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In chapter 2 beginning on page 45, the textbook will tell you about the 3 key economic indicators: Gross Domestic Product, the Unemployment Rate, and the Price Indexes, which tell you what the rate of inflation is. The first of the 3 key economic indicators is Gross Domestic Product.
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Here is your text’s definition of Gross Domestic Product from page 45. (Read definition.) I have underlined two parts of this definition. I have underlined “final” because Gross Domestic product excludes so‐called intermediate goods. I have underlined “in a country” because the determinant of which country’s GDP the production of a given good or service goes in is WHERE WAS THE GOOD OR SERVICE MADE? The nationality of the company that owns that factory is irrelevant. All that matters is “in which country is that factory located?”
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GDP is the result of one year’s collaboration between business owners, workers, and landowners. The businesses say to the landowners (enter) “I’ll pay you some rent” and the landowners say “you can use my land this year.” The businesses say to the workers (enter) “I’ll pay you some wages” and the workers say “I’ll work for you this year. I’ll do whatever you tell me to do – within reason.” The businesses carefully analyze consumer tastes and preferences. They study the best and most efficient ways to manufacture things. Then they (enter) make the set of goods and services they think will be most highly valued by consumers, and they make it as efficiently as they can. And they say to the workers and landowners – who are also the consumers by the way – here’s what I made: I made some (enter) cars and some (enter) food and some (enter) clothing and some (enter) new houses and some (enter) new buildings and some (enter) medical services and some (enter) other stuff. What do you think? And the landowners and workers say “Wow! You made a lot of stuff! And it was just the stuff we wanted! Thanks!”
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Per capita GDP is The country’s GDP in a given year divided by its population in that same year. By the way, This is the most popular way to measure a country’s standard of living.
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So per capita GDP measures how much goods and services each person in a country would get IF we passed out all those new goods and services equally to everyone. Notice that we are focusing not on the WAGES workers earn due to the existence of business – we’re focusing on the goods and services made by business. Businesses don’t want these goods and services. They want to sell them to consumers. They want the revenue. If the businesses in a given country make a lot of goods and services per person, then the people in that country will be materially better off. They will be more comfortable. They will have more and better stuff to use and consume. That’s why per capita GDP is the most popular measure of the standard of living in a country.
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Purchase Price Parity‐adjusted per capita GDP, also known as PPP‐adjusted per capita GDP, is the country’s GDP per capita, adjusted for differences in price levels between countries.
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PPP‐adjusted per capita GDP varies widely between countries. There are about 200 nations in the world. Here are just a few of them. PPP‐adjusted GDP per capita in the United States was $53,143 in 2013. That’s the amount of new goods and services per living, breathing person in the United States that we made in the year 2013 alone. That’s not per working person – that’s per living, breathing person – so it includes old people, babies, unemployed people, even people in a coma. GDP per working person would be much higher – about $91,000 in 2013 in the United States.
Look at North Korea. It only made $1,800 dollars‐worth of goods and services per living, breathing person within its borders in 2013. That includes medical care, food, education, new housing – everything. That’s right – goods and services made by government, such as education, are included in GDP. You can be sure that this very low GDP per capita translates into a lot of human suffering in North Korea. Many people in North Korea today are starving, or do not have access to adequate medical care. And their housing is just awful.
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Some people say that North and South Korea’s fortunes since the 38th parallel was drawn in 1945 are like a controlled laboratory experiment being conducted in the real world on the effectiveness of two forms of economic organization: communism and capitalism. They argue that the culture, geography, work ethic, and initial economic starting points of North and South Korea were virtually identical in 1945, so the relative success of these two countries should tell us whether capitalism – which was adopted in South Korea in 1945 –
or communism – which was practiced in North Korea – is better for its people. The answer seems pretty clear. People in South Korea enjoy the 38th highest standard of living in the world. That puts them in the top 20% of all nations. People in North Korea are living in some of the most impoverished conditions on the planet. Many are starving to death. This terrible outcome is one of the reasons communism is becoming an extinct form of economic organization in the world.
On page 41, your book defines Communism as an economic and political system in which the government makes almost all economic decisions and owns almost all of the major factors of production. The government of North Korea is the best example of an economically communist nation today. It is also a command economy.
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On page 42, your book defines Command Economies as Economic systems in which the government largely decides what goods and services will be produced, who will get them, and how the economy will grow. North Korea is a command economy. A command economy is a 100% planned economy. In a planned economy, the government owns 100% of the means of production, and has a central national planning committee which decides how much of each major category of goods and services the nation should manufacture next year. So for example they might decide that they want 10% of their output to be for health services, 10% to be for new housing stock, 20% to be for food, 5% each to be for the military and new furniture, and so on. This national planning committee will decide which regions should specialize in the production of food, automobiles, et cetera. They develop regional quotas and they allocate them to these regions. Then each region has a planning committee that decides which cities shall make which goods, what exact goods they shall make, and so on. All economic output is planned and overseen by government committees and agencies.
Both China and the Soviet Union used to be command economies but aren’t any longer.
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China is still politically communist today; but is no longer economically communist because it allows private business ownership. It also is no longer a command economy. China began to allow private business ownership in 1978. They started by privatising agricultural production. Ten years later, they set about to privatize their industrial and service sectors. Finally, ten years after that, they set about privatizing their banking sector. Since beginning to allow private business ownership in 1978, China’s standard of living has improved very rapidly.
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Here is one look at the rapid improvement in Chinese standard of living which took place beginning in about 1978. Each phase of privatization produced additional increases in standard of living. This chart shows that China’s improvement in its standard of living since 1978 has been much better than India’s. Both China’s and India’s economies are considered socialist economies today; which, as we will learn, means an economy with an amount of government ownership and economic control intermediate between that of pure communism and pure capitalism. But of the two, India’s economy is more socialist, meaning more regulated and controlled by the government, and China’s is less socialist, meaning less regulated and controlled by the government. As you can see, the degree of regulation and control of the economy by the government seems to directly affect the rate of improvement of standard of living.
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The Soviet Union was a communist command economy until about 1989. The Soviet Union’s transition to capitalism has not been as smooth or successful as China’s. Some people think this is because Soviet school children were taught that capitalists are greedy by nature.
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The Soviet Union abandoned economic communism in about 1990. FSU means “Former
Soviet Union.” Here is the standard of living in both the U.S.S.R. and the Former Soviet Union from about 1970 until about 2010. As you can see, they made very little improvement in this measure of the economic welfare of the average citizen between 1990 and 2010.
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All of the world’s formerly communist economies save one have abandoned economic communism. Why? For four reasons: Because of the negative effect communism had on the amount of effort people exerted while at their jobs or managing their factories, because communism tended to produce relatively poor allocative efficiency, because communism tended to produce relatively poor productive efficiency, and because the citizens of those countries got tired of reading about or seeing on television how much more comfortable the citizens of the other nations of the earth seemed to be.
1. In communist economies, peoples’ effort tends to be reduced because their incomes are based on their socioeconomic status and/or on whether they have any powerful friends or family members rather than on how much value they have to offer in the marketplace for labor and entrepreneurship. In communism, there is a saying (enter) “From each according to his ability to each according to his need.” Do you know what this saying means? It means if you are fortunate enough to be born with both the mental and physical skills needed to be a brain surgeon, you should be happy to give freely of those gifts to your community; because they are, after all, your comrades. At the same time, what society gives back to you will be determined not by the kind of work you do, but by your age, gender, and marital status. If you are a single male with no children, you will get the same 600 rubles a month salary and the same one room efficiency apartment as all other single male citizens with no children. This will be true whether you work as a dishwasher or as a brain surgeon. What you receive from the society shall be determined solely by your needs – not by the quality or type of work you do. Well this doesn’t give someone very much incentive to go through the hard work of getting through medical school, does it? And doing brain surgery is stressful. Washing dishes is relatively easy and stress free. Why should I bust my butt to be a brain surgeon if my salary’s not going to be any higher? This is how people started to feel. And it was worse than that. Because a communist economy is a centrally planned economy, if you happen to have a relative on the local planning committee, such as an uncle, your chances of being named factory manager, which is a relatively cushy job which comes with some perks, like a better apartment, were greatly enhanced. In other words, it wasn’t WHAT you knew it was WHO you knew that determined which job you got. People got sick of working hard for such a rigged system. Many workers began to deliberately do as little work as possible during the day because they were so disgusted with the unfairness of the system.
Allocative efficiency occurs when the welfare‐maximizing MIX of goods and services is made. Under communism, because all decisions about WHAT should be made are made by committees, a mix that is far from the welfare‐maximizing mix tends to get manufactured. In a capitalist economy, by contrast, businesses tend to do an astonishingly good job of making the most valuable mix of goods and services because their revenues and profits depend on it. Private business owners and managers tend to pay very close attention to what consumers seem to want and value, and give them exactly what they want. Their own welfare is depending on it.
Productive efficiency occurs when, given the ratios of the goods and services we have decided on, we use our resources so cleverly and frugally that the maximum QUANTITY of each category of goods and services is made with available resources, such as the amount of labor hours available per year. Productive efficiency in a communist economy tends to be poorer than in a capitalist economy because the behavior of business owners and managers in the latter is influenced by the carrot of profits and stick of competition. The carrot is the possibility that, if you find a really efficient way to make your products, your profit margins will be really high. The stick is the threat that, if you don’t pay as much attention to lowering or controlling expenses as your competitor does, he may lower his prices and drive you out of business. He can afford the lower prices because he’s doing a good job of controlling his expenses. He’s doing things in the most efficient way possible.
The book says that most communist countries today are suffering severe economic depression, and they cite North Korea and Cuba as two examples.
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To summarize one of the points made on the preceding slide, Allocative efficiency means producing the right mix of goods and services – meaning the mix of food, healthcare, movies, books, cars, clothing, et cetera that consumers value the most highly – out of all possible mixes of goods and services you could have made with the available factors of production.
Productive efficiency means, once you decide what MIX of goods and services to make, making that particular mix of goods and services in the most efficient way possible. Capitalism, socialism, and mixed economies all produce higher levels of both kinds of efficiency than communism was able to do, despite the best efforts of the central economic planners.
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What I and the authors of your textbook refer to as socialism, Wikipedia has other names for. In France, they call it France’s dirigism period. In the United Kingdom, they call it the post‐World War II period. In the Scandinavian countries, such as Sweden, Norway, Denmark, and Finland, they call it the Nordic model. Here are seven classically socialist countries in descending order by their 2013 GDP. Note that the rightmost column is TOTAL gdp for the country. It is NOT gdp per capita as on the preceding slides. Basically, I just wanted to show which of these countries have the largest economies. Of this list, India’s economy is the largest with a 2013 GDP of almost 7 trillion dollars. Finland’s economy is the smallest with a 2013 GDP of about 208 billion dollars.
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On page 41, you text says that the major benefit of socialism is social equality – but I think they meant to say economic equality. And by this, we do not mean equal economic opportunities – that’s what CAPITALISM tries to achieve. We mean greater equality of economic outcomes – primarily a more equal standard of living between the various citizens of the country.
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Generally speaking, socialist countries ACHIEVE this greater equality of outcomes by pursuing a three‐pronged strategy. First, their tax rates are higher – especially their tax rates o the rich. Secondly, they use all the extra tax revenues they collect in step 1 to fund a very generous set of public services, such as a free four‐year college education to everyone who passes their high school exit exams with adequate scores, free government‐
paid healthcare for all citizens, regardless of income or even employment status, and a much more generous set of social safety net programs, such as generous lifetime disability income for people who are injured on the job, unemployment insurance, job retraining programs, public housing for those who can’t afford to pay rent, and things of that nature. Because most of the TAX revenues come from the rich and most of the GOVERNMENT PROGRAMS are utilized by the poor and unsuccessful, economic OUTCOMES tend to be equalized by these two policies. Finally, classically socialist countries will have a much higher percentage of industries directly owned and managed by government. In the 1960s, all coal mining, trains, and television production was performed by the government. In the industries government owns and manages, the government can pay any wage they want. There is no pressure to earn a profit, because if the organization loses money, tax revenues are used to make up the difference. For this reason, the wage rates in these industries tend to be more generous. This was another way socialist countries tended to equalize economic outcomes within their populations.
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Here’s government spending as a percent of GDP for 10 countries in both 1993 and 2003. Sweden, Denmark, France, Finland, the Netherlands and Britain were classical socialist countries in the 1960s. Between the 1960s and today however, they have reduced their use of all three of the strategies shown on the preceding slide. This particular slide just captures one ten year period within that time frame. And it shows that during that 10 year period, Ireland, Spain, Canada, Finland, and Sweden substantially reduced their government spending as a percent of GDP.
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Here’s another look at government spending as a percent of GDP. This time, the period is a little closer to the present. It is an average of four years: 2004 to 2007. This slide shows that, of the countries listed, Sweden, France, Denmark and Austria were the most socialist in terms of their use of strategy number 2 from the earlier slide: funding a generous set of government programs. Notice the spending on the bottom layer, “social protection,” which is the black portion of each bar, is often the major differentiator between nations whose governments spend a very high share of gdp versus nations whose governments spend a relatively low share of gdp such as South Korea. Social spending is spending on things like unemployment benefits, job retraining, and disability income for those who cannot work because they were injured.
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This chart shows the degree to which 29 nations pursued policy #3 from the earlier slide as of 2008. That is, what percentage of all workers are employees of the government? By this measure, Norway was the most socialist of the 29 nations listed. Denmark was the second most socialist. Sweden was the third most socialist. Finland was the fourth most socialist and France was the fifth most socialist. Notice that approximately 29% of all workers in Norway were government employees in 2008. the United States is in the middle of the chart. They are labeled “USA.” Their percentage is around 16% ‐ only around half as much as Norway. Japan has the lowest percentage of the 29 nations listed here. Their percentage is around 7% government employees.
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If you carefully read the material in learning goals 2, 3, and 4 in the textbook, you can deduce the following relationship between economic communism, socialism, and capitalism. Socialism is Intermediate Between Capitalism and Economic Communism in Three Ways: One, The share of all productive assets that are owned and operated by the government. Two, The degree to which government regulates economic activity, and three, The degree to which equality of economic outcomes is treated as a major public policy goal by the government.
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Here is an image of the relationship between Communism, Socialism, and Capitalism. The expression “Highly Controlled” next to Communism has two meanings. First, under communism, ALL of the productive assets of the economy are owned and managed by the government. One hundred percent. Second, under communism, the government tells people what occupations they may pursue, what types of factories to build, and what to build in those factories. So the degree of government control over economic activity is basically 100%. All economic activities are 100% controlled by the government, usually through a series of economic committees, which set yearly and quarterly production targets for each region and factory. This type of economy is called a COMMAND ECONOMY, because individuals are COMMANDED to engage in specific economic activities by the government.
The expression “Little Control” next to Capitalism has the same two meanings. In a capitalist economy, 100% of the productive resources of the society are PRIVATELY owned and managed. Government exerts very little control over what people can and cannot make, what occupations they pursue, what types of goods and services are made and what types of goods and services consumers can buy. You may be wondering why it says LITTLE CONTROL instead of NO CONTROL. Well, even in capitalist countries, you can’t make heroin and sell it to whoever wants it, and you can’t sell machine guns to kindergarteners. These productive activities, along with some others, are outlawed by the government. So the level of control is not zero. There is SOME government control about what types of products people can make, buy and sell, even in the most capitalist of countries.
One of the reasons communism came into being was because of the highly unequal distribution of wealth and income that we tended to find in capitalist countries in the late 1800s and early 1900s. It is no accident that Russia went communist in 1917. This was a period of particularly unequal wealth and income among a nation’s citizens – a sort of “wild west” period that immediately followed the birth of the world’s first mega‐corporations, such as railroads, banks, and oil companies. One of the main goals of communism when it was started was to produce more EQUAL ECONOMIC OUTCOMES. The people that liked communism held equality of economic conditions to be a very high value. So communism sets FAIRNESS of economic outcomes as one of the primary policy goals of government, while capitalism enshrines allocative and productive EFFICIENCY and the effects of the economic system on peoples’ EFFORT levels as being the primary goals of government policy. Economist Robert Frank, who has written one of the best‐selling economic textbooks in the U.S., calls this fundamental difference in the aims of communist versus capitalist governments “the big tradeoff.” You can’t have highly equal economic outcomes and high levels of efficiency and effort all at the same time, he says. You have to choose which one is more important to you. Because if you have a lot of one you will have only modest amounts of the other. He says there’s no way around this.
Socialism takes an intermediate position between Communism and Capitalism in all three of these dimensions. Classic socialist countries of the 1960s included Sweden, Norway, Finland, France, and India. These countries put a much greater emphasis on fairness of economic outcomes than capitalist countries. Government owned and operated an
intermediate amount of the productive resources of the economy – typically 40 to 60% during this period. Today in even the most socialist countries, fewer than 30% of the productive resources of the economy are owned and managed by government. That’s why there’s a dashed arrow pointing from Socialism toward the point on the graph marked “Mixed Economy.” Most of this movement took place between about 1975 and the year 2000. At the same time, capitalist countries like the United States have actually increased their taxes and social welfare spending programs during this same period. Thus, the most capitalist economies of 1970 have moved toward socialism while the most socialist countries of 1970 have moved toward capitalism. Most of the world’s leading nations are moving a lot closer to one another. They are all converging on an economic model called a “mixed economy,” which combines elements of classic capitalism with elements of classic socialism to produce an economic that produces moderately high levels of both efficiency and effort with SOME equalization of economic outomes.
Another way that socialist countries increase the fairness of economic outcomes is by having much more generous social welfare programs than capitalist countries. For example, people in socialist countries get free university education, free lifetime health care, and have very generous unemployment benefits. All of these social welfare programs are funded by having much higher tax rates on private enterprise than you will find in capitalist countries.
Since the 1960s, socialist countries have sold off a lot of the productive resources they used to own and manage to private entrepreneurs, thus putting an ever‐greater percentage of the productive assets in the economy under private control. This process is called “privatization.” They have also trimmed back their social welfare programs and reduced their tax rates. Thus, they have moved in the direction of capitalism.
At the same time, capitalist countries have increased the number of regulations businesses must comply with, increased their tax rates, and added more generous social safety net programs. Thus, the capitalist and socialist countries have moved toward each other, and are both converging on a middle‐solution which is here labeled a “Mixed Economy.”
Meanwhile, both China and Vietnam, formerly pure communist countries, are allowing much wider private ownership of business assets. They are allowing entrepreneurs to keep most of the profits they earn from starting and managing private businesses, and they are thus also converging, from an economic standpoint, on the mixed economy solution. These countries are still POLITICALLY communist, but ECONOMICALLY they are moved toward becoming mixed economies.
Thus, almost all countries – except the bottom one‐sixth economically – are converging on the mixed economy model, with more emphasis on fairness and government regulation than so‐called PURE capitalism, but more emphasis on efficiency and effort than the socialism and communism of the past.
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Here is Great Britain’s government spending as a percent of GDP from 1967 to 2013, with a projection to 2018. The high point was reached in the 1975‐76 fiscal year, when government spending was 50% of gdp. The low point was reached in fiscal year 2000‐
2001, when government spending was only 35% of GDP. The spike beginning in 2008‐2009 is extra spending needed to help the people thrown out of work during the Great Recession, which began in 2009.
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There are three reasons the world’s classical socialist economies have moved away from classical socialism and toward a more moderate approach between 1975 and today:
They have done this by reducing their use of all three of the strategies presented near the beginning of this lecture. They have reduced the percentage of productive resources by privatizing many formerly government‐controlled industries, and they have reduced both taxes and government spending by reducing the amount of social safety net spending. They have also tried to reduce the amount of government regulation on business generally in order to lessen the burden of that regulation so that their businesses can better compete on world markets.
First, under socialism, businesspeople tended to work shorter hours. Tax rates were very high, so employees would generally say “no thank you” to opportunities to work overtime. Also, entrepreneurs were very frustrated by the high degree of government control and bureaucracy over every aspect of their businesses. Sometimes, they would give up trying to open or run a business in their home country, and would emigrate to the United States, Canada, or some other capitalist country where tax rates were not so high and regulations were not so difficult to comply with . Second, many socialist countries became worried about a phenomenon called brain drain. In the 1950s, sociologists began to notice that, of all the people leaving socialist countries permanently or semi‐permanently, most had advanced university degrees. This phenomenon was labeled “brain drain.” Some socialist countries became concerned that, if they allowed this phenomenon to continue unchecked, it might actually lower the average intelligence of their home population!
Finally, the high tax rates and high levels of government regulation and control over business activities caused there to be fewer inventions and less innovation in socialist countries. Inventing things takes time and effort. When tax rates are high, the reward for making this effort is smaller. Also, if you try to do something new in a highly regulated economy, you run into lots of regulatory barriers. Capitalistic countries are more willing to let businesspeople try new things.
For ALL these reasons, all of the world’s most socialist countries have made a major move toward 31
the mixed economy model since the 1970s, moving away from socialism and toward freer markets and less government intervention in markets.
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Let’s see if you remember what you have learned about gross domestic product. (Read question. Pause. Hit enter. Read answer.)
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Classically socialist countries, such as Sweden, Denmark, Norway, and France, aim for some efficiency and effort and some equalization of economic outcomes. They aim for intermediate levels of both these good things. They do not elevate either of the goals shown in the light blue boxes over the other. You see, efficiency and effort is associated with rapid economic growth – meaning rapid improvement in a country’s standard of living. Socialist countries are willing to SACRIFICE some economic growth in order to have more equal economic outcomes today.
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Here’s U.S. gdp per capita, adjusted for inflation, from 1871 to 2009. The black line is the actual line. The green line is the trend line. So what GDP and GDP per person do, after adjusting for inflation, is that they grow in fits and starts. These fits and starts are called business cycles. Some of the dips and surges are bigger than others. (Enter) Here’s the Great Depression. GDP per capita went (enter) down, then (enter) rose faster than normal from about 1932 to 1944, then it fell for 2 years before resuming its climb. That extra‐fast growth rate after a depression or recession is typical. The steeper the upward slope of this line is, the faster GDP is growing during that time period. So an extra‐steep upward‐sloping line means an extra‐fast growth rate. The average annual growth rate of GDP in the United States during this period has been remarkably constant at about 4% per year. GDP grows for two reasons: one is because our population is growing; the other is because we are increasing labor productivity. Each of these factors has contributed about half of the 4 percent average annual growth rate of GDP during this period.
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Labor productivity is another important economic indicator. It doesn’t make our list of the top three, but if we had room for one more, this would be it.
The reason it’s so important is it’s pretty much the ONLY WAY to increase standard of living!
Remember standard of living? That’s GDP per living, breathing person in the economy.
Well, labor productivity is simply GDP per worker. (Circle top row with a callout, then let it fade out.) It is Tightly coupled to standard of living through this formula: GDP per person equals gdp per worker times workers per person. Workers per person is called the employment to population ratio. GDP per worker is labor productivity. GDP per person of course is standard of living.
If you want to increase standard of living, which is the number on the left, you have to increase one or both of the numbers on the right. There’s simply no other way to do it!
You have to either increase labor productivity the employment to population ratio. In
modern times in the United States, the population ratio runs around 62‐64% when unemployment is at its minimum sustainable level. Minimum sustainable unemployment is around 4%. 36
Here’s the employment to population ratio in the United States from 1948 to 2010. Notice that until about 1974, the employment to population ratio hovered between (enter) 55 and 58%. For the period between 1984 and 2010, it averaged around (enter) 61%. What changed? Why did the normal level of the employment to population ratio go up from 57% to 61% with a transition period around 1974 to 1984? (Pause.) The answer is the entry of women into the labor force in greater numbers! The dip from 2006 to 2010 (circle with callout) is the Great Recession. As of June 2014, the employment to population ratio was at 58%. So basically, the best we can hope for here is around 62 to 63% long term – and that’s if we can get unemployment down to its minimum sustainable level of 4%. But the point is, the employment to population ratio has a ceiling you can’t get past of around 63%. After that, the ONLY way to increase standard of living is to increase labor productivity. Remember, standard of living has increased at an average rate of about 2% since 1820. People expect the standard of living to keep rising. That’s what gives them hope. If standard of living stops rising, people get mad at the politicians and they vote them all out of office.
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So how do we increase worker productivity? They answer is by doing all or most of the things on this list. (Read list.) These are things we have done every year since 1820 and we will never stop trying to do them. 38
Sometimes increases in labor productivity in an industry make some peoples’ jobs obsolete. When that happens, what economists say we need to do is let market forces tell the people in that industry that they need to get re‐trained and find work in a new industry. Let me give you an example. In 1900, fully one‐third of the U.S. labor force was employed in the food industry. They were either farmers or farm laborers or truck drivers who drove nothing but shipments of food all day long or owners of grocery stores or grocery store employees or owners of restaurants or restaurant employees or food processing plant workers. However, in the early 1900s, farmers started using better seed, better fertilizer, better irrigation systems, and better equipment like tractors and combines. The yield at every farm went up, up, up. That means the farmers were able to produce more food per acre. The farmers thought they were going to get rich. But what they hadn’t counted on was there was only so much food people could eat. The productivity of every farm went up so much that there was a glut on the market of almost every conceivable farm product. This caused prices to fall way down. This was good for consumers of course, but bad for the farmers. The prices of farm commodities fell so low that many farmers didn’t earn enough money from selling their crops to pay back their annual bank loans. This caused the banks to foreclose on those family farms. Thousands of farmers across the nation were suddenly thrown out of a job. They had to move to the city to find work. What economic forces were calling for is for some of the land and most of the workers to be taken out of farming and devoted to other uses, but none of the family farmers wants to sell the farm that has been in the family for generations, so they don’t go willingly. By the year 2000, productivity in all aspects of the food business had increased so much, that one 1% of the U.S. labor force is employed doing all the same jobs that needed doing in 1900: farmers, restaurants, grocery stores, and food processing plants. Now the good side to that is that 32% of the U.S. labor force was freed up to create value in ways other than farming, yet all of us still have plenty to eat. In fact, obesity is a growing problem in America!
But I will tell you that this 100 year period has also been a trail of tears for family farmers.
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In 1942, American economist Joseph Schumpeter called capitalism “a perennial gale of creative destruction”. Perennial means “never ending.” What he means by this statement is that sometimes, the only way capitalism can tap into the benefits of productivity increases is by pushing some of the resources in that industry into other uses. It does this by causing the market price of the unneeded products to fall to very low levels. This is the interaction of supply and demand. This is a signal to farmers and others in the food industry that they should seek employment elsewhere. Technological change, which
ALWAYS causes productivity increases, SOMETIMES also causes UNEMPLOYMENT in the affected industry. This happens when there are limits to how much of a given product people want. Now, we want to put those people back to work as soon as possible, but often they must be retrained before we can do that. We want to put them to work in the industry in which they are MOST NEEDED and MOST VALUED. Those are the industries in which wages and prices are the highest. High prices and high wages are signals to business owners and workers that more resources should be dedicated to the manufacture of those scarce products. Only if we allow markets and market prices to direct the allocation of resources in this way will our standard of living rise at anywhere near the fastest possible rate. Many people intuitively resist the idea that we should allow impersonal market forces to decide what to make. But the alternative is a command economy; and although the Soviet Union and Communist China tried very hard to make it work, in the end they gave up on trying to maintain a planned economy. As counter‐intuitive as it may seem, letting impersonal market forces and independent businesses decide what to make works better.
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For the period (enter) 1954 – 2010, the U.S. employment rate has stayed between 4% and 10%.
Why has unemployment never been driven below 4% in modern times? That turns out to be an important question. To explore it, let’s look at the four components or kinds of unemployment.
These are listed in your book in a yellow inset panel on page 46.
Frictional unemployment consists of those individuals who either quit their last job or who are entering the labor market for the first time. It does NOT include people who were FIRED or LAID OFF of their last job. Labor market friction is the lag or delay between the time a person with skills employers want STARTS LOOKING for a job and the time that person gets hired. In an ideal world, all markets would be frictionless – buyers and sellers would be able to find each other right away. But in the real world, markets have friction. It takes time for the employer and the employee to find each other. Electronic job boards like HotJobs.com and Monster.com probably are decreasing the amount of friction in the labor market, and that’s a good thing. The sooner these people find a job, the better. From the employee’s perspective, low friction is good because they’re ready to work right now. From society’s perspective, low friction is good because the sooner that person starts working, the more value or GDP we will be able to create this year.
Structural unemployment is that portion of unemployment that is caused by a mismatch between the skills that the unemployed people in a particular geographic area have, and the skills that employers in that geographic area are looking for.
For example, if there are 500 laid‐off aerospace engineers currently seeking employment in the South Bay Area, but there are only 100 job openings for aerospace engineers, then there are at least 400 people in the South Bay who are structurally unemployed. There may be hundreds of job openings for people with other skills, such as software engineers, but if those aerospace engineers don’t have the skills for those jobs, they are not going to get hired into them.
The main solution to structural unemployment is job retraining. As some industries grow and others decline, some individuals are going to have to go back to school and acquire new skills in order to become employed again.
Seasonal unemployment is that portion of unemployment that is caused by seasonal ups and downs in demand for workers which occur rhythmically each year in certain industries. For example, California farmers employ far more workers during the picking season than they do at any other time during the year. This annual spike in employment can cause a corresponding dip in employment for the remainder of the year for those individuals who have few or no other skills to offer to employers.
Finally, cyclical unemployment is caused the tendency of free‐market economies to grow their gross domestic product not at a steady rate, but in spurts of extra‐rapid growth, separated by periods of relatively poor growth, or even decline in GDP.
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Now that we have looked at the four types of unemployment, we are prepared to understand why unemployment has (enter) never gone below 4 percent in modern times. Four percent (enter), which is sometimes called the “natural rate of unemployment,” is the sum of the frictional and structural components of unemployment. Any unemployment (enter) ABOVE 4% is called “excess unemployment.” It is the cyclical component of unemployment. This is an exaggerated picture of the tendency of free market economies to experience business cycles.
Periods of (use callout) RAPID GROWTH in the level of (use callout) real output or real GDP are called “ECONOMIC RECOVERIES.” But these periods tend to be interrupted at somewhat regular intervals with (use callout) periods of recession. The low point in this cycle is called the trough and the high point is called the peak.
Classical economists of the early 1900s couldn’t understand why recessions and troughs lasted so long. Their theories predicted that when there is excess unemployment, wages should adjust downward immediately and as much as necessary to cause the labor market to “clear;” that is, to cause the quantity of labor demanded to match the quantity of labor that people want to supply This process should take at most a few months, but recessions and troughs were lasting for six to nine years typically. They scratched their heads and said this is impossible. Yet it happened again and again. In the 1930’s, a young economist named John Maynard Keynes was shocked and saddened by the widespread suffering created by the great depression, which started in 1929 and continued through much of the 1930s. Official unemployment rates in the United States reach 25% during the Great Depression, but many people believe the real rate was much higher. Parents were separated from their children and never saw them again. People committed suicide, they were so ashamed that they could no longer provide for their families. A fist fight broke out in New York city between 50 men over the rights to the contents of one pail of garbage. This was levels of suffering that had not been seen before in the Twentieth century, and Mr. Keynes vowed to get to the bottom of it. He set out to invent a new theory of economics that could explain how this terrible tragedy could have occurred, and give economic policymakers a road map for making sure it never happened again. He invented macroeconomics as we know it.
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The purpose of modern macroeconomic policy is to dampen the amplitude of the business cycle. To make the vertical distance from the peak to the trough smaller. This way, there will be less (use squiggle callout) excess unemployment during the troughs. Excess unemployment is a complete waste. When someone who wants to work is idle for a year, you can never get that time back. Economists call this kind of loss a “pure deadweight loss.” You see, when my neighbor is unemployed, it not only hurts him, it hurts me, too. Because if he had been working, he might have built a web page I could have used, or a car I wanted to buy, or cooked some restaurant meals I wanted to buy. When people are working, they create wealth and value out of thin air, using their hands and minds. When they are not working, no such value is created.
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The dampened business cycle will, under ideal conditions, look something like this. We have (enter enter enter, then use 3 crossout callouts) gotten rid of some of the excess unemployment.
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Modern macroeconomic policy has two components: fiscal policy and monetary policy. Fiscal policy is control of government spending and taxes by the government. Monetary policy is control of interest rates and the money supply by the Federal Reserve Bank, which is technically a government agency, but it operates very independently from the other parts of the federal government. The goals of fiscal and monetary policy are the same: to dampen the fluctuations in the GDP growth rate to avoid some of the excess unemployment that we would otherwise haved experienced during the recessions and troughs. They know that can’t completely ELIMINATE the fluctuations, but they would like to dampen them as much as possible. This should produce a slightly more rapid rate of growth in standard of living and will CERTAINLY eliminate a substantial portion of the deadweight loss.
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The kind of economic policy that Mr. Keynes invented is called FISCAL POLICY. Fiscal policy has two tools: government spending and taxes.
Fiscal policy is an effort by the government to put their FOOT ON THE GAS when the economy is unnecessarily sluggish or slow or cold and to put their FOOT ON THE BRAKE PEDAL when the economy is growing at rate that is unsustainable and merely likely to create a bunch of inflation rather than improve real standard of living. In fiscal policy, the government can put its foot on the gas pedal either by increasing government spending or by decreasing taxes.
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In the middle column, the government is putting its foot on the gas pedal. It can do that either by INCREASING GOVERNMENT SPENDING or by DECREASING TAXES. If it does both of those, it’s like stomping on the gas pedal, but it will cause the national debt to increase, so doing that isn’t very popular. Increasing government spending puts people back to work by directly creating demand for more goods and services. Decreasing taxes puts people back to work by giving people more take‐home pay, which causes them to demand more goods and services, which causes the businesses they buy goods and services from to hire more people. The government call also put its foot on the brake pedal either by DECREASING government spending or INCREASING taxes. If it does both of those at the same time, it’s like STOMPING on the brake pedal.
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Generally speaking, macroeconomic policymakers don’t have to worry about inflation and unemployment at the same time. At the peak (enter), unemployment will be 4% ‐ or maybe even a little below. Inflation will be 4% or higher, and if you try to hold at that peak by stepping on the gas, inflation will begin to accelerate and will continue to accelerate indefinitely. There are countries that have experienced inflation rates as high as 1000% per year because their governments followed unwise economic policies. Your economy can only grow if you are educating your workforce, inventing new products and manufacturing methods, and buying better tools for your workers. But some countries couldn’t wait. They just stepped on the gas. Instead of getting real GDP to grow, they created an inflation monster, with runaway inflation that is very, very hard to fix once you unleash it.
At the trough (enter), unemployment tends to be around 8 to 10%, and inflation tends to be close to zero percent. It can even be negative. During the Great Depression, price levels fell for about 3 years in a row. That’s called Deflation. It’s when the inflation rate is negative.
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Monetary policy is the other kind of macroeconomic policy besides fiscal policy.
Monetary policy is administered by a federal government agency called the Federal Reserve Bank. While technically a federal government agency, the Federal Reserve bank is highly independent from the other branches of the federal government. So, by “the Fed,” we don’t mean “the federal government,” we mean “the Federal Reserve Bank.”
Monetary policy adds one more tool to government’s toolkit for navigating a course between unwanted inflation and unnecessary unemployment. Both this slide and chapter two imply that monetary supply adds two tools: the money supply and interest rates; but in
reality, these are just two faces of the same tool. If the economy is overheated because it is nearing a peak, then there is a risk that unnecessary and undesirable levels of inflation will occur. By RAISING INTEREST RATES (or contracting the money supply, which will CAUSE interest rates to rise,) the Federal Reserve can COOL OFF THE ECONOMY. That is their BRAKE PEDAL. When the economy has cooled more than it needs to, which means that unemployment is higher than it needs to be, the Federal Reserve can LOWER INTEREST RATES. This will cause the economy to SPEED UP. Lower interest rates are the GAS PEDAL of monetary policy.
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When the economy is booming, the Fed will find that inflation is above 4%, gdp is growing at 2% or more per year, and
unemployment is at or near 4%. Unemployment at or near 4% is good, and gdp growing at 2% or more per year is good, so the only problem here is that inflation is dangerously high. In this situation, inflation will be public enemy number one, and the Fed will raise interest rates to cool off the economy. When interest rates go up, two groups of people will spend less money: consumers who are thinking of buying something by taking out a loan will spend less money, and BUSINESSES who are thinking of EXPANDING their business by taking out a loan will also spend less money. So if a family is thinking of putting a second story on their home by taking out a mortgage loan, when they look at how high the interest rate on that loan will be, they say “You know what? Let’s wait ‘til next year to build that second story.” The same is true of businesses that are thinking of taking out a loan to expand their factory. At a high interest rate, when they run the numbers, they find “we can’t make a profit with an expanded factory if we have to pay such a high interest rate on the loan we will need to take out in order to BUILD the factory.” With these two groups REDUCING their spending and all other groups keeping their spending the same, the overall level of demand for goods and services will go down. Construction companies and factory equipment companies will find that there is less demand for their products. This takes away the excess demand pressure that causes inflation. It also lowers GDP a little bit. But lowering GDP is exactly what we want to do. GDP is too high. It’s at levels that are unsustainable. That’s an “overheated” economy.
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I said earlier that fiscal and monetary policymakers have the same goals. Now I am ready to tell you what those goals are, at least for the U.S. economy. Their goals are: 1. to keep inflation steady at between 1.5% and 2% per year. 2. to keep unemployment steady at between 4% and 4.5% per year, and 3. to keep real GDP per capita growing at 2% per year or higher.
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When the U.S. economy is in recession, or when the unemployment rate is substantially above 4%, both fiscal and monetary policy makers will want to step on the gas. Our economy’s monetary policymakers, who work at the Fed, will do this by lowering interest rate.
When interest rates go DOWN, two groups of people will spend MORE money: consumers who are thinking of buying something by taking out a LOAN, and businesses who are thinking of expanding their business, such as by building a new factory, by taking out a loan. When these two groups increase their spending and all other groups keep their spending the same, the overall level of demand for goods and services goes up. This causes more economic transactions to take place than would have taken place without the monetary stimulus. But more economic transactions is just another way of saying higher GDP. So GDP will go up and businesses will re‐hire all those unemployed workers and put them back to work.
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If you give me a supply curve for an industry and tell me the current price in the industry, I will be able to tell you how many units all the producers in the market, taken together, will supply to the market per period time. The supply curve is a HYPOTHETICAL schedule. It does not represent actual past quantities and prices. One way to draw a supply curve would be to interview all the current and potential suppliers of a given homogenous product and ask each one how many units per period of time they would supply to the market at various prices, then you would combine this information to find out how many units all suppliers together would supply at each price. Their answers will depend on the shape of their cost curves, and they will choose (to supply the) profit‐maximizing quantity at each price. When you add together the quantities each supplier would supply at each price, you get that aggregate quantity that will be supplied at each price, and that is what the supply curve shows.
The origin or zero‐zero point is in the bottom left corner of this graph. As we move to the right, the quantity goes up. As we move upward, the price goes up.
Note that the choice of putting price on the vertical axis and quantity on the horizontal axis is backward from the usual convention in algebra. Normally, the independent variable is on the horizontal axis and the dependent variable is on the vertical axis; but in economics, the reverse is true. The price is the independent variable and the quantity supplied is the dependent variable, and they are not on their traditional axes based on traditions in algebra generally. 55
But they ARE on their traditional axes as far as economics is concerned.
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If you give me a demand curve for an industry and tell me the current price in the industry, I will be able to tell you how many units all the buyers in this market, taken together, will demand from the market per period time. Like the supply curve, the demand curve is a HYPOTHETICAL schedule. It does not represent actual past quantities and prices. One way to draw one would be to interview all the current and potential buyers of this product and ask each one how many they would buy this year at various prices, then you would combine this information to find out how many units all buyers together would demand or want to buy at each price.
As in the supply curve graph, the origin or zero‐zero point is in the bottom left corner. As we move to the right, the quantity goes up. As we move upward, the price goes up.
Note price is on the vertical axis and quantity is on the horizontal axis. That must be the case, because in a moment we are going to want to draw the supply curve and the demand curve in the same two‐dimensional space. You can’t do that unless you have the same variables on the vertical and horizontal axes in each graph.
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The point of this slide is that if the price happens to start out either significantly ABOVE or BELOW the price at which the demand curve and supply curve cross, there are natural forces in each market that will tend to cause the price to move TOWARD this equilibrium price over time.
For example, if price of bicycles starts out at $160, the quantity demanded will be 15 million bicycles per day while the quantity supplied will be about 4 million bicycles per day. In this situation, we would have excess demand of about 11 million bicycles a day. Bicycle stores would run out of bicycles every day at around noon, when their normal business hours are 10AM to 8PM. When there is a shortage, suppliers know from past experience that they can earn higher profits by changing their behavior the next day. More specifically, they know they can raise the price a little and still sell all the bicycles they choose to make at that price. If after the first day they raise the price to, say, $180 per bicycle, the excess demand or shortage will be smaller. In fact I can see from this diagram that it will be about 5 million bicycles per day, because the quantity demanded will fall to about 12 million bicycles per day and the quantity supplied will rise to about 7 million bicycles per day. So on the second day, the bicycle stores will not run out of bicycles until 3 or 4 in the afternoon, but they will still run out. Again, their business experience and intuition tell the bicycle manufacturers that they could make more money by raising the price again tomorrow and supplying even more bicycles to the market. If on the other hand the price of bicycles had started out at $260, there would have been an excess supply or surplus of about 12 million bicycles. Firms do not like excess inventories. Their business experience and intuition will tell them that they should lower the price tomorrow to get rid of these extra bicycles, because they will be paying for warehouse space to store them and meanwhile the bicycles will be getting older and harder to sell with each passing day. Once the excess inventory is sold, they will be more cautious and will lower the price so that the quantity demanded will be closer to the quantity they desire to produce and sell at that price. They know that the most profitable situation is for every bicycle they make to be sold shortly after it is made, and they will keep lowering the price and decreasing the quantity produced until one day the quantity demanded equals the quantity supplied.
The point of all this is that if the price happens to start out either significantly ABOVE or BELOW the price at which the demand curve and supply curve cross, there are natural forces in the market that will tend to cause the price to move TOWARD this equilibrium price over time. Only when the price of bicycles reaches $200 is there no incentive for producers to set a different price tomorrow. That is why we call it the equilibrium 57
price. Once the price arrives at $200, it will tend to stay there. Each day, 9 million bicycles will be sold at a price of $200. The market will have reached an equilibrium.
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