVC at this output level. Because the shutdown rule states that the firm will produce where MR = MC if P is greater than or equal to AVC, we conclude that the firm will operate in this case. The firm’s TR in this scenario is equal to $296 (=$8 per unit times 37 units). The firm’s TC is equal to $518 (=$14 per unit times 37 units). Therefore, the economic profit is equal to -$222. In addition, the firm’s TFC is equal to$222, which may be calculated as the product of AFC (= $6) and Q (= 37 units). Therefore, if the firm shuts down, it will suffer an economic loss of$222 (= -TFC), which is exactly equal to its loss from operating. In Figure 9.11, the shaded region represents both the TFC and the economic loss from operating. Even though the firm is indifferent between operating and shutting down, we conclude that the firm operates.
Another way to argue that the firm is indifferent between operating and shutting down is to note that the firm is earning just enough revenue to cover its TVC. The firm’s TVC is equal to $296 because TVC may be calculated as the product of AVC (=$8) and Q (= 37 units). In other words, the firm can just pay wages out of revenue so it is only the TFC that it cannot cover when it operates.
The final case that we will consider for the short run is the case in which the monopolist decides to shut down as shown in Figure 9.12.
In this case, the firm produces no output because the price of $6 per unit, which is directly above the MR = MC intersection, is below the AVC of$7 per unit. Because the monopolist shuts down, its TR is $0 and its TVC is$0. It must still pay its TFC and so its economic profit is equal to –TFC. As always, the TFC may be calculated as the product of AFC and Q, which is here equal to $272 (=$8 per unit times 34 units). The firm’s economic loss of $272 is depicted as the top shaded box in Figure 9.12. If the firm were to produce 34 units and charge a price of$6 per unit, then its economic loss would be much greater. In that case, the monopolist’s TR would be $204 (=$6 per unit times 34 units), its TC would be $510 (=$15 per unit times 34 units), and its economic profit would be -$306 (=$204 – $510). The economic loss in that case would be equal to the combined area of the two shaded boxes in Figure 9.12. As a result, the firm opts to shut down and limit its losses to the TFC. Im plications for Efficiency and the Long Run The five cases that we considered in the previous section are all possible scenarios that the monopolist will face in the short run. As we observed, it is only in cases 1-4 that the monopolist will operate in the short run. Whenever price falls below AVC, as in case 5, the firm shuts down. The reader might wonder which of these cases is possible in the long run. In the long run, the firm will withdraw its capital and exit the industry if it is experiencing economic losses. Cases 3-5 all include economic losses and so these cases cannot apply to the monopolist in the long run. On the other hand, cases 1 and 2 involve an economic profit that is greater than or equal to zero. As we have seen, an economic profit of zero will be acceptable even to a monopolist in the long run because all costs are being covered, including opportunity costs. Furthermore, we have seen that barriers to entry make long run economic profits a real possibility because competitors cannot enter and drive down the price. Therefore, either of these two cases is a possible long run equilibrium. Our next task is to consider the efficiency implications of monopoly markets. We have seen that perfectly competitive markets achieve economic efficiency in the sense that they lead to least-cost production (productive efficiency) and the appropriate quantity of the good produced (allocative efficiency). They also maximize the total of consumer surplus and producer surplus. It is worth asking whether monopoly markets achieve the same desirable outcomes. Figure 9.13 allows us to compare the efficiency effects for the cases of pure monopoly and perfect competition. The monopoly firm also fails to achieve least-cost production. If we look back at Figure 9.8, for example, in which the firm is enjoying economic profits, we can see that the price charged is clearly above the minimum ATC, which exists at the intersection of MC and ATC. If the firm was to produce more, then its ATC would fall due to further specialization within its production plant. It chooses not to expand production, however, because holding back production allows the firm to raise the price by more than enough to make up for the higher unit cost. Returning to Figure 9.13, we can also see that the reduction in output that occurs in the monopoly market leads to a loss of consumer surplus and producer surplus. The reader should recall that the consumer surplus is equal to the area above the current price and below the demand curve. In this case, the increase in price that the monopolist pursues causes the consumer surplus to shrink by the amount of the shaded rectangle and the top shaded triangle. The top shaded triangle, however, represents a pure loss to society because it corresponds to the reduction in quantity that accompanies the monopolization of the market. These units are not produced anymore and so this consumer surplus is completely lost. The shaded rectangle, however, corresponds to units that are still produced in the monopoly market. This area represents a transfer to the producers in the form of producer surplus. For this reason, the shaded rectangle is referred to as the rectangle of redistribution. These units are still sold but now at the higher monopoly price. The reader should recall that producer surplus is represented as the area below the current price and above the supply curve (or the marginal cost curve). The reduction in output that occurs with the monopolization of the market thus leads to the loss of the bottom shaded triangle in Figure 9.13. Because these units of output are no longer produced, this producer surplus is simply lost. This loss of producer surplus, of course, raises the question as to why the monopolist would restrict output when it leads to a loss of producer surplus. The reason is that this reduction in output makes possible a rise in price, which allows the monopolist to capture a significant part of the consumer surplus. A net gain for the monopolist is the result. What happens in this case is that the total surplus (TS) that society realizes shrinks due to the loss of consumer surplus and producer surplus. This loss of TS represents an efficiency loss from the monopolization of the market. The two shaded triangles in the graph represent the deadweight loss of monopoly. The larger triangle formed from the combination of these two smaller triangles is called a Harberger Triangle after the American economist Arnold Harberger for whom it is named. In summary, the total economic pie shrinks due to the monopolization of the market even as the monopolist grabs a larger share for itself at the expense of consumers. Additional characteristics of monopoly markets also strengthen the case that such markets tend to be inefficient. Specifically, monopolistic firms have an incentive to incur additional costs to maintain the barriers to entry that keep competitors out of their markets. Firms may hire lobbyists to pressure lawmakers to extend their patents and copyright protection. Lawyers may be hired to initiate lawsuits against those believed to be infringing on the firm’s rights of ownership of patents and copyrights. Because these expenses are incurred to protect the firm’s economic profits rather than to increase production, they are regarded as wasteful from a social perspective. Neoclassical economists label these efforts to appropriate benefits that exceed the economic cost of the required resources as rent-seeking activities. To the extent that these legal barriers to entry encourage innovation, that benefit may provide some economic justification for these expenses. Any costs that exceed what is needed to encourage innovation, however, are regarded as socially wasteful in neoclassical theory. In terms of long run economic growth, monopolies are also often accused of being technologically backwards.[10] That is, because they are not subject to competitive pressure, the claim is made that they will not have the incentive to innovate and keep production costs down in the same way that a perfectly competitive firm would. An example of a large firm that lost considerable market share due to a failure to innovate is General Motors. Although it was not a pure monopoly in the American automobile market given the presence of other large automakers, it was the market leader in the mid-twentieth century. Its failure to keep up with market trends caused it to lose considerable market share to Japanese auto producers as Japanese auto companies began selling smaller, more fuel-efficient cars in response to the rise in gas prices in the 1970s. Another interesting example of the tendency of large corporations to stagnate technologically is U.S. Steel’s refusal to develop a new steel beam known as a Grey beam at the beginning of the twentieth century. By 1926, U.S. Steel was secretly producing the Grey beam in violation of Bethlehem Steel’s patent rights. Eventually, U.S. Steel was forced to pay royalties to Bethlehem Steel in exchange for permission to produce the Grey beam.[11] Natural Monopoly and Price Discriminating Monopoly Overall, monopolies appear to be economically inefficient. Nevertheless, we can identify some exceptions to this general rule. One example is when a natural monopoly exists. As we have seen, natural monopolists enjoy an economic cost advantage due to economies of scale. It is this cost advantage that allows them to dominate the market. If significant economies of scale exist in an industry, then our assumption breaks down that the MC of the monopolist is the same as the market supply curve in a perfectly competitive market. With significantly lower per unit production costs, the natural monopolist may end up being more efficient than the perfectly competitive market. As we discussed earlier in this chapter, a natural monopolist enjoys falling LRAC over a large range of output. Public utilities are frequently cited examples of natural monopolies. The startup costs are very large and so these costs are spread out over a large quantity of output. Most areas are served by a single electric company, a single natural gas company, and a single water company. Imagine the inefficiencies that would arise if many suppliers each had their own electrical wires, gas lines, and water delivery systems. Consider the case of an electric company that enjoys large economies of scale in production and so monopolizes the local electricity market. This case is depicted in Figure 9.14. An alternative regulatory strategy is to require the monopolist to charge a price equal to LRAC. This regulatory strategy is known as average cost pricing and guarantees that the firm will earn an economic profit of zero. If the firm charges a price of$0.10 per kwh and produces an output level of 25 million kwh, then the firm will break even. This pricing rule leads to a larger quantity of output sold than in the monopoly outcome but not as much as the marginal cost pricing rule. It also leads to a lower price than the monopoly price but one that is higher than the perfectly competitive price. It thus represents a compromise between the two possible outcomes that is still acceptable to the natural monopolist, even in the long run since economic profits are zero.
Another possible scenario in which a monopolist may be more efficient than the basic model occurs when the monopolist can engage in price discrimination. Price discrimination refers to the practice of charging different prices to different consumers of the same product. For example, student discounts on restaurant meals or movie tickets are good examples of price discrimination. Regular customers must pay full price but the students are given a discount to encourage them to patronize specific establishments. Senior discounts on restaurant meals and kids’ menus are other examples. Additional examples include bulk discounts. When a consumer buys a 24-pack of soda, for example, she will generally pay a lower price per can than if she purchases a 6-pack of soda.
The examples of price discrimination cited above involve different groups of consumers being charged different prices based on some distinguishing characteristic of the consumer or the quantity that is purchased. The purest form of price discrimination, however, occurs when every consumer in a market is charged the maximum price she is willing and able to pay. This form of price discrimination is referred to as perfect price discrimination because it is only possible when the seller can perfectly discriminate between consumers. For this form of price discrimination to occur, the firm must be a monopolist. If competitors can charge lower prices than the maximum that the consumers are willing and able to pay, then this pricing strategy will be undermined very quickly. The monopolist must also have complete knowledge of the market demand curve. Otherwise, it will be impossible to identify the maximum prices that consumers are willing and able to pay. Finally, it must be impossible for consumers to resell the units they purchase.[12] If a consumer who is willing and able to pay a low price can turn around and sell that unit to a consumer who is willing and able to pay a much higher price, then the monopolist may fail to make the sale to the consumer who is willing and able to pay the high price, particularly if the consumer who resells the unit charges a slightly lower price for that unit.
Figure 9.15 shows the case of a monopolist that is capable of perfect price discrimination.[13]
The major difference between this graph and the graph of the single pricing monopolist is that this monopolist’s MR curve is identical to the demand curve facing the firm. With a single pricing monopolist, the MR curve is steeper than the demand curve because the firm must cut the price on all units sold to sell another unit. When the monopolist can perfectly price discriminate, however, it does not need to cut the price on other units sold to sell one additional unit. As a result, the MR of an additional unit is the same as the price. Therefore, the market demand curve and the MR curve are the same in the case of perfect price discrimination. In Figure 9.15, the first unit is sold for $9 per unit, which is the maximum price that a consumer is willing and able to pay for that unit. The second unit sells for$8. Notice that the first unit still sells for $9 even though the second unit sells for$8 because perfect price discrimination occurs in this case. The MR of the second unit then is $8 because TR rises by the full amount of the price of that unit. The third, fourth, and fifth units sell for$7, $6, and$5, respectively. Notice that the monopolist will stop producing at 5 units because at this point MR = MC. The firm’s TR is calculated as the sum of the different prices charged as follows:
$TR=9+8+7+6+5=\35$
The monopolist’s total cost is calculated as it always is. If we multiply the ATC at the profit-maximizing output by the quantity produced, then the TC is equal to $20 (=$4 per unit times 5 units). The firm’s economic profit then is equal to $15 (=$35 – $20). Because the perfectly price discriminating monopolist can charge the maximum price the consumer is willing and able to pay, the firm appropriates the consumer surplus that consumers normally enjoy when they pay the single market price. This transfer to the monopolist allows the monopolist to increase its economic profit at the expense of the consumer. This result is important because it demonstrates that price discrimination is not a practice that is adopted to help special groups like senior citizens, parents with small children, and college students. The practice is adopted because it maximizes economic profits. By charging lower prices to senior citizens and kids and higher prices to everyone else, a restaurant can appropriate (at least in part) the smaller consumer surpluses of the senior citizens and children and the larger consumer surpluses of everyone else. We can also see that a perfectly price discriminating monopolist is more efficient than a single pricing monopolist. Specifically, if we assume once more that the MC curve of the monopolist is the same as the market supply curve if the market was instead perfectly competitive, then we can evaluate the efficiency effects of price discriminating monopoly relative to perfect competition. In Figure 9.15, the perfectly competitive equilibrium can be found at the intersection of the market demand curve and the MC curve of the monopolist (i.e., the perfectly competitive supply curve). The perfectly competitive output level is 5 units of output, which is the same as the profit-maximizing output of the price discriminating monopolist. In other words, the price discriminating monopolist achieves allocative efficiency. It fails, however, to achieve least-cost production because the ATC of$4 per unit is above the minimum ATC, which occurs at the intersection of the ATC and MC curves. The implication is that perfect price discrimination does not shrink the economic pie, but it does redistribute a large part of the pie away from consumers and towards the monopolist.
Government Policy Regarding Monopoly
Because monopolists tend to operate inefficiently, the question arises as to how society should respond when monopolistic markets emerge. We can identify five possible responses. Each response may be associated with a specific school or schools of economic thought.
1. The Austrian and Randian perspectives: Allow private monopolies to thrive without government intervention.
2. The conservative neoclassical perspective: Divide inefficient monopolies into competing firms by enforcing antitrust laws.
3. The liberal neoclassical perspective: Publicly regulate privately owned natural monopolies and divide monopolies into competing firms with even stricter enforcement of antitrust laws.
4. The statist perspective: Create public monopolies through nationalization (state acquisition)
5. The traditional socialist perspective: Grant the power to bodies of working people to cooperatively plan production in monopoly firms in coordination with other bodies of working people and consumers.
We can place each of these views along the political spectrum ranging from far right to far left as shown in Figure 9.16.
We will briefly discuss each of these responses beginning with the neoclassical perspectives since we have already explored the neoclassical theory of monopoly in detail. According to conservative neoclassical economists, the ideal market structure is the perfectly competitive one. Therefore, efficiency can be enhanced by breaking up monopolies into competing firms, effectively transforming a monopolistic market structure into a perfectly competitive market structure. The notion that government intervention can be used to create a more competitive environment is one that has a long history in the United States. The 1890 Sherman Act was the first major piece of federal legislation to outlaw unreasonable restraints of trade. In the early twentieth century, federal action was taken against Standard Oil, U.S. Steel, American Tobacco, and other firms because they had allegedly established illegal monopolies in their industries. The Clayton Act of 1914 and the creation of the Federal Trade Commission (FTC) that same year to enforce the nation’s antitrust laws further strengthened this instrument of federal control over markets. The conservative neoclassical perspective takes seriously the benefits of perfect competition, but its proponents prefer that this federal tool be used conservatively (i.e., only when a clear and convincing case can be made that a monopoly is firmly established in a specific industry and is harming consumers).
The liberal neoclassical perspective advocates even stricter enforcement of the nation’s antitrust laws as well as public regulation of privately owned natural monopolies. Again, the aim is to force the natural monopolist to produce a larger output and charge a lower price than its profit-maximizing choices of these variables. In theory, successful regulation using average cost pricing or marginal cost pricing rules will move the industry closer to the perfectly competitive outcome. Conservative neoclassical economists tend to object to regulation because regulatory boards are susceptible to regulatory capture.[14] That is, these boards may come under the influence of the monopolist itself, which can use the coercive power of government to impose its will, thereby creating an even worse situation than that which exists in an unregulated environment. In addition to their advocacy of public regulation of monopolies, liberal neoclassical economists have a lower threshold at which point they advocate antitrust action against potential violators. The remaining perspectives on responses to monopoly are discussed in the next two sections.
The Austrian and Randian Critique s of Neoclassical Monopoly Theory
The Austrian and Randian perspectives of monopoly theory and antitrust laws are similar and so have been treated together. Differences do exist among adherents of these worldviews, but their commonalities are much greater than the differences. The former chairman of the Federal Reserve Board, Alan Greenspan, was once a member of Ayn Rand’s inner circle. His perspective on U.S. antitrust laws represents the Randian perspective quite well.[15] Specifically, Greenspan challenges the conventional view of the western railroad monopolies that operated in the late nineteenth century. The western railroads have been accused of operating independently of competition even though many were poorly built. Greenspan argues, however, that their monopoly power derived from government subsidies and government restrictions.
According to this Randian perspective, if a single firm becomes dominant in an industry, that fact alone is not reason enough to oppose its existence. Assuming its dominance is the result of its own efficient operation and competitors are free to enter the industry and compete, then the monopolist should not be punished for its success. The only objectionable monopoly, according to this view, is a coercive monopoly. A coercive monopoly is one that maintains its dominance due to legal restrictions that prevent competitors from entering. Once such restrictions are removed, a free capital market will ensure that competitors will enter the industry if they expect that they can compete with the monopolist, argues Greenspan. If the monopolist remains the dominant firm even in the presence of a free capital market, then it will not necessarily have its profits reduced. If the firm is highly efficient and keeps production costs low, then its profit margins may be large. Greenspan argues that a free capital market only ensures that a monopolist that earns big profits by charging high prices will soon face competition that drives those profits down. He identifies ALCOA as an example of a monopoly firm that maintained its monopoly in the market for aluminum for many years prior to World War II due to cost-cutting and efficiency rather than high prices. This opinion contrasts with our earlier suggestion that ALCOA’s control of a key resource was the source of its market power. In summary, a monopolist should never be punished when it achieves and maintains its dominance in an environment of free competition and voluntary exchange.
The Austrian critique of neoclassical monopoly theory resembles the Randian critique. D.T. Armentano, for example, explains that neoclassical economists have placed great emphasis on non-legal barriers to entry like economies of scale and commercially successful product differentiation as sources of monopoly power.[16] Examples of product differentiation include the annual models of automobile companies. Armentano explains that consumers clearly prefer to pay the higher prices that accompany such differentiation. Similarly, consumers could pay the higher prices of firms that do not enjoy scale economies if they wished to do so. From the consumer’s perspective, resources are allocated efficiently and so to use antitrust laws against such firms is in complete opposition to the wills of consumers. Armentano also warns against evaluating the efficiency of monopoly markets against the neoclassical model of perfect competition. He explains that the perfectly competitive model is completely static (i.e., devoid of time and process). As a result, all the features of actual competition, such as product differentiation, advertising, price discrimination, and innovation, are treated as monopolistic practices that lead to the misallocation of resources. If we regard all such activities as monopolistic, then most competitive interaction will be viewed as requiring government intervention, in Armentano’s view.
Along similar lines, Armentano explains how the Austrian economist Murray Rothbard argues that it is not possible to conceptually distinguish between a monopoly price and a free market competitive price. If we compare the price of a good in a competitive market with the price of a good in a monopolistic market, then we are simply comparing the prices of two different goods. If consumers are willing to pay a higher price for one of the goods, then the price paid is consistent with the supply and demand for that good just as the lower price is consistent with the supply and demand for that good. Additionally, if the market price of a good rises over time, why should we assume that the initial price is the competitive price and the new price is a monopolistic one? All free market prices ultimately emerge from the interaction of supply and demand and attempts to label some prices as monopoly prices and other prices as competitive prices are simply efforts to justify government interference in the free market.
The Marxian Theory of Monopoly Capital
Marxian economists have also constructed analyses of monopoly capital. These analyses have been complicated, however, by the fact that Marx primarily investigated the conditions of competitive capitalism. Nevertheless, he did recognize the tendency towards monopoly within capitalist industries. One source of this tendency, Marx refers to as the concentration of capital. As an individual enterprise accumulates capital over time, it grows as it devotes a portion of its profits to expansion. The centralization of capital, on the other hand, refers to the tendency of strong, productive enterprises to absorb weaker, less productive enterprises and may be an important factor during capitalist crises. The process is never complete, however, as competition between large capitalists inevitably breaks out again. In Marx’s view, competition gives rise to monopoly and monopoly gives rise to competition.
When Marxian economists have referred to “monopoly capital,” the phrase has been used more generally than the strict neoclassical definition of a single seller in a market for which no close substitutes exist and in which barriers to entry keep competitors from entering. Instead, it seems to refer to industries in which the concentration and centralization of capital have become so great that the law of value no longer prevails. That is, a monopoly capitalist must have the power to increase the price of a commodity above the value that would prevail if the market was intensely competitive. In other words, the monopoly price will be higher than the competitive price that would be charged if the value of the commodity was determined by the SNALT embodied in it. Marxian economists have not put forward an explanation of any economic law that would determine the magnitude of the difference between the monopoly price and the competitive value.
Because of the difficulties associated with the identification of a precise economic law to explain the difference between monopoly price and competitive value, Marxian economists have concentrated more on general qualitative analyses of monopoly capital. The most famous of these analyses is Paul Baran and Paul Sweezy’s Monopoly Capital (1966). Baran and Sweezy argue that over time within capitalist societies a persistent rise in the economic surplus occurs, which is simply the difference between the total social product and the cost of producing it. Because of income inequality, insufficient aggregate demand exists to absorb the surplus. Capitalist consumption and investment are not sufficient to absorb the surplus, and so stagnation is the expected outcome of monopoly capitalism. Some counteracting forces do exist, however, which include the sales effort. The sales effort refers to advertising and product differentiation, which may stimulate demand to a certain degree but which mainly create an enormous amount of waste. Government expenditure is the other major counteracting factor that Baran and Sweezy discuss. Because capitalists have a major influence over government officials, however, they emphasize military expenditures much more than spending on social programs and public assistance because the latter might threaten the class structure of society.[17]
In 2006, John Bellamy Foster and Fred Magdoff argued that the stagnation problem that Baran and Sweezy identified as consistent with the monopoly capital phase had worsened. While the counteracting factors are “superficial, weaker, and self-limiting,” the stagnation tendency is “deeply rooted, powerful, and persistent.” At the same time, Foster and Magdoff argue that the capitalist system has found new ways to offset (at least partly) the stagnation tendency of monopoly capital. They explain that the explosive growth of finance has led to a new hybrid phase of the capitalist system that they refer to as monopoly-finance capital. They explain that the massive growth of finance has led to new outlets for the economic surplus in the finance, insurance, and real estate (FIRE) sectors in the form of new investment in office buildings and equipment. This counteracting factor was limited, however, in that most money capital has been used for speculation in the financial markets rather than for real investment in productive capacity. Due to the inconsistent connection between the financial sector and the industrial sector, the financial explosion has been unable to compensate for the stagnation tendency of monopoly capital enough to revive the rapid accumulation of capital.[18]
F ollowing the Economic News [19]
Andrew Leigh recently noted that in a recent study involving the examination of thousands of financial reports of U.S. businesses, a 75% reduction in the use of the word “competition” has occurred since the start of the twenty-first century. This lack of interest in competition among U.S. firms suggests that American industry has become increasingly concentrated. Leigh further explains that large corporations charged prices that were 10 to 20 percent above unit costs in the 1980s, whereas now they charge prices that are 60 percent above unit costs. Australia has a similar problem, Leigh argues, because Australian firms have been allowed to merge so that they can more effectively compete in the international marketplace. Leigh recognizes a favorable opinion about large enterprises as consistent with the kind of thinking associated with the Chicago School of Economics. This position, which is very similar to the Objectivist view of monopolies, is that the large corporations possess a large market share because of their superior efficiency. If they raise prices much above their unit production costs, then competitors will enter the market and undermine their monopoly status. As Leigh puts it, large corporations will be “kept in check by the free market.” Leigh also argues that this laissez-faire approach to large firms influenced Australia’s courts and lawmakers, which has led to the increasingly concentrated markets for beer, baby food, insurance, and internet providers. When the government refuses to prosecute firms that behave like monopolies and is willing to approve corporate consolidations, the consequence is a deepening of industrial concentration and enhanced market power. In Australia, for example, Leigh reports that the number of mergers and acquisitions has risen nearly 5 times in the past 25 years. Ultimately, Leigh rejects the automatic acceptance of claims to superior efficiency and wants to shift the focus to the negative impact on consumers through higher prices and on workers through lower wages. When firms cut production below the level that would prevail in a perfectly competitive market, they raise prices to consumers and reduce the amount of labor demanded, which may contribute to wage stagnation.
Summary of Key Points
1. A monopolist is a single seller in a market for which no close substitutes exist and into which competitors cannot enter due to barriers to entry.
2. Barriers to entry include copyrights, patents, licenses, ownership of key inputs, and economies of scale.
3. For a single-pricing monopolist, MR falls faster than price because the firm must cut the price for all units sold to sell another unit.
4. The profit-maximizing output for the monopolist occurs where MR = MC, and the price charged is set above this output level on the market demand curve.
5. The monopolist will operate in the short run if the price is at least as great as AVC. The firm will operate in the long run if the price is at least as great as ATC.
6. Single pricing monopolists fail to achieve allocative efficiency and productive efficiency.
7. Natural monopolies and perfectly price discriminating monopolies can offset some of the inefficiencies of single pricing monopolies.
8. The possible government policies to address monopolization range from laissez-faire to outright nationalization or support for worker control.
9. The only kind of monopoly that is objectionable according to Austrian and Randian thinkers is one that is the product of government entry barriers (i.e., a coercive monopoly).
10. According to Marxian economists, stagnation is the dominant tendency in the monopoly phase of capitalism, but it is mitigated by the sales effort, government spending, and the expansion of finance.
List of Key Terms
Monopolies
Price-setter
Natural monopoly
Rectangle of redistribution
Harberger triangle
Rent-seeking activities
Marginal cost pricing
Average cost pricing
Price discrimination
Perfect price discrimination
Regulatory capture
Coercive monopoly
Monopoly capital
Concentration of capital
Centralization of capital
Economic surplus
Sales effort
Monopoly-finance capital
Problems for Review
1.Suppose a monopolist reduces the price of its product from $8 per unit to$5 per unit. The quantity demanded of its product subsequently rises from 200 units to 350 units. Calculate the marginal revenue. (Hint: Strictly apply the definition of marginal revenue in this case.) Is the firm operating in the elastic or inelastic portion of the linear demand curve? How do you know?
2. The first two columns in the table below represent the demand schedule facing a pure monopolist. Complete the rest of the table using MS Excel.
3. At which output level and price will this monopolist maximize economic profits? How do you know?
4. Create a single graph in MS Excel using the data above that shows the demand curve (D), the marginal revenue curve (MR), the marginal cost curve (MC), and the average total cost curve (ATC). Be sure to label both axes.
5. Using the graph below, identify the following, assuming the firm maximizes its economic profit in the short run:
• Output
• Price
• Total revenue
• Total cost
• Economic profit
• Will the firm operate in the short run?
6. Using the graph below, identify the following, assuming the firm maximizes its economic profit in the short run:
• Output
• Total revenue
• Total cost
• Economic profit
• Will the firm operate in the short run?
• What is the firm’s total fixed cost?
1. Bagdikian (2004), p. 72.
2. Ibid. Pp. 72.
3. Rys, Dan. “A Brief History of the Ownership of the Beatles Catalog.” Billboard. January 20, 2017. Web. Accessed on May 7, 2018. https://www.billboard.com/articles/columns/rock/7662519/beatles-catalog-paul-mccartney-brief-history-ownership
4. Ibid.
5. This example is a commonly cited example in neoclassical textbooks. See Hubbard and O’Brien (2019), p. 512.
6. McConnell and Brue (2008), p. 430, offer a graphical method of demonstrating this point.
7. Bade and Parkin (2013), p. 407, emphasize that a monopolist’s economic profits may persist indefinitely.
8. McConnell and Brue (2008), p. 431-432, mention that a demand reduction can threaten monopoly profits.
9. Bade and Parkin (2013), p. 407, consider an example of a rise in fixed cost that may cause monopoly losses.
10. Hubbard and O’Brien (2019), p. 522, point out that disagreement on this issue exists with some economists, like Joseph Schumpeter, arguing that firms with greater market power have the resources to test out new products in the marketplace and other economists arguing that the greatest innovation originates with small firms.
11. Hessen (1975), p. 267-269.
12. McConnell and Brue (2008), p. 437, identify the required conditions for perfect price discrimination.
13. This example is not a pure case of perfect price discrimination because of the use of discrete quantities. It does represent a close approximation though.
14. See Chiang and Stone (2014), p. 232, for a discussion of George Stigler’s views on regulation.
15. Greenspan (1967), p. 63-72.
16. Armentano (1978), p. 94-110.
17. A more complete description of Baran and Sweezy’s book may be found in Hunt and Lautzenheiser (2011), p. 530-532.
18. Foster and Magdoff (2009), p. 63-67.
19. Leigh, Andrew. “More competition, less Chicago.” The Australian Financial Review. Melbourne. 17 Dec. 2018. p. 38. | textbooks/socialsci/Economics/Principles_of_Political_Economy_-_A_Pluralistic_Approach_to_Economic_Theory_(Saros)/02%3A_Principles_of_Microeconomic_Theory/09%3A_Theories_of_Monopolistic_Markets.txt |
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