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An Introduction to
Micro and Macroeconomics
for
Econ 105
Introduction to Economics as a
Social Science
Fall 1997
J. Watkins
Email: [email protected]
http://www.wcslc.edu/pers_pages/j-watkins/
 1997 by J. Watkins. All rights reserved
ii
TABLE OF CONTENTS
Chapter One : You Can’t Always Get What You Want ________________________________1
The Cultural Basis of Scarcity or the Scarcity of Nature _________________________________ 2
Three Questions, Three Answers _____________________________________________________ 3
Microeconomics and Macroeconomics ________________________________________________ 4
Models as Metaphors ______________________________________________________________ 5
Subjective Element in Economic Theorizing ____________________________________________ 7
Economic Fallacies_________________________________________________________________ 8
Scarcity, Choice, and the Production Possibilities Frontier ________________________________ 9
Capital Formation, Military Spending, and Economic Growth ___________________________ 11
Efficiency versus Equity ___________________________________________________________ 11
The Role of Institutions ____________________________________________________________ 14
Review Questions ________________________________________________________________ 15
Chapter Two : Origins of the Market Economy _____________________________________18
Markets versus Market Economy ____________________________________________________
Feudalism _______________________________________________________________________
Factors involved in the Decline of Feudalism __________________________________________
Mercantilism (1600-1800) __________________________________________________________
Laissez Faire or Market Capitalism (1800-1930s) ______________________________________
Corporate, Welfare State (1930s-) ___________________________________________________
Review Questions ________________________________________________________________
19
20
21
25
26
28
30
Chapter Three : The Heart of Microeconomics: Rational Choice ______________________31
Utility Theory of Value ____________________________________________________________
Historical Backdrop of Rational Choice ______________________________________________
Rational Choice: Maximization and Minimization _____________________________________
Rational Applications and Irrational Results __________________________________________
The Ironies of Rationality__________________________________________________________
Firms and Rational Choice_________________________________________________________
Profits in a Market Economy _______________________________________________________
Review Questions ________________________________________________________________
31
34
35
38
42
44
46
47
Chapter Four : The Laws of the Market: Demand and Supply _________________________48
Demand and Supply_______________________________________________________________
Equilibrium _____________________________________________________________________
Shift versus Movement ____________________________________________________________
Elasticity ________________________________________________________________________
Review Questions ________________________________________________________________
48
49
52
54
58
Chapter Five : Market Structures: From Competition to Monopoly ______________________59
Perfect Competition: The Unreal Ideal _______________________________________________
Monopolistic Competition: Between Competion and Monopoly ___________________________
Oligopoly: The Other Reality _______________________________________________________
Monopoly: The Other Ideal ________________________________________________________
Evaluating Market Structures: What’s Best? __________________________________________
The Static and Dynamic Concepts of Competition ______________________________________
Review Questions _________________________________________________________________
59
60
61
61
62
65
71
iii
Chapter Six : Economics of the Environment ______________________________________72
Nature as a Commodity ____________________________________________________________
Conditions for a Sustainable Economy________________________________________________
Externalities _____________________________________________________________________
Conclusion ______________________________________________________________________
Review Questions ________________________________________________________________
72
74
75
77
79
Chapter Seven : Distribution of Income ___________________________________________80
Marginal Productivity Theory of Distribution _________________________________________
Segmented-Labor Force Theory _____________________________________________________
Empirical Findings on the Distribution of Income ______________________________________
Concluding Remarks ______________________________________________________________
Review Questions ________________________________________________________________
80
83
84
85
87
Chapter Eight : Introduction to Macroeconomics: The Big Picture _____________________88
Measuring Output, Employment, and the Price Level ___________________________________ 89
Business Cycles: What goes up must come down _______________________________________ 97
Aggregate Demand and Aggregate Supply ____________________________________________ 98
Review Questions ________________________________________________________________ 102
Chapter Nine : Classical Economics as The Economics of Laissez Faire _______________103
Historical Backdrop: Market Capitalism_____________________________________________
Assumptions ____________________________________________________________________
The Classical View of Depressions __________________________________________________
Review Questions _______________________________________________________________
103
104
104
106
Chapter Ten : Keynesian Economics and the Welfare State __________________________107
Historical Backdrop: The Great Depression _________________________________________
Assumptions Underlying Keynes’ Theory ___________________________________________
Consumption and Saving _________________________________________________________
Investment _____________________________________________________________________
Aggregate Demand ______________________________________________________________
Paradox of Thrift _______________________________________________________________
Cause of the Depressions: Keynes’ View ____________________________________________
Rationale for the Mixed Economy __________________________________________________
Review Questions _______________________________________________________________
107
109
110
111
112
113
114
115
117
Chapter Eleven : Money Makes the World Go Round _______________________________118
Money _________________________________________________________________________
Money Supply __________________________________________________________________
Quantity Theory of Money ________________________________________________________
Review Questions _______________________________________________________________
118
120
125
129
Chapter Twelve : Budget Deficits and Balanced Budgets ____________________________130
Historical Background ___________________________________________________________
Supply-Side Economics___________________________________________________________
Debt and the Deficit _____________________________________________________________
Solving the Debt Problem _________________________________________________________
Review Questions _______________________________________________________________
131
132
135
137
140
iv
Chapter Thirteen : International Trade and Development ____________________________141
Free Trade: The Theory of Comparative Advantage ___________________________________
Fair Trade _____________________________________________________________________
Development: ___________________________________________________________________
Review Questions _______________________________________________________________
142
143
146
148
Chapter One : You Can’t Always Get What You Want
“I can’t get no, sa-tis-fac-tion.”
Mick Jagger
“Economy is the art of making the most of life.”
George Bernard Shaw
"The economist is not concerned with ends as such. He is concerned with the
way in which the attainment of ends is limited. The ends may be noble or they
may be base. They may be "material" or "immaterial"--if ends can best
described. But if the attainment of one set of ends involves the sacrifice of
others, then it has an economic aspect."
Lionel Robbins
There is a pleasure to the study of economics, a pleasure that stems from understanding the
ways of the world. The young couple wanting to buy a house, the business person lamenting
Clinton's tax policy, the transient longing for a hot meal and a warm bed are all concerned with
economic issues. Even those who disdain economics, the jargon, and the thought, cannot escape.
Before one contemplates the starry skies above, or the moral law below one must first eat. The
needs of the stomach are prior to the soaring of the mind.
Economics is filled with irony. The father-in-law claims unions are the bane of civilization;
the union worker claims its management. One month its the deficit that draws attention; another
month it’s health care; this month it’s military cutbacks. Economics affects everyone, yet few
understand it. It aspires to be unemotional, yet its topics are filled with emotion. The savings gained
by cutting the military is one thing, the suffering of those people who will lose their jobs is another.
Cutting health care expenditures may be financially prudent, but financial prudence may leave a
person's life hanging in the balance. Advocating higher taxes on the wealthy may sound fairer, but
the wealthy argue that some people will lose their jobs as a result.
Economics comes from the Latin word oeconomia, which in turn comes from the Greek words
oikos and nomos. Oikos means household, nomos means management. The precursor of the word
economic then is household management. The head of the household in Ancient Greece confronted
the problem of allocating resources in such away so as to meet the needs of his family.
The idea of oeconomia captures the central problem of economics: scarcity. Scarcity implies
that wants exceed the means to satisfy them. Students lack time to study, work, and party too.
People lack income to buy the commodities they desire. And Congress lacks the resources to
provide basic health care to each American while maintaining a strong military. The concept of
2 You Can’t Always Get What You Want
scarcity is reflected in Thomas Carlyle's less than flattering characterization of economics as the
"dismal science." It's also reflected in Mick Jaggar's observation, "You can't always get what you
want."
Scarcity has its origins sometimes in nature, sometimes in society. It may arise from contracting
the means, or by increasing wants. Famines, floods, climatic changes and other natural disasters create
scarcity by contracting the means. A frost in Florida, lack of rain in the Midwest, or gypsy moth in
California may devastate the produce industry leading to price increases. But this raises a question: is
scarcity caused by natural forces, or cultural?
The Cultural Basis of Scarcity or the Scarcity of Nature
The Biblical view suggests that scarcity is natural, our punishment for original sin. Reflect a
moment in the story of Genesis of the Garden of Eden. In Eden everything is provided; the earth,
plants, animals, and fish are all under man's dominion. Adam and Eve want for nothing.
They may eat of the fruit of any tree in the garden, except the tree in the middle, the tree of
knowledge. The serpent, however, beguiles Eve to eat of the forbidden fruit, claiming that she shall be
like God with the knowledge of good and evil. She eats, offering the apple to Adam who also eats.
As punishment God bans them from the garden saying to Adam "cursed is the ground because
of you; in toil you shall eat of it all the days of your life . . . . In the sweat of your face you shall eat your
bread." Why must Adam toil? Because life outside the garden is characterized by scarcity, wants exceed
the available means. Insofar as economics is the study scarcity, economics is the study of the
implications of original sin.
Others, however, argue that scarcity is cultural. The anthropologist Marshall Sahlins
speculates that people in the hunter gatherer societies of our ancestors lived in relative affluence.
Their affluence stemmed not from having so many wants, far from it. But because their wants were
so few and the means to satisfy their wants so abundant. "An affluent society is one in which all the
people's material wants are easily satisfied. To assert that the hunters are affluent is to deny then that
the human condition is an ordained tragedy, with man the prisoner at hard labor." With few material
wants, people may "enjoy unparalleled material plenty--with a low standard of living."1
It is one of the paradoxes of modern society that our great wealth is characterized by scarcity.
Scarcity may be created either through creating wants or contracting the means. Advertising for veg-o1
Marshall Sahlins, Stone Age Economics. New York: Aldine-Atherton, 1972, pp. 1-2.
You Can’t Always Get What You Want 3
matics, imitation car-phone antennas, and other "essential" items creates scarcity by creating wants.
People buy these and other items not out of need, but out of status. Alternatively, increases in
population, or exporting crops to raise cash may generate scarcity by contracting the means. A rise in
inequality of income such that some individuals have more than they can consume, while others have
less may exacerbate the existing scarcity, potentially leading to conflict.
The emergence of scarcity played an important role in the origins of civilization. The inability
of the land to support the burgeoning populations of early humans at the end of the last ice age forced
change. Scarcity required humans to alter their form of production, and hence their social organization.
Nomadic society gave way to a society characterized by settled communities, in part because farming
and the domestication of animals permitted increases in food supplies.2 With the formation of settled
communities new institutions arose enabling societies to deal with scarcity.
Three Questions, Three Answers
All societies confront three fundamental questions: what goods to produce, how to produce,
and for whom to produce. Traditional societies answer these questions by relying on custom and
tradition. Why am I a baker? Because my father was a baker, and his father before him. In contrast
to modern societies, traditional societies make no distinction between the economic, political, and
religious spheres of life. Production is not based on profit, but on serving some social or religious
purpose. The Pueblo Indians of the American Southwest produced Kachinas for religious purposes.
Only with the domination of the market economy are Kachinas now produced for profit. Markets
exist in traditional societies, but not as the dominant institution. Markets existed as an adjunct to
society, as a means of disposing of the surplus product.3 Communities produced most of their own
goods for their own consumption.
Centrally-planned societies answer these questions using a central bureaucracy, committee,
or dictator. The committee decides how many shoes to produce, what sizes, colors, and so on. It
decides how much leather is required to produce the shoes, the price at which they are sold, and the
type of machine. Whether Nazi Germany, the Soviet Union, or the United States during World War
II, centrally planning is usually based on some principle of social justice.
2
Marvin Harris, Cannibals and Kings: The Origins of Cultures (New York: Vintage Books), 1978, Chapter 3.
3
Karl Polanyi, Primitive, Archaic and Modern Economies (Boston: Beacon Press), 1968.
4
You Can’t Always Get What You Want
Capitalist societies answer these questions by relying on the market. In contrast to centrally-
planned societies, decision making is decentralized. In theory, capitalist or market societies are based
on the doctrine of consumer sovereignty. A sovereign is a ruler. Hence, consumer sovereignty
means that individuals voting with their dollars decide what goods to produce, how to produce the
goods, and for whom the good are produced. Dollars are like votes. The more dollars one has, the
more votes. Hence, the market system represents the preferences of those who have the votes.
Regardless of the type of economic system, the production and allocation of goods and
services requires the dissemination of information. How does a cobbler in 16th century Britain know
what price to charge for shoes? How many pairs of shoes does the manager produce to meet his
quota set by the state? How does a farmer in Kansas know whether to raise more wheat or less
wheat?
The cobbler, the manager, and the farmer must have access to information. Information,
however, is obtained and conveyed in different ways. In traditional societies information accumulated over a time is expressed in the various customs and traditions. In command societies
information is collected and disseminated by the central authority. One of the problems with
command societies is ensuring that the planners receive information. A manufacturer filling his
quota to supply 10,000 shoes a month may be unaware that the shoes are not selling. His
information comes from the sate. Until he is informed otherwise, he will continue to produce.
This can’t happen in a market system. In the market system information is conveyed by
prices. Prices are indices of relative scarcity. Shoes that go unsold are reflected in falling prices.
Falling prices convey to the manufacturer to stop production. To consumers falling prices means
they should consume more. The ease with which information is conveyed in the market system
implies that relative to the command system adjusts in production are probably faster, albeit more
destabilizing.
Microeconomics and Macroeconomics
An important part of economics lies in understanding the role of markets in capitalist
societies. Traditionally, economics divided into microeconomics and macroeconomics. Micro,
meaning small, is the study of how individuals, firms, and society as a whole allocate their scarce
resources to achieve their objectives. Individuals maximize happiness; firms maximize profits or,
You Can’t Always Get What You Want 5
what amounts to the same thing, minimize costs; and society maximizes the well-being of its
members.
The effort to maximize the well-being of society raises a number of questions. Do
minimum-wage laws create unemployment? Why are monopolies regulated? How does competition
benefit society? What does economics say about pollution? Is college worth the costs?
In contrast, macro, meaning large, is concerned with the economy as a whole. Macroeconomics is the study of the determinants of national income, the price level, and employment. Why, for
example, is unemployment currently at six percent rather than ten? What are the implications of
increases in the federal debt? Will our children have the burden of paying off our debt? Is it true that
increases in military spending promote economic growth? Will reducing capital-gains taxes stimulate
the economy?
Models as Metaphors
To answer whether increases in military spending increases growth, or cutting taxes stimulates
the economy, economists resort to models. Models are metaphors, juxtapositions of two unrelated
things suggesting that they share commonalities. Thinking metaphorically involves using that which we
know well to understand that which we know less well.
As metaphors economic models are “pictures” of the economic process. The purpose of these
pictures is to gain insight into the workings of the economic process by isolating those variables and
relationships that are considered most important. Models help clarify our thoughts by eliminating
extraneous and irrelevant influences.
Economic models are based on deductive logic. Deductive logic (also called deduction)
proceeds from the whole to the part. Models begin with an economist’s vision of the economic
phenomena. Vision conveys an image of the world as the economist sees it. This vision is expressed
in a set of assumptions arranged logically in order to generate deductions or conclusions. These
conclusions are then used to generate hypotheses in order to "validate" the theories.
A specific form of deductive logic is Aristotle's syllogism. The syllogism is comprised of a
major assumption, a minor assumption, and a conclusion. The conclusion is the "intersection"
between the two assumptions. The following is an example taken from elementary algebra: X + Y =
5; X = 2; hence, Y = 3. Virtually all mathematics is based on deductive logic. An alternative example
is found in the following: all black birds are doves; Alice's bird is black; hence, Alice's bird is a dove.
6
You Can’t Always Get What You Want
Assumptions
(Vision)
Logical Process
(Principle of non-contradiction)
Conclusions
(Presented as hypotheses
to predict or explain)
The figure above is a model of a model. We begin with a set of assumptions that incorporate
the theorist’s vision, an expression of how the theorist sees the world. We then proceed through a
logical process to generate conclusions. These conclusions are then restated as hypotheses, which we
can subject to empirical tests.
The three parts—assumptions, logic, and our conclusions--point to three ways that we can
test our model. First, are the assumptions realistic? The assumption that black birds are doves is
false; doves are white. Hence, our conclusion that Alice's bird is a dove is invalid because one of our
assumptions is invalid. Assumptions are like the foundation of a house. Once the foundation
crumbles, the whole house soon collapses. Hence, an important way of attacking a model lies in
attacking the assumptions.
Second, is the model consistent? That is, are the conclusions consistent with the
assumptions? From the point of view of logic the conclusion of the above syllogism is sound: Alice's
bird is a dove. The conclusion is true by definition.4
And third, can the hypotheses generated from our model predict future events or explain
past events? This involves subjecting the hypothesis to empirical data which is the subject of
An example of a breakdown in logic is offered by Bertrand Russel in what has become known as Russel’s
paradox. Russel offers the following illustration paraphrased here. There is a town with a barber who cuts those
people’s hair and only those who do not cut themselves. Does he cut his own hair? If he does not cut his own hair, he
does; and if does cut his own hair, he does not. See Bertrand Russell, Bertrand Russell: Autobiography (London:
Unwin Paperbacks), 1971, p. 150.
4
You Can’t Always Get What You Want 7
statistics and econometrics. If the data does not refute our hypothesis we accept it as valid. If the
data refutes our hypothesis we can do one of two things. First, we can revise our model. Change the
assumptions; add new ones; or delete the old ones. Or second, we can reject our model altogether
and begin anew.
The subjection of hypotheses to empirical data relies on inductive logic. Inductive logic (also
called induction) proceeds from the part to the whole. In other words, induction assumes the whole
is like the part, or in the case of forecasting the future is like the present.
Models make our efforts to understand the economic system easier. The economy is
enormously complex, comprised of individuals, firms, governments, and so on related through
prices, taxes, wages, profits, and so on. In turn, an economy is also comprised of capital, technology,
and culture all of which are inherited from the past. The literally millions of relationships that make
up an economic system are too complex to be understood as a totality. Economists are forced to
theorize, to construct models of how the economic system works both in order to understand, and
perhaps improve the system.
Subjective Element in Economic Theorizing
The complexity of the economic system introduces a subjective element into our theorizing, an
element that enters at the very ground level. To find a parallel we might focus on spelunking, an
activity more commonly known as caving. Upon entering a cave the light falls on the entrance side of
rock formations. Leaving the cave the light falls on the opposite side, which gives the disconcerting
feeling that one has lost one's way. Spelunking merely reminds one of the obvious: what you see
depends in part on your point of view.
The most famous example from the history of science is the distinction between the
Ptolemaic and Copernican views of the universe. Picture yourself in the second century A.D.
conversing with the ancient philosopher Ptolemy. You have just dined on wildebeest, grape leaves,
and wine. Sitting around the fire, Ptolemy reflects on the observation that the sun, moon, and the
stars rise in the east and set in the west. And this occurs day after day, week after week, year after
year, as long as you can remember. You recollect that your father said it was so, and his father
before him and so on. Hence, you conclude along with Ptolemy that the earth is the center of the
universe, and the sun, moon, and the stars revolve around the earth. Moreover, this is confirmed by
8 You Can’t Always Get What You Want
your religious beliefs that God created you in his image, and that all the animals of the earth, the fish
of the sea, and the plants of the forest exist for you.
The Ptolemaic view dominated Western-European thought until Copernicus said otherwise
in the sixteenth century. Copernicus claimed that the earth along with the other planets revolves
around the sun, and the moon revolves around the earth. The theory was subsequently confirmed by
Galileo, who was among the first to point the newly invented telescope toward the heavens.
While Galileo may have been receptive to Copernicus' theory, the Catholic church was not.
The Catholic church considered Copernicus and Galileo heretics. The church clung to the Ptolemaic
view because it corroborated the Biblical view that God created the universe for man, and that man
held God's divine attention.
The Ptolemaic versus the Copernican view of the universe demonstrates how the same facts
can be interpreted in differing ways. The advantage of the Copernican view lies in its simpler
explanation. Economics too has its examples where different points of view lead to differing
interpretations. One such example is the Great Depression of the 1930s. On the one hand, you have
the interpretation claiming that the depression was the result of a failure of market capitalism.
Hence, government must intervene to prop up the system. At the same time, you have the
interpretation presented by the more conservative economists such as Milton Friedman. The
depression was not caused by a failure of market capitalism, but by government intervention
transforming a minor banking panic into a major depression.
Economic Fallacies
Economic theorizing is subject to three fallacies: post hoc ergo propter hoc, the fallacy of
composition, and the fallacy of misplaced concreteness. Post hoc ergo propter hoc means after this therefore
because of this. Translating the translation the fallacy means relating two unrelated events. Picture
yourself walking down a road and stepping on a crack. The next day your mother breaks her back.
Another example: Your mother says "I hope you don't step on a crack today," to which you respond
both in words and deed, "knock on wood." As though the act of knocking on wood will somehow
avert the dreaded event. Another example: we elect Bill Clinton President and the economy improves;
or as the case may be, the economy turns downward. While the President may have an impact on the
economy, he also may not. In either case, the President is credited or blamed for changes in the
business cycle.
You Can’t Always Get What You Want 9
The second fallacy is the fallacy of composition, the notion that what is true for the part is
true for the whole. Picture yourself watching a parade in which everyone is sitting. If you choose to
stand to see better that is good for you; but if everyone stands then everyone, except for those on
the front row, sees worse. Or another example, if one farmer decides to double his acreage to
double his income that is good for him. But if all farmers increase their acreage producing twice as
much as before, prices decline causing a decline in profits.
The third fallacy is the fallacy of misplaced concreteness. As noted, models are in some
sense pictures of the economic process. As such, they are necessarily distortions; something is left
out. The fallacy of misplaced concreteness refers to treating the "picture” as though it is real, that is,
mistaking the model for the process.
From this perspective models are metaphors, a juxtaposition of two unrelated things.
Thinking metaphorically proceeds by drawing parallels between unrelated things. We use that thing
which we know well to understand that which we know less well. The fallacy of misplaced
concreteness raises the question whether the comparison is justified. Is our metaphor accurate?
Scarcity, Choice, and the Production Possibilities Frontier
Scarcity means that the choices we make involve tradeoffs. In order to obtain one thing we
must give up something else. The decision to go to school means forgoing other choices: traveling,
higher income in the present, a new car, and so on. The value of that which we give up economists call
opportunity cost. More formally, opportunity cost is the value of the next best alternative forgone.
Why the next best alternative? Because you chose the best alternative.
The concept of opportunity costs can be expressed using the production possibilities frontier. The production possibilities frontier (PPF) is defined as the different combinations of goods
that society is capable of producing given that its resources are fully employed.
Table 1 indicates the tradeoff between military goods, and capital and consumer goods. Recall
Points Military Capital and
Goods Consumer
Goods
A
B
C
D
E
F
0
1
2
3
4
5
15
14
12
9
5
0
Opportunity
Cost
of one more
military good
1
2
3
4
5
Table 1: Tradeoff between Military Spending
and Capital
that capital goods are goods used to
produce other goods, such as machinery,
tractors, and so on. In contrast, military
goods are a type of consumer goods. While
it is true that the $500 to $600 million used
to produce the stealth bomber provides
10 You Can’t Always Get What You Want
jobs to people and profits to companies, the bomber itself is a dead end. Once the stealth bomber is
created, it cannot be used to plow fields, clear rivers, or make books. Capital is different. Expenditures
on capital goods benefit the economy both now and in the future. The economy benefits now because
expenditures on capital goods create jobs and enhance the profits of capital-producing industries. The
economy benefits in the future because such expenditures add to the capital stock, making possible the
creation of additional goods and services. Hence, economic growth may be greater in the future.
Capital &
Consumer
Goods
The trade off between
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
military
A
B
and
capital
and
consumer goods is indicated in
the graph in Figure 1. Beginning
C
at point A, for example, the
country is allocating all its
D
resources
production
towards
of
capital
the
and
consumer goods. No resources
E
are
allocated
toward
the
production of military goods.
F
0
2
4
Military Goods
Figure 1: Production Possibilities Frontier
The decision to move form
point A to B involves a tradeoff.
At point A society is producing
15 capital and consumer goods,
and 0 military goods; at point B
society is producing 14 capital
and consumer goods, and 1 military good. The decision to obtain one more military good implies that
the opportunity cost in terms of consumer and capital goods is 1. Now assume that society chooses to
obtain one more military good. The opportunity costs in terms of capital and consumer goods now rise
to 2. Each additional military good that society chooses to obtain costs society more and more. This is
called the law of increasing relative costs. More formally, the law is defined as follows: in order to obtain
equal increments of one good, society must give up increasing amounts of the other good. The reason:
specialization and division of labor. The factors of production used to produce one good are imperfect
substitutes for the production of the other good. The decision to build more stealth bombers, for ex-
You Can’t Always Get What You Want 11
ample, means taking people away from the production of stereos. Those people have to be retrained
and factories retooled all of which involve greater costs.
Capital Formation, Military Spending, and Economic Growth5
The production-possibilities frontier is a useful concept for understanding the different
growth rates in the Soviet Union, the United States, and Japan during the 1980s. The Soviet
economy grew negligibly, in fact in recent years it has declined; the United States' economy grew at
2% for the decade; and the Japanese economy at 4-6%. Growth is affected by a number of different
factors: differences in culture, management styles, entrepreneurial spirit, institutions, and so on.
Undoubtedly, however, an important factor in explaining differences in growth is differences in the
allocation of resources toward investment. Investment represents society's expenditure on capital,
goods used to produce other goods. Japan had the highest growth rate because she spent the most
on capital. Why, or how, was Japan able to allocate so many resources toward capital? Undoubtedly,
one reason is found in the tradeoff between military goods and capital goods. Japan spends less than
1% on military, the U.S spends 7%, and the Soviet Union 20%.
This fact also yields insight into the demise of the cold war. Gorbachev realized he could not
win the arms race with the United States. By making peace, Gorbachev sought to reallocate
resources from military uses to consumer and capital good industries. The problem confronting the
US and former Soviet Union is this: how to reallocate resources from military uses to civilian uses,
without causing unemployment.
Efficiency versus Equity
The production-possibilities frontier can be used to explain the concepts of efficiency and
equity (fairness). Efficiency implies that goods and services are produced at minimum cost. But efficiency does not guarantee that goods and services are allocated equitably. Nor does efficiency mean
that goods are produced with the minimum waste of resources. The United States is among the
most efficient countries in the world. At the same time, we are also the most wasteful.
5
Paul Kennedy traces the relationship between military spending and economic growth historically. He finds
that to be a great military power requires that one also be a great economic power. But what frequently occurs is that
countries allocate so many resources in military spending, that economic growth slows, and eventually the economy
lags. Paul Kennedy, The Rise and Fall of the great Powers: Economic Change and Military Conflict from 1500 to
2000 ( New York: Random House, 1987).
12 You Can’t Always Get What You Want
Capital & Consumer Goods
Economists refer to efficiency in two different senses: efficiency in production and effi-
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
ciency in distribution. Efficiency in production
means that you cannot increase the production of
F
one good without decreasing the production of
another good. Efficiency presupposes that re-
D
sources are fully employed. Hence, increasing the
output of one good implies reallocating resources
from another good.
A
Figure 2 illustrates our meaning. Guns
(military goods) are on the horizontal axis, butter
(capital and consumer goods) are on the vertical.
0
2
4
Point D on the production possibilities frontier is
Military Goods
efficient, since to produce more of one good we
must reduce the production of the other. Point A is
Figure 2: Efficiency in Production
within the frontier, so it is possible to increase the
production of both goods. While desirable, point F is outside the frontier, and therefore impossible.
You Can’t Always Get What You Want 13
Efficiency in distribution is defined
16
Eve's 15
Utility
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
similarly: society cannot increase the happiness of
A
one person without reducing the happiness of
another. Figure 3 illustrates our meaning. Assume
that we have two individuals in our society, Adam
and Eve. Eve's utility is indicated on the vertical axis,
Adam's on the horizontal. At point A Adam's utility
is zero, Eve's is at a maximum implying that Eve has
all the income, Adam has none. Is this point
efficient? Yes, in order to increase Adam's utility we
B
must reduce Eve's. Is point A equitable? No, equity
means fairness, treating two or more individuals relatively the same. Point A implies that a situation may
0
2
4
Adam's Utility
Figure 3 Happiness Possibilities Frontier
be efficient, yet violate our sense of social justice.
Point B is certainly more fair, but less efficient.
Which point should society choose?
Affirmative Action
Affirmative action is a classic case of equity versus
efficiency. In Colorado a contractor was denied the
contract in favor of a Hispanic, although the Hispanic bid
higher. The contractor who lost sued claiming that his
rights had been violated. The Supreme Court agreed, in
effect suggesting that contracts should not be awarded on
equity considerations, but efficiency. Should certain
people—minorities, women, people with disabilities—be
given special treatment? Or should everyone compete on
the same playing field?
14 You Can’t Always Get What You Want
The Role of Institutions
Economists’ observation that choices involve tradeoffs emphasizes the role of individualdecision making. This has its roots in the philosophy of individualism, the theory that social
phenomena are reducible to the choices of individuals. The individualist philosophy is reflected in
John Locke’s assertion that individual rights—particularly the right to property—are sacred. It is also
reflected in Adam Smith’s comment that the individual knows best his or her own self-interest.
The individualist approach to economics, however, should not blind us to the manner in
which choices are bounded by institutions. Institutions are sets of rules that define those choices
that are acceptable and those that are not. For example, in parts of South East Asia serving dogs as
the entrée is common. In our culture, the thought of eating Rover is repulsive to most people,
despite a surplus of dogs. In parts of the Middle East women are forbidden to bare their face, much
less their legs. In the US, it is customary to drive on the right; in Britain, people drive on the left.
These are examples of institutions that impose boundaries on our choices. People have
choices, and these choices often involve tradeoffs. Institutions raise the cost of making some
choices, while lowering the costs of making others. Institutions structure our choices, selecting
which choices are “available” and which are not.
Most people are unaware of the extent to which institutions and culture influence the
choices we make. This has given rise to a debate in economics and the social sciences. Do the
choices that people make arise from the individuals themselves? Or are the choices to a degree a
product of the institutions of capitalist culture? Is the market neutral in the choices that individuals
make? Or does the market itself channel individual choices?
In the chapters that follow these questions arise over and over again in different contexts.
While we may not be able to answer these questions with any definity, they nevertheless are
worthwhile asking. After all, we all want some control over our lives, and the forces that shape our
lives.
You Can’t Always Get What You Want 15
Review Questions
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
IX.
X.
XI.
XII.
XIII.
Define or discuss:
A.
oeconomia
I.
induction
B.
economics
J.
fallacy of composition
C.
macroeconomics
K.
post hoc ergo propter hoc
D.
microeconomics
L.
scarcity
E.
deduction
M.
models
F.
opportunity costs
N.
equity
G.
production possibilities
O.
individualism
frontier
P.
institutions
H.
law of increasing relative
costs
What are the three fundamental questions that all societies must answer, and what are the
three different types of economic systems?
What is the function of price in a market economy?
Explain the source of the subjective element in economic theorizing.
What is meant by the realism of the assumptions?
Explain the concept of the syllogism. Try formulating your own syllogism.
What is the basis of validity in deductive logic?
Give examples of the two economic fallacies (they need not be economic examples).
Define efficiency in both production and distribution.
Using the concept of the productions possibilities frontier critically evaluate the argument
that increases in military expenditures promote economic growth. Use graphs. (Note:
Critically evaluate means under what assumptions is the argument valid, and under what
assumptions is the argument invalid.)
On a utility-possibilities frontier identify the following points: efficient but inequitable,
inefficient but equitable, and efficient and equitable.
Does efficiency mean that resources are not "wasted?" Explain.
In what sense are the choices that people make channeled by institutions? Can you offer
some examples?
Chapter Two : Origins of the Market Economy
"Thus [economics] is on the one side a study of wealth; and on the other and
more important side, a part of the study of man. For man's character has been
molded by his every-day work, and the material resources which he thereby
procures, more than by any other influence unless it be that of his religious
ideals; and the two great forming agencies of the world's history have been the
religious and the economic."
Alfred Marshall
Both micro and macroeconomics are products of the capitalist culture. Economics as a
discipline did not exist prior to the existence of the market economy. Economics as a system of
ideas aspiring to describe how our economic system works originated and developed alongside
market system itself. Microeconomics in particular legitimizes consumption as the end all of human
existence. Maximizing consumption, of course, means maximizing production. At the macro level
the objectives are complementary: promote economic growth to enhance the incomes of both
individuals and governments alike.
The notion of economic growth as a precondition for human happiness coincides with the
most obvious feature of Western civilization: its affluence. Despite the varied cultures that exist
today, the West dominates. With the collapse of the Soviet Empire, the command system as an
alternative method for organizing an economy has lost its appeal. Capitalism has triumphed. Japan,
which little more than a hundred and fifty years ago was a traditional society, made a conscious effort
to follow the West and industrialize at the end of the last century.
Japan, of course, is the most successful non-Western country to adopt Western values. But
others are catching up. Peoples in third-world countries are abandoning their traditions, clearing their
jungles, and developing their resources to embrace Western ways. Throughout the world television
conveys an image of life in America to which many aspire: wealth without work, mindless
consumption, and unbounded greed.
What is the source of the West’s affluence? How did the West achieve a level of affluence
unequaled in human history? Nobel Laureate Douglas North and Paul Thomas argue that affluence
results from an efficient economic organization,6 a set of institutional arrangements that channel
individual effort into activities conducive to economic growth. The institutional arrangement to which
6
Douglass C. North and Paul Thomas. The Rise of the Western World: A New Economic History. New York:
Cambridge University Press, 1973.
Origins of the Market Economy 19
North refers is known as the market economy, or more generally capitalism. By capitalism we mean
both the market economy plus its associated culture.
Markets versus Market Economy
A market is not the same as a market economy. As places where buyers and sellers meet,
markets have existed for thousands of years embedded in an otherwise traditional economy. In such
economies markets are not the central institution upon which people depend. In such economies
people produce the goods that they themselves consume. Nature provides sustenance, and people
provide support. Markets exist as a means to dispose of surplus goods.
In contrast, a market economy means subjecting human relations to market forces. This
requires transforming nature and people into commodities, into something for purchase and sale.
Human relations are governed by the laws of the market, not customs, not traditions, not some
principle of social justice.7
Transforming nature and people into commodities requires separating the economic sphere
from the religions sphere. The viewpoint is reflected in Bernard Mandeville’s comment that “trade is
one thing, religion another.” For economics to emerge as a discipline separate from morality and
law, economic relations had to become separate. This is why people in previous civilizations did not
recognize economics as an independent discipline.
The effort to create a market system invariably requires force. People seldom willingly
forego the certainty of their previous life to engage in the uncertainty of another. This is why
extending the market system to traditional peoples always leads to conflict. The problem in settling
the American West was disposing of the Indians, in effect, removing them from the land. The same
is true for harvesting the rain forests of Brazil, Malaysia, and other third world countries. The
transformation of these natural resources into commodities means separating the indigenous
populations from the means of production. The result: social dislocation, impoverishment, and
conflict.
The same was true at the birth of the market system. The transition from feudalism to
capitalism required separating the means of production from the indigenous peoples. Happening so
7
See Karl Polanyi, The Great Transformation (New York: Rinehart), 1944.
20 Origins of the Market Economy
long ago, the effects of the separation are almost forgotten. But the market system was born of
blood and tears. It represents a unique event in human history.
Feudalism found its legitimacy in religion; the market system found its legitimacy on science.
It is no coincidence that the laws of the market that the economists discovered are that same laws
that Newton discovered in describing the cosmos. Were the laws of the market something inherent
in society? Or were they in the air so to speak?
Five-hundred years ago to charge interest on a loan was considered a sin against God
punishable by eternal damnation. Dante placed the moneylender in the center of Hell, the voyeur he
placed on the outskirts. Profit and interest were considered immoral. Today they are considered
good business. Capitalist enterprise is not possible without capitalist values. People must be
predisposed to earning profits. Profits must be acceptable, even desirable. In a society in which
profit making and interest are considered immoral, business is not possible.
Happening so long ago the transition from feudalism to capitalism is a dim memory in our
collective consciousness. What was feudal society like? What factors were involved in its demise?
And what gave rise to the capitalist system?
Feudalism
Feudalism existed in Western Europe approximately from 500 to 1600 AD. Feudalism is a
traditional economic system, an economic system in which the rules for conduct are reflected in the
traditions and customs of the people. The rules of conduct channel effort towards serving God,
preparing for war, and general survival. Making money other than for the objectives mentioned was
against the rules.
The transition from feudalism to capitalism represents a revolution in both thought and
practice. Serving God yielded to pursuing money. Production for one’s own use or use by the
community gave way to producing goods for exchange. The personableness of community gave way
to the impersonableness of markets. Under feudalism markets are subordinate to society. Under
capitalism, society is subordinate to the market.
Feudal society was divided into two classes: the feudal lord, the priests, and the knights on the
one hand, and the serfs on the other. The customs and tradition of the manor governed the relations
between them. The serfs paid rents in kind to the lord, payments in the form of goods or labor
services. In return, the serfs received protection and justice. Each class had a particular function to
Origins of the Market Economy 21
perform, each was necessary to the whole. Society was compared to the human body: the feudal lords
were the brains; the knights the hands to fight with, and the serfs the feet supporting the whole
structure. Unemployment did not exist. This is not to say that there was no poverty. Poverty was a
characteristic of a group or a class, not an individual. Beggars, in fact, were viewed as opportunities to
do good deeds.
The attitude towards beggars reflects the purpose of feudal society: to serve God. Every
activity had to be justified before the religion. Religious life permeated feudal society in ways that we
cannot understand. Profit and interest were considered wrong in part because they appeared to take
advantage of another's need, and hence contrary to the service of God.
Private property did not exist, as we know it. The feudal lord owned the land as a steward.
Ownership entailed rights and responsibilities, rights to the rents; and responsibilities to car for the
serfs. Serfs too had rights, rights to use the land--cultivate the fields, tend the animals, and use the
commons for hunting and gathering wood. Hence, serfs had direct access to the means of
production.
Factors involved in the Decline of Feudalism
In the fourteenth century there was no indication that the West would emerge triumphant. The
locus of civilizations was not in the West, but the East. The Byzantine empire, located in modern
Turkey and the Middle East, was in its ascendancy. Byzantine excelled in science, mathematics, and art.
From them we received the institution of the university. China excelled in education, fine silks, and
organization. Moreover, China’s wealth was evident in its silks, spices, and dress. The cities of
Byzantium and China excelled in both beauty and cleanliness.
How then did the West emerge triumphant? Marx contends that the demise of feudalism
was the result of class struggle. The Feudal structure could no longer generate enough surplus to
maintain the ruling classes. Henri Pirenne contends that the origin of capitalism lie in the emergence
of long-distance trade. Max Weber finds the origins in new religions attitudes toward trade. To look
for a single cause, however, is folly. Many rivulets, streams, and trickles merge to form the new
civilization. What follows are some of the more notable trickles that subsequently formed a torrent.
22 Origins of the Market Economy
Long-distance Trade
During the dark ages (500 - 1000 AD) Western Europe slumbered. The great cites of the
Roman Empire were long since abandoned. People retreated into the countryside, swearing allegiance
to a feudal lord in return for his protection. Goods and services produced locally were consumed
locally. Trade for any distance was non-existent.
In the eleventh century Charlemagne launched the first of four crusades. The purpose of the
crusades was to capture Jerusalem for Christianity. As a result, however, contact was made with the
Eastern Mediterranean initiating the reemergence of trade. The emergence of trade gave rise to the
cities of Flanders, Venice, and Antwerp--islands of capitalism in a feudal sea. The ensuing wealth
that poured into the cities helped finance the Renaissance.
Renaissance
Renaissance means rebirth. The Renaissance originated in Italy in the thirteenth century, made
possible by the donations of wealthy financiers. Initially, the purpose of the Renaissance was to create
works of art and literature equal to those of ancient Greece and Rome. Ideologically, however, the
Renaissance meant a decline of religious influence. Artists, for example, turned away from religious
themes to paint people in every day activities.
There are two important offshoots from the Renaissance that are particularly important for
the rise of capitalism. First, the philosophy of humanism challenged the dominance of religion
summed up in the humanist phrase "man is the measure of all things." And second, modern science
challenged the ancient view stressing the harmony of nature. Science rests on the assumption that
nature exists to be dominated and controlled. This assumption underlies the development of
modern technology, which for good or bad has vastly increased our power over nature. Only
recently has the threat of pollution and global warming questioned the scientific view of nature.
Discovery of the New World
The reemergence of trade occurred in the Mediterranean. Hence, the initial impetus to
development occurred not in England, but in Italy. Italy was the centers of Western civilization in the
13th, 14th, and 15th centuries. After the discovery of the New World the center shifted to Holland.
Trade with the East proceeded by boat from Italy to the middle east, and then over land to
India and China. The Ottomans, however, realizing their monopoly over the trade routes in the
Origins of the Market Economy 23
middle east, increased their tolls. To satisfy Europe’s appetite for silks and spices the Portuguese
found an alternative route around Africa. Columbus sought to find his route by heading west.
In looking for India, or course, Columbus stumbled upon America. The two centuries that
followed initiated the commercial revolution that changed the face of Europe and the world forever.
The discovery of the New World had two major impacts. First, the Europeans pillaged the
temples of the Aztec civilization, sending the precious metals back to Spain. From there the metals
flowed throughout Europe. The influx of the precious metals increased the money supply in
Europe, which in turn resulted in inflation (a general rise in the price level). This in turn
redistributed income to the emerging commercial classes.
Second, contact with the Spanish decimated the Indians. The Spanish claimed their souls for
heaven, and their bodies for work. But soon there were few Indians to claim. Estimates place the
population of Mexico prior to the Discovery of the New world at 25 million. Fifty years after Cortez
the population had shrunk to 3 million. By 1600 90% of the indigenous population had died from
diseases introduced by the Europeans. The Spanish, of course, interpreted their deaths as divine
punishment.
Protestant Reformation
The revolution in commerce forms the backdrop for the revolution in ideas. The Protestant
reformation was an effort to reform the practices of the Catholic Church. Participants in the
reformation found objectionable the practices of indulgences. One could sin all week, and by paying a
simple fine have his sins washed away. The cycle of sin, repentance, and redemption became a source
of abuse. This abuse came to a head when in 1515 the Pope expanded the indulgences in order to raise
revenue for the Sistine Chapel. Luther objected vehemently.
It is not by doing good deeds Luther argued that one achieves salvation, but by faith alone.
People could no longer “buy” their way into heaven. Luther further challenged the authority of the
Church itself, arguing that all men are brothers in the eyes of God. In the Catholic view, the priest is
superior to the lay people. The priest’s superiority lay in his authority as the mediator of one’s
relationship with God. He offered the sacrament, heard confessions, and taught the people God’s
word.
24 Origins of the Market Economy
As one economic historian put it, “Luther destroyed the faith in authority by establishing the
authority of faith.” The upshot of Luther’s ideas was to introduce a degree of religious individualism.
Each person is responsible for his or her salvation, no one else.
Another person participating in the Protestant reformation is John Calvin.8 First, Calvin
enunciated the doctrine of predestination, the idea that God has already predetermined one's life.
God has determined already one's fate: salvation or damnation. The problem, however, is that God’s
plan remains unknown. The only indication of one's eternal fate is whether one has received God's
grace. An indication that one has received God’s grace is material prosperity. If things are going
well, if prosperity reins, one is probably going to heaven; if not, hell. Wealth and poverty become a
measure of one's moral character.
Second, Calvin formulated the doctrine of the Calling. In feudal times the doctrine of the
calling--the idea that one has been called by God to one's work--pertained only to church offices.
Calvin generalized the concepts to all forms of work. One does not show his love for his fellow man
through sentiment or emotion, but through hard work. To be a butcher, brewer, or baker is not
merely a job. It is a calling. You have been called by God to cut meet, bake bread, or brew beer.
Hence, you have a moral obligation to do it well. Over time the religions connotation underlying the
calling was forgotten, but the psychological predisposition it created continued in force. Making
money is no longer a sin, it is a duty to God. This marks the origin of the Protestant work ethic.
The third doctrine is the doctrine of this-worldly asceticism. An ascetic is one who denies
himself pleasure. The idea is that to consume, to enjoy life is inspired by the devil and hence evil.
The implication is that one should deny oneself the pleasures of the flesh. Over time the religious
meaning was forgotten, but the psychological predisposition continued in the idea that saving is a
virtue.
The doctrines of the Protestant Reformation took hold, in part, because they represented an
ideology conducive to the accumulation of wealth. Profit and interest are no longer sins, but part of
God’s divine plan. You cannot have capitalism without a capital stock. And you cannot accumulate
a capital stock without many individuals working hard, while at the same time saving and investing
the result of their work.
8
See for example Max Weber, The Protestant Ethic and the Spirit of Capitalism, (New York: Charles Scribner's Sons),
1958.
Origins of the Market Economy 25
The Enclosure Movement
The commercial explosion brought about by the discovery of the new world offered many
opportunities. In England the consolidation of the nation had occurred two centuries before. The
serfs, once used as labor services and as soldiers, were no longer necessary. In earlier times the basis of
wealth lay in the number of serfs in the kingdom, now it lay in the number of sheep.
With the price of wool rising, feudal lords had an opportunity to make money. In response,
they forcibly removed the serfs from the land. The lords enclosed the land with hedges and stone
fences, and began raising sheep. The serfs, dispossessed of their traditional lands, crowded into the
countryside.
Queen Elizabeth was shocked at the number of rogues and vagabonds. England's initial
reaction was to outlaw it.
Unlicensed beggars above 14 years of age are to be severely flogged and
branded on the left ear unless someone will take them into service for two years; in
case of a repetition of the offense, if they are over 18, they are to be executed, unless
someone will take them into service for two years; but for the third offence they are
to be executed without mercy as felons.9
When they realized that outlawing poverty did not eliminate it, the English passed the Poor
laws. The Poor laws have gone through a lengthy evolution. But they represent Britain’s efforts to deal
with poverty. In the very early years the attitude was that if poverty could not be abolished, at least
make it profitable.
Mercantilism (1600-1800)
Many people believe that that the natural state of the economy is one in which government
does not intervene. There is, however, no basis for this historically. Governments have always
intervened. No where is this more evident than in the first stage of capitalism, known as Mercantilism.
In the first blush of their youth the newly emerging commercial classes needed government.
Governments offered protection, granted monopolies, opened new markets, fostered industries, and
so on. Mercantilism represented a symbiotic relationship between government and business. Under
feudalism government allied itself with the Church in trying to restrain self-interest. Under
9
Karl Marx, Capital: A Critique of Political Economy, vol. 1, (New York: Vintage Books), 1976, pp. 897-98.
26 Origins of the Market Economy
mercantilism government realized that by encouraging business, governments could increase their
revenue. A thriving business community meant a thriving government.
Mercantilists identified wealth with gold and silver. For nations such as England that found
themselves without gold or silver mines the means to achieve wealth was to run a balance of trace
surplus: that is, the value of exports exceed the value of imports. This in turn required the regulation
of business to ensure that they did not import goods from abroad, and to ensure that they promoted
exports. Economic relations where conceived as a zero-sum-game. One country’s gain was another
country’s loss. Hence, in contrast to Adam Smith economic relations were seen as conflictual.
Colonization initially represented an effort to provide raw materials such as tobacco, cotton,
cocoa, sugar, labor and so on. Only later when a portion of the people had sufficient income could
the colonies serve as a vent for disposing of the surplus production of the industrial countries.
The turmoil of the 16th and 17th centuries must be looked in light of the mercantilist
policies. The European nations were trying to expand their realm of influence in the pursuit of gold.
The result was war, conflict, and the forcible subjugation of the indigenous peoples of the world.
Laissez Faire or Market Capitalism (1800-1930s)
By the late eighteenth century the Industrial Revolution swept away the old system, and
created a new system: laissez faire or market capitalism. The Industrial Revolution is heralded by the
introduction of machines into the workplace. The mercantilist system of regulations interfered with
the increased supply of goods, and the increased demand for inputs. In brief, business interests
needed to be set free.
Prior to the Industrial Revolution manufacturing had to be located on waterways. A water
wheel was used to run machines, grind grain, and so on. All over Europe small manufacturies
sprouted along the waterways. With the invention of the steam engine, however, manufacturing
could be freed from dependency on water.
Production was characterized by what is know as the putting out system. Skilled craftsman
working in their homes performed most production prior to the Industrial Revolution. The
capitalists brought them the raw materials and picked up the finished prouduts. The craftsman, for
the most part, owned their one tools, set their own time, and worked at their own pace. Production
became a family matter, with each part of the household contributing.
Origins of the Market Economy 27
The Industrial Revolution changed all that. First, the Industrial Revolution meant new
innovations based on the steam engine; new machines for processing cotton, for transforming that
cotton into cloth, and so on. This in turn manifested itself in a decline in the price of capital relative
to labor. Capitalists responded by substituting capital for labor. The skilled craftsmen were no longer
needed, resulting in an increase in poverty.
Second, the new type of production altered they type of labor needed. Machines simplified
the labor process by dividing up the tasks. One person performed one task, another person another
task. This extended division of labor reduced the demand for skilled labor, and increased the
demand for unskilled labor. But the increase in the demand for skilled labor was insufficient to
restore full employment.
Third, the demand for unskilled labor meant in general a decline in pay. In many cases
women and children were preferred. The first effort to regulate the use of child labor—in effect
protect children from market forces--was met with hostility. Business owners responded that this is
my property. Who are you to tell me what to do?
Fourth, the Industrial Revolution introduced the factory system. The capitalist no longer had
to take the raw materials to a craftsman to work them up. The new system enabled the capitalist to
control all aspects of the work process. He could now hire workers, bringing them under one roof;
regulate the times they began and went home. Working conditions were generally horrible: the
machines were loud; lighting was poor; hours were long and arduous. Another by product of the
factory system is that relations between workers and the capitalist became impersonal.
The Industrial Revolution, however, was not a total disaster for workers. By the late
nineteenth century incomes actually rose. The welfare of many working people, at least those in the
developed world, actually improved.
Internationally, the market economy became a worldwide phenomenon. Britannia,
unequivocally the master of the seas, needed access to markets to feed its growing industries. And
access to markets meant free trade, which Britain was quick to enforce.
As noted, a market economy means the subjection of human beings to market forces. In this
respect, laissez faire represents a conscious decision on part of governments not to intervene. In
brief, laissez faire was planned. But the decision not to intervene was met with an almost
spontaneous counter movement demand that governments intervene in order to protect human
28 Origins of the Market Economy
beings from market forces. The culmination of this effort manifests itself in the emergence of the
corporate, welfare state or what is sometimes referred to as the mixed economy.
Corporate, Welfare State (1930s-)
The corporate, welfare state has its origins in two sources. First, the merger movement of
the late nineteenth century led to the emergence of the corporation century as the dominant form of
business enterprise. Corporation arose in part as a means of controlling ruinous competition that
had bankrupted so many businesses. And second, the welfare state has its origins in the effort on
part of governments to provide economic security. The depressions of the nineteenth and early
twentieth became politically unacceptable. The artificial separation between the economic and
political spheres erected by the policy of laissez faire quickly fell. People voted for bailouts. And
bailouts require government intervention.
The specific events, however, that spelled the demise of the laissez faire capitalism began in
1917. World War One shattered the tranquillity of the market economy. Referred to at the time as
the war to end all wars, World War One resulted from the efforts on part of the industrialized
powers of Europe to obtain resources. In brief, it was a capitalist war. The First World War, ensuing
depression of the 1930s, and the Second World War that followed represent a single revolution in
the global economy.
The second great event was the Russian Revolution, the product of blood shed by people in
the hopes of creating a better world. The rise of totalitarianism both in Russia and Germany was a
response to the problems and issues created by the market economy: poverty, depression, and so on.
By the end of the twentieth century the great wars that consumed so many lives and wasted
so many resources appear ended. And the great experiment in central planning has proved a failure.
The problem for the former centrally-planned societies is how to create a market economy. But the
problem with the market economy continues to vex, namely, how do we motivate people to do that
which is in societies interest?
The market economy imposes a particular form of motivation, namely, the promise of profit
and the threat of hunger. At no time in human history has their been a more efficient form of human
motivation. In the past it was thought that people had to be coerced to what was in society’s interest.
Adam Smith said let them be free. “It is not from the benevolence of the butcher, the brewer, or the
Origins of the Market Economy 29
baker that we expect our dinner, but from their regard to their own interest.”10 If Smith promised
profit, however, Malthus promised pain.
Evil exists in the world not to create despair but activity. We are not patiently to submit
to it, but to exert ourselves to avoid it. It is not only the interest but the duty of every
individual to use his utmost efforts to remove evil from himself and from as large a
circle as he can influence, and the more he exercises himself in this duty, the more
wisely he directs his efforts, and the more successful these efforts are, the more he will
probably improve and exalt his own mind and the more completely does he appear to
fulfill the will of his Creator.11
The idea that profit and pain motivate human beings is encapsulated in the concept of
rational choice, which forms the very heart of microeconomics
10
Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations (New York: The Modern Library),
1937, p. 13.
11
T. R. Malthus, Principles of Political Economy (London: John Murray), 1820, p. 217.
30 Origins of the Market Economy
Review Questions
I.
What is the most obvious characteristic of the West?
II.
Distinguish between a market and a market economy?
III.
Define feudalism. How does feudalism differ from capitalism?
IV.
What are five factors involved in the emergence of capitalism?
V.
What is mercantilism?
VI.
How are the policies underlying mercantilism consistent with the ethos associated with the
Protestant Reformation?
VII.
What is laissez faire or market capitalism?
VIII.
What is the corporate, welfare state?
Chapter Three : The Heart of Microeconomics: Rational Choice
"It is better to be a human being dissatisfied than a pig satisfied; better to be
Socrates dissatisfied than a fool satisfied. And if the fool, or the pig, are of a
different opinion, it is because they only know their own side of the question.
The other party to the comparison knows both sides."
John Stuart Mill
“If I am not for myself, then who is for me? And if I am not for others, then who
am I? And if not now, when?”
Rabbi Hillel
As noted, microeconomics is concerned with how individuals, firms, and society allocate
their scarce resources to achieve their objectives. The assumption underlying microeconomics is that
in allocating resources individuals, firms, and society choose rationally. Rational choice means that
individuals allocate their resources in such a way so as to enable them to achieve their ends. The need to make
rational choices arises because factors of production are scarce. Not enough land, labor, and capital
exist to produce all the goods and services that people want.
This, however, raises a question: on what basis do people choose? People choose those
things they value the most. This, however, begs another question. What do we mean by value?
The Utility Theory of Value
Microeconomics traces its origins to the marginalist revolution of the 1870s. Those initiating
the marginalist revolution—Stanley Jevons in Britain, León Walras in France, Karl Menger in
Austria, and John Bates Clark also in Britain—sought a new answer to an old question: what
determines value? Why do some things sell for a higher price than other things? Or to drive home
the point, why does water command such a low price, and diamonds such a high price? After all,
water is a necessity, diamonds are not.
The classical economists—Adam Smith, David Ricardo, and John Stuart Mill—asserted that
prices are proportional to the quantities of embodied labor. As Adam Smith claims, “Labour was the
first price, the original purchase money that was paid for all things.”12 By the late nineteenth century,
however, even those who had not read Marx understood the implications of the labor theory of
12
Adam Smith, The Wealth of Nations, p. 30.
32 The Heart of Microeconomics: Rational Choice
value. Labor creates all value, yet labor must share the produce with the capitalist in order to access
the means of production. Profits arise from the exploitation of labor.
The marginalists rejected the labor theory of value on three grounds. First, they rejected the
idea that capitalists contribute nothing, and hence, they rejected the whole idea of exploitation.
Second, the labor theory value has some difficulty explaining prices that differ from quantities of
embodied labor. For example, how does one explain the value of those items the price of which far
exceeds the quantity of labor embodied, such as rare paintings, coins, or rents.13 And third, the labor
theory of value in focusing on costs in determining value tends to diminish the role played by
demand.
Those initiating the marginalist revolution knew that price is determined by supply and
demand, but they sought to ascertain what underlies the supply and demand curves. Their answer
marks the ascendancy of the utility theory of value, the notion that what underlies prices is not
quantities of embodied labor, but utility. The central point of the founders of the marginalist
revolution is that price is proportional to the satisfaction derived from the last unit purchased. That
is, prices paid for goods represent the satisfaction derived from those goods. The viewpoint
represents a shift away from emphasis on labor costs as the basis of value, to an emphasis on
individual preferences.
Individual preferences are expressed in the form of a utility function: U=(Q1, Q2, . . . Qn).
U represents utility or level of happiness;  is functional notation indicating a positive relationship
between U and Q1, Q2, . . . Qn (utility and ownership); and Q1, Q2, . . . Qn represents the different
goods and services. The function means that one’s happiness, or utility, is dependent on the quantity
of goods and services consumed. In other words, happiness depends on the quantity of apples
consumed, the quantity of bananas, and so on. Stanley Jevons referred to the utility theory of value
as the “felicific calculus,” the calculus of happiness; Francis Edgeworth as “mathematical psychics.”
Their views reflect their belief that economics is a science more akin to physics than biology.
Noticeably absent from utility functions are the influences of other people. One person’s
utility does not depend upon another’s, otherwise the mathematics would become too complicated.
In other words, tastes and preferences are taken as given. Inquiring into the origin of people’s
preferences become unimportant, or beyond the scope of economics. The denial that utility
13
The classical economists assumed that only human beings create value. Creating value involves an activity,
something which only humans are capable. Hence, rents and so on are the return not for effort, but for ownership.
The Heart of Microeconomics: Rational Choice 33
functions are interdependent implies that society is conceived atomistically. Society is a collection of
individuals, a series of Robinson Crusoes. The only relations that exist among individuals are those
that individuals engage in voluntarily. Other relations are considered exceptional, or irrelevant.
This concept of society differs markedly from that implied by the labor theory of value. The
labor theory of value has a class view of society; the utility an Atomistic view. The labor theory
implies that society is comprised of both productive and unproductive labor; the utility theory
implies that so long as one person receives an income, he is contributing to society. The labor theory
of value is primarily concerned with distribution and growth. The utility theory of value is primarily
concerned with the allocation of scarce resources. The differences between the two theories of value
are summarized in the table below.
Labor Theory of Value
1. Economic Problem: Production and Distribution
2. Value
Pa/Pb = La/Lb
(prices are proportional to quantities
of embodied labor)
3. Distribution
4. Harmony or
Disharmony
5. Concept of society:
Based on exploitation. Profits
(surplus) accrue to the owners of the
means of production.
Implies disharmony. Those who own
the means of production live off
those who do not.
Class view of society based on
property ownership.
Utility Theory of Value
Allocation of scarce resources
Pa/Pb = MUa/MUb
(prices are proportional to the
happiness of the last units
consumed)
Income reflect the value of
one’s contribution to society.
Implies harmony. There is no
exploitation. Each receives his
or her due.
Atomistic view of society.
Society is a collection of
individuals.
The marginalist revolution marks a fundamental shift in the central problem of economics.
No longer are economists concerned with the problems of distribution and growth. Rather, the
emphasis is on the allocation of scarce resources. Individuals allocate their scarce resources in such a
way so as to maximize satisfaction; firms to maximize profits; and society to maximize social welfare
(the utility of all those in society).
34 The Heart of Microeconomics: Rational Choice
Homo Economicus: Rational Economic Man
The utility theory of value presupposes a particular concept of human nature, that of homo
economicus, (rational) economic man. This view of human nature derives from the philosophy of
utilitarianism. The founder of Utilitarianism, Jeremey Bentham, defined human nature as follows:
Nature has placed mankind under the governance of two sovereign masters,
(pain and pleasure). It is for them alone to point out what we ought to do, as well as
to determine what we shall do. On the one hand the standard of right and wrong, on
the other the chain of causes and effects, are fastened to their throne. They govern
us in all we do, in all we say, in all we think: every effort we can make to throw off
our subjection, will serve but to demonstrate and confirm it. In words a man may
pretend to abjure their empire: but in reality he will remain subject to it all the while.
The principle of utility recognizes this subjection, and assumes it for the foundation
of that system, the object of which is to rear the fabric of felicity by the hands of
reason and of law.14
Bentham sought to reform Britain’s legal system by basing it on the principle of utility. He
believed that by manipulating pain and pleasure individuals could be led to do what was in society’s
interests, as determined by the legislature. In other words, his theory leads to the view that society
can be engineered. Assuming that individuals are rational, and by further making the expected cost
of a crime exceed the expected benefit, crime could be eliminated.
Is Bentham’s concept of human nature accurate? Are human beings rational? Do they
pursue pleasure and avoid pain? If so, is it not possible to eliminate crime? Could we engineer the
“perfect” society? If not, why not? Or is human nature more complicated than that suggested by
Bentham?
Historical Backdrop of Rational Choice
The principle of utility generalizes to all that which business men have been doing for
centuries. The objective of business to maximize profits, to increase the difference between
14
Jeremy Bentham, An Introduction to the Principle of Morals and Legislation (Garden City, N.Y.: Anchor
Books), 1973, p. 17. Jeremey Bentham viewed himself as the Isaac Newton of the social sciences. A wealthy
gentlemen, he once won a prize for the most original idea to reform Britain's penal laws. Applying the principle of
utility, Bentham advocated redesigning prisons in order to minimize the number of guards required. He referred to
his design as Panoptican, a prison that has five sides shaped as a star.
Eccentric in manner, Bentham left his sizable estate to the University of London on condition that he be
present at all future board meetings. Upon his death he left his body to science. His body was dissected, and his head
was shrunk in the manner of the South American head hunters. To meet the terms of the will, his body was placed in
a glass case clothed, and his head was placed at his feet and a wax head placed on his shoulders.
The Heart of Microeconomics: Rational Choice 35
incoming revenues and outgoing expenses, has always characterized business activity. But such
activities were controlled by society at large. Moreover, individuals themselves were not thought to
engage naturally in such activities. Avarice, the pursuit of money, was in medieval times one of the
seven deadly sins. Reason served as the basis through which individuals could reign in their passions.
With the emergence of capitalism, however, the deadly sin becomes the basis of a new
society. Reason no longer serves to constrain self-interest. Rather, reason serves to legitimize selfinterest. The pursuit of self-interest comes to be thought of as something natural. In medieval times
reason was invoked to restrain acquisitive behavior; today reason legitimizes such behavior. The
notion that individuals pursue their self-interest is relatively modern. It represents a generalization of
the principle underlying business. It is also consistent with a culture that emphasizes pecuniary
pursuits as the highest good.
Rational Choice: Maximization and Minimization
As noted, microeconomic theory incorporates Utilitarianism in assuming that individuals
seek to maximize utility, or what amounts to the same thing, minimize disutility. Maximization and
minimization are two sides of the same coin.
Utility means satisfaction, pleasure, happiness, and so on. Utility is an ambiguous concept
because it is inherently subjective. In microeconomic theory utility is a function of the quantity of
goods and services that one consumes. Total utility is the satisfaction derived from consuming a
quantity of a good in a specified amount of time. Marginal utility is the increment in satisfaction
derived from consuming one more unit of a good.
The law of diminishing marginal utility defines the relation between total and marginal
utility. This law states the following: As a person consumes successive units of a good, satisfaction
increases but at a decreasing rate. Put differently: as a person consumes successive units of a good,
the satisfaction derived from each successive unit declines. Each unit consumed yields less
satisfaction than the one before.
A util is a measure of utility (a measure of pleasure). The early economists assumed that
satisfaction could be measured using money.
Based on the following demand curve, Qd = 10 - P, we can derive the marginal and total
utilities. The demand curve relates the prices that the individual would be willing to pay at different
quantities. It does not reflect the price he actually pays.
36 The Heart of Microeconomics: Rational Choice
The concept underlying the idea behind rational choice is that the individual weighs the cost
(market price) and benefits (marginal utility) at the margin, that is, he weighs the costs and benefits
for each additional good consumed. The equilibrium condition for utility maximization is this: MU
= market P. The individual will consume up to the point that the marginal utility equals the market
price. The underling intuition is this: each unit consumed prior to equilibrium yields more utility than the individual
gives up to purchase it; and each good consumed after equilibrium yields less utility than the individual gave up to buy
the good. Hence, the individual maximizes utility at equilibrium. Alfred Marshall, one of the founders
of microeconomics, put it this way:
The simplest case of balance or equilibrium between desire and effort is found when
a person satisfies one of his wants by his own direct work. When a boy picks blackberries for
his own eating, the action of picking is probably itself pleasurable for a while; and for some
time longer the pleasure of eating is more than enough to repay the trouble of picking. But
after he has eaten a good deal, the desire for more diminishes; while the task of picking
begins to cause weariness, which may indeed be a feeling of monotony rather than of
fatigue. Equilibrium is reached when at last his eagerness to play and his disinclination for
work of picking counterbalance the desire for eating. The satisfaction which he can get from
picking fruit has arrived at its maximum: for up to that time every fresh picking has added
more to his pleasure than it has taken away; and after that time any further picking would
take away form his pleasure more than it would add.15
The concept of equilibrium can be demonstrated using the concept of consumer’s surplus.
Consumer’s surplus is the difference between the price the individual would be willing to pay, and
what he actually pays if the alternative is to do without the good. Put differently, it is the difference
between the total utility received and the utility given up to buy the good, if the alternative is to do
without the good. In other words, it is the satisfaction derived over and above what the individual
pays.
Assuming the following:
1. Market price = $6
2. $1 = 1 util
Table 2 helps explain the concept of rational choice. The first column represents the prices
the individual is willing to pay for different quantities of the good. The price the individual actually
pays, however, is the market price (in this case $6). The second column represents the different
quantities. The third column represents the marginal utility, the additional satisfaction of consuming
one more unit. The fourth column represents the market price of $6, the price that the consumer
15
Alfred Marshall. Principle of Economics. 8th ed. (New York: MacMillan Press, 1924), p. 276.
The Heart of Microeconomics: Rational Choice 37
actually pays per unit. The fifth column represents the consumers’ surplus per unit, that is, the
difference between marginal utility and market price. The sixth column represents the total utility up
to the quantity the individual is consuming. To determine the total utility corresponding to a
particular quantity, we add the marginal utilities for each unit up to the quantity we are consuming.
For example, if the individual is consuming three units, we sum 9, 8, and 7 to derive a total utility of
24. The seventh column, costs in utils, is found by multiplying the market price by the quantity. For
three units, that would be $6 times 3 to get 18. And the last column, consumer’s surplus, is simply
the difference between the sixth and seventh columns, that is, its the different between total utility
and costs.
38 The Heart of Microeconomics: Rational Choice
Price
Quantity
10
9
8
7
6
5
4
3
2
1
0
0
1
2
3
4
5
6
7
8
9
10
Consumers’
Total
Total
Surplus per
Utility
Costs
Unit
9
6
3
9
6
8
6
2
17
12
7
6
1
24
18
6
6
0
30
24
5
6
-1
35
30
4
6
-2
39
36
3
6
-3
42
42
2
6
-4
44
48
1
6
-5
45
54
0
6
-6
45
60
Table 2: A Tabular Illustration of Rational Choice
Marginal
Utility
Cost Per
Unit
Consumers’
Surplus
3
5
6
6
5
3
0
-4
-9
-15
Assume for the moment that the individual buys the first good. He receives nine utils of
pleasure; he gives up six utils to buy it (each dollar is worth one util). Hence, he receives a consumer’s surplus of three. He buys the second good. He receives eight utils from the second, he gives
up six to buy. Total utility is now 17, the cost in utils is 12 for a consumer’s surplus of 5. He will
continue this process, weighing the benefits and costs of each additional unit, until the satisfaction
derived from consuming one more unit just equals the cost. At this point he has maximized
consumer’s surplus. He won’t go beyond this point since the costs of one more unit exceed the
benefits.16
Rational Applications and Irrational Results
The concept of rational choice is among the more important concepts in economics. It is
fundamental to microeconomics, environmental economics, international, public finance, as well as
to the other disciplines in business such as accounting, finance, management, and marketing.
Rational choice has also influenced other disciplines: sociology, political science, and even biology.
The concept of rational choice describes the particular philosophic viewpoint characteristic of
capitalist enterprise. But this viewpoint today is so much a part of our culture that its legitimacy is
rarely questioned. All of us has been told one time or another that making a decision involves
16
Micro theory does not require the assumption that utility is measurable. We do so here merely to illustrate the
concept of rational choice.
The Heart of Microeconomics: Rational Choice 39
weighing the costs and benefits. Rational choice takes this one step further: costs and benefits are
weighed at the margin to ensure an overall maximization or minimization.
Rational Health Care?
From society’s point of view the purpose
of health care is to provide for the social welfare.
It is, in brief, to provide medical services to
millions of Americans. People object to the
socialization of health care in this country, and
their fears are not without reason. But in fact
health care has already been socialized, socialized
by the insurance companies.
The purpose of insurance companies is to
make profits, or more precisely, to maximize the
return to stockholders. They maximize return by
maximizing revenue and minimizing costs. This
means selling insurance to as many people as
possible while paying out as little as possible.
Insurance companies reduce their pay out in the
following ways. First, do not insure those
individuals who get sick frequently. Sick people are
unprofitable. Second, reduce costs by eliminating
“non-essentials.” Many insurance companies have
decided that those “non-essential” personnel are
nurses. They are expensive, and in the eyes of
many hospitals their tasks could be done by those
with less training: LPNs, assistants, and so on.
Third, reduce hospital stays where possible. For
example, require women entering the hospital to
give birth to stay no longer than 24 hours. Some
insurance companies suggest 12 hours is long
enough, others have suggested 6 hours.
Rational choice has many applications
in everyday life. As noted, rational choice is
fundamental to the world of business. An
entrepreneur continues to produce goods so
long as the revenue generated by the sale of
one more unit exceeds the cost of that unit. An
entrepreneur chooses to invest, based on the
belief that the income that the investment
generates exceeds the costs. Similarly, an
entrepreneur will not hire a worker unless the
value that the worker contributes exceeds what
the entrepreneur pays him in wages, a point
fundamental to the neoclassical theory of
distribution. Theoretically, each factor of
production—land, labor, and capital—are paid
the value of their contribution to production.
There is no exploitation.
We can also apply the concept of
rational choice to the purchase of commodities.
The purchase of a commodity is based on the
anticipation that the benefits exceed the price.
The excess benefit is referred to as the consumer’s surplus (see above). If you believed otherwise
you would not have purchased the commodity. From this point of view, we can see how the
concepts of rational choice and consumer’s surplus supports the invisible-hand doctrine. So long as
trade is voluntary, everyone benefits. They must believe that they are getting more out of the
exchange than they are giving up, otherwise they would not trade. Receiving a surplus does not
mean that anyone is getting ripped off, for the surplus that people gain from trade is psychological.
You give the car dealer $50,000, he gives you a Porsche. He prefers the $50,000 to the car, you
40 The Heart of Microeconomics: Rational Choice
Economic Nonsense?
One of the purposes of the Central Utah
Project was to bring water to the farmers of central
Utah. Recent studies indicate that the cost of bringing water to central Utah farmers exceeds the costs
involved in paying farmers to buy comparable products on the free market.
prefer the car to the $50,000. Hence, both
parties gain. To paraphrase Adam Smith,
each individual pursuing his own self
interest
unintentionally
benefits
the
interest of all.
The application of the concept of
rational choice to voting helps explain low voter turnouts. In many elections voter turnout is less
than ten percent. Why? The concept of rational implies that voters are behaving rationally. The
decision to vote is a matter of weighing the costs and benefits. The costs of voting includes
familiarizing yourself with the issues and the positions of the candidates; it includes driving to the
place of voting; standing in line, and casting the vote, and possibly being selected for jury duty. The
benefits may or may not be negligible. If the election outcome is determined beforehand (such as
George Bush carrying Utah) or if the result has a negligible impact (such as who becomes
dogcatcher), then the decision not to vote may be rational.
Curiously, the rationality of not voting may pose a problem. If everyone finds it rational not
to vote, however, the democratic process breaks down. Either no one is elected, or those in office
achieve their position by undemocratic means. Hence, what is rational for the individual becomes
irrational for society.
The application of the concept to lobbying efforts yields insight into the nature of the
political process. In 1986 a bill before Congress required used-car dealers to give a history of the car.
Estimates indicated that the bill would increase used-car prices by $500 per-vehicle. Despite the
increased costs, consumers would save money on fewer repairs. Who has a greater interest in
influencing the legislation, used-car dealers or consumers? From the point of view of the dealers, the
bill would have a serious effect on their incomes. As a group they would be willing to spend to
influence Congress an amount up to the potential cost of the bill. As a consumer, you would be
willing to spend up to the amount that you thought the bill might save you in car repairs, discounted
over several years. Clearly, the amount that the used-car dealers would be willing to spend exceeds
the amount that the car buyers would be willing to spend. So what happened? The bill never made
to the floor; it was defeated in committee.
The Heart of Microeconomics: Rational Choice 41
There are other examples. The auto industry delayed introducing seat belts for twenty years.
The chemical industry successfully put off adding a chemical that would render ammonium nitrate
inert. Ammonium nitrate, a common fertilizer, was used as the explosive in the Oklahoma bombing.
The application of the concept of rational choice to the political process indicates that a
priori the process is biased in favor of special interests: corporations, labor, and so on. As the golden
rule says, “He who owns the gold makes the rules.”
Cost-benefit analysis provides another example of the application of the concept of rational
choice. Cost-benefit analysis is used by businesses, government, and other organizations to evaluate
the dollar benefits generated from dollars spent. For example, the government decided over twenty
years ago to build the central Utah project, a system of tunnels and reservoirs designed to bring
water from the Uinta mountains to the Wasatch front. Since then costs have skyrocketed to over
$20 billion. Using an unrealistically low interest rate, the government was able to show that for every
dollar spent society receives a $1.06 in return. Had the market interest rate been used the CUP could
not have been justified using cost-benefit analysis.
What is the value of Life?
Most to us find questions regarding the value of life uncomfortable. But these questions arise
all the time. How much life insurance should you purchase? How much should be spent to keep a
premature baby alive? How much should families be compensated for the wrongful death of a loved
one? Should we perform heart transplants or liver transplants costing hundreds of thousands of
dollars for those who cannot afford it, or whose earning potential is far less than the cost of the
operation?
The decision to purchase life insurance is in a sense a decision to place a value on life. Life
insurance is about purchasing sufficient insurance to make up the lost income in the event of an
untimely death. But how can one place a monetary value on life?
The approach taken by economists to these questions begins with the concept of present
value. Simply put, what is the value today of a sum of money received tomorrow? One thousand
dollars put into the bank today at 5% interest will be worth $1050 a year hence. Put otherwise, the
present value of $1050 received a year from now is $1000.
The concept of present value is also important in resolving wrongful death suits—suits
involving the death of someone as a result of the actions of another. What is the present value (value
today) or someone’s future earnings? Since a twenty year old is expected to earn far more in his
42 The Heart of Microeconomics: Rational Choice
remaining years than a sixty-year old, the value of the twenty-year old’s life is greater than say a sixty
year old, all other things reaming the same.
Take the case of Bhopal. Union Carbide Corporation operates a chemical plant in Bhopal
India. In 1983 several tons of a dangerous pesticide leaked out resulting in the death of several
thousand people. The average annual income of a citizen in Bhopal is about $300 per year. The
average income of an American is about $12,000. Lawyers for the families of those killed wanted the
case tried in the United States. Union Carbide wanted the case tried in India. The case was tried in
India, and Bhopal compensated the families of the victims. The compensation per person killed:
$3,000. Had the case been tired in the United States the compensation would have been much
larger, in the hundreds of thousands per person. The moral of the story: it appears life is worth less
in India than in the United States. And from a corporate point of view: it is better to have dangerous
plants in less developed countries than in the West. If there is a disaster, the costs are much less,
while the revenues from the sale of the product are about the same.
The Ironies of Rationality
The concept of rational choice is a useful construct for making relatively simple,
straightforward decisions. Rational choice yields little insight in making choices involving moral
dilemmas. In the book Sophie’s Choice. Sophie is forced to decide which of her two children to send
to the concentration camps. How does one weigh the costs and benefits in making such a decision?
In India such decisions are apparently less complicated, and hence more rational. Female
infanticide is commonplace, practiced by one out of every two families. From the viewpoint of
microeconomics the practice is rational; from an ethical viewpoint the practice is repulsive.
Females represent a financial liability. As one woman said: “Even a useless male buffalo calf
fetches 100 rupees”, or about $3.50. “A girl means nothing but expense.” Marrying off a female
daughter requires giving the husband a dowry. In a society in which many families cannot afford a
dowry, or are unwilling to pay the dowry, infanticide becomes the least-cost solution. In effect, the
culture of India makes female infanticide “rational”.
There are perhaps several solutions to this practice. First, change peoples’ values, a difficult
task at best. For values are deeply rooted in the psyche of a people, and slow to change. Second,
raise the incomes of the people so that families can better afford female children. Again, raising
incomes is a difficult, long-term solution. A third solution introduced by the Indian government lies
The Heart of Microeconomics: Rational Choice 43
in socializing the cost of raising females. Cradles have been placed outside hospitals where families
may leave their daughters, thereby shifting the costs of raising females from the families to the
government.
Another problem with the concept of rational choice arises from the individual’s response to
uncertainty. Economists differentiate between uncertainty and risk. Risk means that the probabilities
of an event occurring are known. For example, the probability that the flip of a coin will be heads is
fifty percent. Uncertainty, however, means that the probabilities of a particular event occurring are
simply unknown.
The concept of uncertainty is at the basis of an interesting model referred to as the
Prisoner’s Dilemma. In the Prisoner’s Dilemma two individuals, Adam and Eve, are suspected of
having committed a crime. They are separated, interrogated, and denied the opportunity to communicate with one another. They have two choices: confess or not confess. In the table above
Adam’s payoff is indicated first, Eve’s second. If Adam confesses and Eve does not, Adam goes free
while Eve spends 20 years in prison. If Eve confesses and Adam does not, Eve goes free while
Adam gets 20 years. If both confess they each receive 10 years. And if neither confesses each gets 1
year. Assume for the moment that you are either Adam or Eve, which alternative do you choose?
Which choice will maximize your satisfaction?
Without knowing what the other person will do, any choice becomes precarious. A risk
averse individual would seek to minimize the worst-case scenario. He or she would confess knowing
that they get either 10 years or nothing. In part, the decision depends on your values, and the choice
you think the other individual will make.
Uncertainty arises because you have no knowledge of what the other person will do. You
cannot calculate the costs and benefits
Table 3: The Prisoner’s Dilemma
of a particular choice, implying that
rational choice breaks down, at least in
Eve
the sense presented. More generally,
Adam
Confess
Don’t Confess
Confess
(10, 10)
(20, 0)
(Adam’s payoff, Eve’s payoff)
Don’t Confess
(0, 20)
(1, 1)
the prisoner’s dilemma implies that
the invisible-hand doctrine breaks
down. Individuals pursuing their own
self-interest may unintentionally hurt
their own interests, as well as the
44 The Heart of Microeconomics: Rational Choice
interests of others. Everyone may be worse off.
Now assume that rather than pursuing their own interests, Adam and Eve become altruistic.
Each tries to maximize the interest of the other. Each observes that it is in the other person’s
interest not to confess. What is the result? Both Adam and Eve receive only one year in prison.
Collectively, both are better off than they would have been otherwise. The implication is that under
uncertainty, cooperation may be preferred to competition.
The reference to prisoners does not prevent us from generalizing the conclusion of the
prisoners’ dilemma to other situations. Should Coke-a-Cola, for example, raise its prices? How
would Pepsi respond? How will the Russians respond if the US resurrects underground nuclear
testing?
Firms and Rational Choice
As noted, the concept of rational choice was first applied to firms, and only later attributed
to human beings in general. Firms seek to maximize profits or, what amounts to the same thing,
minimize costs. Profits are revenues minus costs. Revenues are the dollar value of a firm’s sales;
costs are the expenses that a firm incurs in the course of doing business.
A firm maximizes profits at that output where the addition to revenue from the sale of one
more product (marginal revenue) equals the addition to costs of one more unit (marginal costs).
Marginal revenue is analogus to marginal utility, except that marginal revenue is expressed in dollars.
The intuition underlying is the same as that encountered in individual choice. The firm will continue
to produce products so long as the revenue generated by one more product exceeds the costs of the
producing that product. The firm will cease producing when it finds that the revenue generated is
less than the costs of the product.
Take a movie theater for example. The marginal revenue of selling one more ticket is say five
dollars. The marginal cost of one more ticket is zero, or very close to zero. Hence, the theater
manager has an interest in selling as many tickets as possible. In fact, if the manager could attract
more people, it would be in the manager's interest to sell discount tickets. Why? Because even
though a discounted ticket may bring in less revenu than a regular ticket, the revenue generated still
exceeds the cost of one more ticket.
Fundamental to the concept of costs is the distinction between the short and long run. The
short run is that length of time in which at least one factor of production remains constant. To
The Heart of Microeconomics: Rational Choice 45
increase production the firm may have to hire more workers, even though the plant size remains the
same. The short run may be a day, a week, a year, or decades.
The long run is that length of time in which every factor of production is variable. The long
run is that time period in which the business is able to expand its factory size.
The distinction between short and long runs points to the distinction between fixed costs
and variable costs. Fixed costs are costs that the firm incurs regardless of the level of output. They
might include mortgage payments, property taxes, and so on. Variable costs, on the other hand, vary
with the level of output. They include raw materials, labor, and so on.
Production in the short run is generally characterized by diminishing returns. As the variable
factor increases, holding other factors constant, output increases at a decreasing rate. Assume for the
moment that you are fixing dinner for some friends. First one friend offers to help, and then
another, and then another. Soon there is not enough room in the kitchen. People are getting in the
way, making dinner difficult to fix (so you leave the kitchen, leaving the others to fend for
themselves). The additional “help” increases the costs of production relative to the output. The
concept in fact is implicit in Malthus theory of population: the fixed amount of land leads food
production to increase at a decreasing rate as the land is farmed more intensively.
In the long run, however, costs may be characterized by economies of scale. Economies of
scale is a situation in which as all the factors of production are increased by a particular amount,
output increases by a greater proportion. Put differently, as output increases, per-unit costs decline.
The reason is specialization and division of labor. Workers come to know their jobs better, and
therefore work faster. The graph above shows economies of scale for calculators.
The concept of economies of scale explains the cost behavior of many industries. In the
mid-seventies few students had calculators; most used slide rulers. The price of calculators limited to
the most rudimentary functions was around $150. What happened? Despite dramatic increases in
demand, the increase in the supply of calculators owing to economies of scale have reduced the
marginal cost (the cost to the firm of producing one more calculator) to a few dollars. The result was
that the price followed suit.
46 The Heart of Microeconomics: Rational Choice
Profits in a Market Economy
The objective of maximizing profits dictates that profits control business activity. Declining
profits signals firms to curtail production; and rising profits signal firms to increase production.
Profits are the carrot, losses the stick.
This gives government an important tool in guiding business activity. Profits are to a firm
what blood is to a person. Without profits the firm dies. The effectiveness of government policies to
curtail pollution or encourage investment depends on the extent to which such policies influence
profits. If we want to discourage pollution, then we should make pollution intensive industries less
profitable. If we want to encourage recycling, offer firms and individuals incentives.
The Heart of Microeconomics: Rational Choice 47
Review Questions
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
IX.
X.
XI.
XII.
Define or discuss:
A.
rational choice
B.
utility
C.
util, marginal utility, and total utility
D.
profits
E.
short run versus long run
F.
fixed costs versus variable costs
G.
risk versus uncertainty
Briefly contrast the labor theory of value with that of the subjective theory of value.
Explain the concept of diminishing marginal utility.
Explain the intuition underlying the utility maximizing condition.
Using Table 2: A Tabular Illustration of Rational Choice on page 38 and assuming that the
market price is 3, answer the following:
A.
At what quantity does the consumer maximize consumer's surplus?
B.
At the equilibrium quantity what is the total utility, the costs in utils, and the
consumer's surplus?
C.
How does the concept of consumer's surplus corroborate the invisible-hand
doctrine?
Identity several areas where the concept of rational choice may apply.
Identify several problems with the concept of rational choice. Identify an activity that is
rational, yet morally repulsive.
Explain the prisoner's dilemma. What does the prisoner's dilemma imply for the concept of
rational choice? For the invisible hand doctrine?
How might government manipulate profits to induce business to engage in socially useful
activities?
Define profits. Discuss the role of profits in a market economy.
Distinguish between the short and long runs.
Explain the concept of economies of scale, identifying its underlying rationale. Explain the
concept of diminishing returns. How does it differ from economies of scale?
Chapter Four : The Laws of the Market: Demand and Supply
“The economic problem of society is . . . how to secure the best use of resources
known to any of the members of society, for ends whose relative importance only
these individual know. Or, to put it briefly, it is a problem of the utilization of
knowledge which is not given to anyone in its totality.”
Friedrich Hayek
The market is a wonder of social organization. Everyday millions of people get the goods
and services they desire through the market system. I don’t have to grow my own food. Instead, I
can hunt and gather at the grocery store. I don’t have to walk to the store. Instead, I can purchase a
car. The market reduces the costs of providing those things that otherwise we would have to
provide ourselves, or more likely, go without. Millions of people buy, sell, and hustle one another to
get the best possible deal. This gives rise to phenomena of almost infinite complexity.
Understanding market phenomena become easier if we assume the existence of certain laws
governing market processes. The laws of the market refer to the laws of demand and supply.
Demand and supply are the vehicles so to speak through which individuals and firms express their
preferences. If people decide that beef-pot pies yield more utility than spam, the change in
preferences will manifest itself in a rising demand for beef-pot pies, and a declining demand for
spam. All other things held constant, the price of pot pies will rise, and the price of spam will fall.
But to understand this situation we must first understand supply and demand.
Demand and Supply
The law of demand is defined as follows: there exists an inverse relationship between price and
quantity demanded. This means that as price rises, all other things held constant, quantity demanded
falls. Quantity demanded is the amount that a purchaser will buy at a given price.
The law of supply is defined similarly: there exists a positive relationship between price and
quantity supplied. The intuition is common to everyone: as price rises the quantity that suppliers are
willing to supply rises as well, because opportunities to earn profits are now greater.
The Laws of the Market: Demand and Supply 49
Table 4 indicates quantity demanded and quantity supplied at different prices. The relationPrice
Quantity
Quantity
Demanded Supplied
Qd = 10 - P
Qs = P
0
10
0
1
9
1
2
8
2
3
7
3
4
6
4
5
5
5
6
4
6
7
3
7
8
2
8
9
1
9
10
0
10
Table 4: Demand and Supply
as price increases quantity demanded
ship between quantity demanded and price in this example is
based on the following demand equation: Qd = 10 - P. If for
example the price is seven, then based on the demand
equation quantity demanded is three. Quantity demanded is
obtained by plugging in the specified price into the equation
above.
The equation underlying the supply function is as
follows: Qs = P. In this case, quantity supplied is equal to
price. For example, at a price of eight quantity demanded is
two; quantity supplied is eight. At a price of two quantity
demanded is eight; and quantity supplied is two. Note that
declines, expressing an inverse relationship. And conversely
for supply, as price rises so too does the quantity supplied, expressing a positive relationship. Both
the supply and demand functions are graphed below.
Equilibrium
The concept of equilibrium is among the more important concepts in economics. The concept
comes from classical physics. Literally, equilibrium means no tendency to change; there exists a balance
of forces. The concept of equilibrium is applied in
different areas in economics. As applied to supply
10
and demand, the equilibrium price is defined as fol-
9
are willing to purchase equals the quantity producers
are willing to supply. Or more simply, it is that price at
which quantity demanded equals quantity supplied (Qd =
Qs). The word willing denotes the notion that the
7
6
Price
lows: it is the price at which the quantity consumers
Supply
8
4
Demand
3
equilibrium price is that price that both suppliers
2
and demanders agree upon. In this sense, the notion
1
of equilibrium price incorporates the concept of the
Equilibrium
5
0
0
1
2
3
4
5
6
Quantity
7
8
Figure 4: Demand and Supply
9
10
50 The Laws of the Market: Demand and Supply
invisible-hand doctrine. In brief, it is the price that maximizes the satisfaction of both parties.
In Table 4 quantity demanded
Rents
equals quantity supplied at a price of five.
$2,000
Hence, five is the equilibrium price. At a
$1,800
price of eight, quantity supplied exceeds
quantity demanded. There exists a glut of
goods,
which
tends
to
push price
$1,400
$1,200
$1,000
$800
quantity supplied is less than quantity
$600
demanded, which tends to push price
$400
upward.
$200
is evident when we impose a price ceiling
or price floor. A price ceiling is defined as
the price above which the market price is
Supply
$1,600
downward. Conversely, at a price of two,
The tendency for price to change
Demand
Shortage
$0
0
20 40 60 80 100 120 140 160 180 200
Qd
Qs
Housing
Figure 5: Rent Control
prevented from rising. In contrast, a price
floor is defined as the price below which the market price is prevented from falling.
Rent control provides a nice example of a price ceiling. Assume for the moment that the
equilibrium price for a basement apartment in Manhattan is $1000. Government officials note that
there are many homeless people in Manhattan, and in an effort to help them imposes rent controls.
The price of a basement apartment now costs only $600. The graph indicates what happens. The quantity demanded for housing increases, as everyone rushes to rent inexpensive housing. But how do the
landlords react? Upon receiving only $600 for their apartment, which previously rented for a $1000,
landlords choose to reduce maintenance. Some may choose to abandon their apartments altogether.
As the quantity supplied of housing declines, fewer people can obtain housing at the regulated
price. The very people that the government was trying to help, namely the poor, are harmed.
The Laws of the Market: Demand and Supply 51
Minimum wage provides a
nice example of a price floor. The
Wage Rate
$8.00
government decides that it wants to
$7.20
help the poor by imposing minimum
$6.40
wages for unskilled workers. Assume
$5.60
for the moment that the equilibrium
$4.80
wage is three dollars. Government de-
$4.00
cides to impose a minimum wage of
$3.20
five dollars. What is the result? Many
$2.40
people who would not work for three
$1.60
dollars decide to work for five dollars.
$0.80
But how do employers react? The
$-
minimum
wage
of
five
dollars
increases their costs, which in turn
reduces their profits. They decide to
Supply
Demand
Surplus
0
20 40 60 80 100 120 140 160 180 200
Qd
Qs
Labor
Figure 6: Minimum Wage
hire fewer workers than before. The result is that many people who are looking for jobs at five
dollars an hour cannot find anything. In fact, some of those who were content to work at three
dollars an hour find themselves unemployed. Again, the very people whom the government tried to
help are in fact hurt.
The examples of rent control and minimum wage are in fact conservative applications of
supply and demand analysis. For example, the idea that minimum wage leads to unemployment is
not so obvious. A liberal might respond that since workers are now earning more, and since poor
people tend to spend what they earn, profits in the aggregate will not decline. The reasoning is this:
while costs increase owing to the greater expense, so do revenues, leaving profits unchanged.
52 The Laws of the Market: Demand and Supply
Shift versus Movement
Abortion
Regardless of one’s position on the issue of
abortion, everyone prefers fewer abortions to
more. People differ, however, on the policies used
to reduce abortions. The Utah legislature, along
with many others, has generally chosen to reduce
(shift) the supply of abortions. This is
accomplished by making abortions illegal,
withdrawing public funds for abortions,
discouraging abortions, and so on. The effect is
that women must pay more to have an abortion by
going out of state, have an illegal abortion, or have
the child.
Another alternative, however, is to reduce
the demand (shift) for abortions. In this country
our approach to reducing demand is summarized
in the phrase “just say no.” While this may work
for some, many others are not persuaded. In
contrast, Holland has been very effective in
reducing the demand for abortions. Holland has
combined aggressive sex education with the
widespread dissemination of birth control. The
result: Holland has the fewest number of teenage
abortions, the fewest number of teenage
pregnancies, and fewest numbers of sexuallytransmitted diseases of any industrialized country.
It is important to differentiate between
a change in quantity demanded (movement
along the demand curve), and a change in
demand (a shift in the demand curve). A
change in quantity demanded is caused by a
change in price alone. A shift in the demand
curve is caused by a change in one of the
nonprice determinants of demand: (1) tastes
and preferences, (2) income, (3) prices of
related goods, (4) expectations, and (5)
population. For example, if expectations
change this will cause the entire demand curve
to shift inward or outward.
Imagine
if
Saddam
Hussein
announced that he had a doomsday device
with which he would destroy the world in six
months. How would you react? On Wall
Street stock prices would plummet, as
everyone tried to unload their stocks. People
would quit their jobs, travel, and have a good time. But what would the pilot of the airline do? The
baggage handler? The waiter? Everyone trying to enjoy the last few months of life would plunge the
economy into chaos.
The distinction between a change in demand and a change in quantity demanded arises
because quantity demanded is a function of several variables. The only two variables indicated on
the graph, however, are price and quantity. A change in a variable not on the axes is indicated by a shift in
the curve. The entire demand curve either moves inward or outward. A change in a variable on the either axis is
indicated by a movement along the curve.
The Laws of the Market: Demand and Supply 53
Figure 7 shows the distinction between a shift and a movement. A shift in demand is
Figure 7: Shift versus a Movement
Price
a
P1
b
P2
D’
D
Q1
Q2
Quantity
indicated by a movement of the entire curve from D to D’, caused by an increase in population,
income, or some other non price variable. A movement along the demand curve, however, is caused
by a change in price, say a decline in price from P1 to P 2.
In formulating predictions economists usually invoke the ceteris paribus assumption. Ceteris
paribus means all other things held equal. Hence, if income increases we would expect that demand
would increase, ceteris paribus. The importance of such an assumption should be clear: if other
variables, say population, were changing, then an increase in demand may not occur. The decline in
population may counteract the effect of an increase in income. Many variables changing at once
reduce our ability to predict the affect that one variable has upon another.17
The distinction between a shift in supply and a movement along the supply curve is
analogous to that of demand. A movement along the supply curve is caused by a change in price. A
shift in the supply curve is caused by a change in one of the nonprice determinants of supply: (1)
technology, (2) expectations on part of entrepreneurs, (3) taxes and subsides, (4) prices of the factors
of production, and (5) the number and size of firms. For example, in 1972 a calculator that could do
17
Economists do not have the luxury of controlling variables, as they do say in chemistry. The chemist can
control for pressure, temperature, purity, salinity, and so on to determine the effect that one chemical has on another.
The economist cannot. The ceteris paribus assumption offers a "measure of control," enabling the economist to
predict what would happen if we had control. Our lack of control have led many to argue that economics is not an
experimental science.
54 The Laws of the Market: Demand and Supply
the most basic functions cost approximately $150. Today, a comparable calculator that is faster and
smaller costs less than $10. Despite the increase in demand for calculators, the price has fallen owing
to advances in technology, shifting the supply of calculators far to the right.
Elasticity
Should the telephone company raise its prices? Should your college or university continue to
raise tuition? Why does Smith's promise the "lowest overall prices?"
Behind the scenes those who manage these organizations are asking the following questions:
will raising or lowering prices raise revenue (dollar value of sales)? In many situations the answer is
yes. But raising prices may also reduce revenue. Why? Intuitively, if raising prices raises revenue,
then why do many firms in fact lower prices? What is going on?
These issues relate to the concept of elasticity. Elasticity measures the percent change of one
variable in response to a one percent change in another. The concept of elasticity has many
applications in economics: the responsive of quantity demanded to price, quantity supplied to price,
quantity demanded to income, and so on.
The price elasticity of demand is defined as the percent change in quantity demanded
resulting from a one percent change in
Cigarette Use and Elasticity
price. Its importance arises because it
For any firm the problem is this: how do
we increase revenue? Some cigarette companies
allegedly found that they could increase revenue by
making their product more desirable. Research has
proven that nicotine is as addictive, if not more so,
than heroin. Hence, in order to make the demand
for cigarettes more inelastic, some cigarette
companies allegedly laced their cigarettes with
additional nicotine. By making cigarettes more
addictive, cigarette purchases became less
responsive to price increases. Those addicted had
to have their smokes. Hence, raising prices caused
a relatively small decline in cigarettes purchased.
The result: more revenue and higher profits
informs the firm the effect that a change in
price has on its total revenue. Increases in
price do not always lead to increases in total
revenue. They may lead to a fall in revenue.
There are three classifications of the
price elasticity of demand: elastic, unitary
elastic, and inelastic. Disregarding the sign,
an elastic demand curve is characterized by
an elasticity greater than 1. A change in
price leads a large response on part of
quantity. Hence, an increase in price leads to a decline in revenue because of a precipitous drop in
quantity sold, while a decrease in price leads to an increase in revenue because of a large increase in
quantity sold. For example, if the demand curve for higher education is elastic having an elasticity of
The Laws of the Market: Demand and Supply 55
ten. In this case a one-percent increase in tuition (price) leads to a ten percent decrease in enrolled
hours (quantity demanded). Revenue falls. To increase revenue the college should in fact reduce
tuition.
More than likely, however, the demand for higher education is inelastic. An inelastic demand
is characterized by an elasticity of less than one. A percent change in price leads a smaller percent
change in quantity demanded. Hence, an increase in price leads to an increase in revenue because
percentage decrease in quantity is less than the percentage increase in price. A decrease in price
reduces revenue because of the percentage decline in price exceeds the percentage increase in
quantity demanded.
If the elasticity equals 1, the demand curve is said to be unitary elastic. A change in price has
no effect on total revenue, because the percent change in quantity and the percent change in price
are the same. An elastic demand leads a large response on part of quantity. Hence, an increase in
price leads to a decline in revenue because of a precipitous drop in quantity sold, while a decrease in
price leads to an increase in revenue because of a large increase in quantity sold.
What determines whether a demand curve is inelastic or elastic? The greater the number of
substitutes, the more elastic the demand curve. Logic dictates that a store manager would increase
his revenues by putting on sale those items for which there are many substitutes such as ivory soap,
not those items for which there are few substitutes, such as dialysis machine, scuba gear, or
economics classes.
The concept of elasticity is much more general than students think. For example, we could
inquire regarding the elasticity of roses. An elastic relationship suggests that giving roses to a loved
one evoke a considerable degree of affection on part of the recipient. An inelastic response suggests
that giving roses evoke little affection. In some cases, it could even evoke antipathy. Similarly, an
elastic relationship suggests that lobbyists who make donations to politicians evoke a large number
of political favors. Where as an inelastic relationship may evoke few if any favors. Of course, from
the politician’s viewpoint an elastic relationship may land him in jail; an inelastic relationship may
cost him or her the election. The trick, as always, is to find the golden mean.
56 The Laws of the Market: Demand and Supply
Figure 8: Elastic and Inelastic Demand Curves
Price
Price
Demand for Gas
Demand for Burritos
P2
P1
Q2
Q1
Burritos
Q2 Q1
Gas
We can illustrate the concept of elasticity of demand as follows. Observe Figure 8. An
increase in price evokes a large cutback on goods purchased. An increase in price from P 1 to P2
causes the quantity demand to fall from Q1 to Q2.. What type of good might this be? One in which
there is considerable competition. For example, if La Frontera doubled the price of its smothered
chile verde burrito, most patrons would probably go elsewhere. Sales at La Frontera would
plummet, while sales at the Red Iguana rise. Even Taco Time might pick up a few patrons.
But if the price of gas rose, people would continue to purchase almost the same amount.
Why? Because there are few substitutes for gas. So why doesn’t government regulate the price of
gas? Because believe it or not there is some degree of competition among gas producers (I know, it's
hard to believe, but this is the argument).
The fewer the substitutes, the more inelastic the demand curve. For example, there are few
substitutes for natural gas. As a profit-maximizing firm, it is in the firm's interest to charge a high a
price. Because of the lack of substitutes, the government regulates utilities in order to protect the
public.
Elasticity is not the same thing as slope. Slope, however, is a good indicator of elasticity. The
steeper the slope the more inelastic the demand curve. And conversely, the flatter the slope the
more elastic the demand curve.18
18
Mathematically, the elasticity of a particular point on the demand curve is the slope of the demand function
divided by the average at that point. The average is found by determining the slope of a ray drawn to that point on
the demand curve.
The Laws of the Market: Demand and Supply 57
Income elasticity refers to the percent change in quantity demanded in response to a percent
change in income. With regard to income elasticity we are interested in the sign. For a normal good,
an increase in income leads to an increase in quantity demanded. If your income rises, you purchase
more jazz tickets, or buy more steak. For an inferior good, however, as income rises you buy less of
the good. For example, as income rises you buy fewer beef-pot pies, or less spam.
58 The Laws of the Market: Demand and Supply
Review Questions
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
IX.
X.
XI.
Define or discuss:
A.
law of demand
B.
law of supply
C.
non-price determinants of demand
D.
equilibrium
E.
price floor
F.
non-price determinants of supply
G.
elasticity
H.
ceteris paribus
Distinguish between a shift in demand and a change in quantity demanded.
Given the following:
Demand curve: Qd = 12 - P
Supply curve: Qs = 2P
A.
Make a schedule relating price, Qd, and Qs.
B.
What is the equilibrium price?
C.
What happens if government imposes a price of 8?
D.
What happens if government imposes a price of 2?
How does the concept of equilibrium price relate to the invisible-hand doctrine?
Discuss the implications of a price floor and a price ceiling. (use graphs). Give examples.
Identify three real-world examples of how changes in non-price determinants of demand or
supply affect price. Show graphically.
Explain the concept of the elasticity of demand. Why is it important?
Assume that the elasticity of your college is .5. Would you recommend raising tuition to
increase revenue? Or lowering tuition? Explain.
Generally speaking, in the summer months the price of tomatoes generally falls. And in the
winter months, the price of tomatoes rises. How might the decision to raise or lower the
price of tomatoes be influenced by changes in the elasticity of demand? Explain.
Define the income elasticity. Give some examples of a normal and an inferior good.
Analyze unemployment from both a Marxist and a supply and demand point of view.
Which theory bests explains unemployment? Are these theories reconcilable?
Chapter Five : Market Structures: From Competition to Monopoly
“The essence of competition is its impersonal character. No one participant can
determine the terms on which other participants shall have access to goods or
jobs."
Milton Friedman
"The initiative in deciding what is to be produced comes not from the sovereign
consumer who, through the market, issues the instruction that bend the
productive mechanism to his ultimate will. Rather it comes form the great
producing organization which reaches forward to control the markets that it is
presumed to serve and, beyond, to bend the customer to its needs."
John Kenneth Galbraith
Do consumers inform corporations what to produce? Or do corporations tell consumers
what to purchase? Do firms compete? Or do they avoid competition? Do firms have a responsibility
beyond earning profits? Or in earning profits do firms automatically perform their social responsibilities? These questions relate to concept of market structures, that is, the environment in which
firms exist.
Firms that compete with many other firms behave differently from those that do not compete.
In part, the reason for the different behavior arises from the structure of the market itself. Market
structure refers to the number of firms, the size of firms, whether firms can move easily into or out of
an industry, and so on. There are four different type of market structures: perfect competition,
monopolistic competition, oligopoly, and monopoly.
Perfect Competition: The Unreal Ideal
Most economists use the perfectly competitive model to evaluate market processes. They use
the model not because its assumptions are realistic, but because theoretically perfect competition
maximizes social welfare. That is, it maximizes the utility of all individuals in society because it
produces the most goods at the lowest prices.19
Four assumptions underlie the perfectly competitive model. First, relatives to other market
structures there exist many buyers and sellers. There are so many that no single firm can influence
19
There are exceptions to the notion that perfect competition maximizes social welfare. The exceptions occurs with
respect to economies of scale, which is considered below in the discussion of monopoly.
60 Market Structures
price. Each firm takes the market price as given. Second, we assume perfect information. Each firm
has the latest technology, and the latest information regarding the location of productive factors.
Third, we assume free exit out of and free entry into the industry. No barriers exist to prevent you
from initiating a business selling lemonade, manufacturing cars, or whatever. Fourth, we assume a
homogenous product. There is no difference in the mind's eye between one firm's product and that
of another firm's. Hence, advertising becomes unnecessary.
The assumptions underlying the perfectly competitive model are highly restrictive. Again,
economists use the model not because it approximates reality; rather, they use it because they believe
that the more reality approximates the assumptions of the model, the better off society. The policy
implications of the perfectly competitive model should be evident: laissez faire. Intervention is
justified if the assumptions underlying the model are not met. Hence, perfect competition serves as
the rationale for anti-trust laws, and the basis for government deregulation of the airlines, AT&T,
and so on.
Monopolistic Competition: Between Competition and Monopoly
The assumptions underlying monopolistic competition are the same as those under perfect
competition with one exception. In monopolistic competition we assume that products are
heterogeneous, not homogenous. Each firm's product is similar to, but slightly different from, every
other firm's. The similarity among the various products means that the firm competes; but the firm has
a monopoly over its particular product. Hence, monopolistic competition is an oxymoron, a synthesis
of both competition and monopoly.
The monopoly over one's own product means that the firm has some monopoly power, that
is, it has some control over price. Influence over price means that the monopolistic competitor finds
it profitable to advertise. An example of a monopolistic-competitive industry might be Mexican
restaurants. There are many Mexican restaurants in Salt Lake Valley, and many different burritos,
but there is only one La Frontera burrito.
Despite the higher price, monopolistic competition has one important advantage over
perfect competition: diversity. The assumption of heterogeneity means that there are many more
different but similar products to choose from. One can also purchase a burrito from Taco Time, the
Red Iguana, and so on. If all burritos were homogenous, as under perfect competition, the perfectly
competitive price would be lower. The higher price is the price society pays for greater choices.
Market Structures 61
Oligopoly: The Other Reality
Oligopoly means few sellers. Oligopoly best describes the US economy. There are probably
hundreds of cereals on the isle of your local grocery. But how many firms produce those cereals?
Probably three or four.
The assumptions underlying oligopoly are as follows. First, as noted we assume few sellers.
The concept of few is ambiguous, but the notion is that a few firms have considerable economic
power, although there may be many firms in the industry. Second, there exist barriers to entry. Even
if you, say, wanted to begin to produce cars, there are many factors that may prevent you from
doing so. First, there are financial barriers. The bank may refuse to extend you the $500 million
necessary to begin automobile production. Second, government regulatory agencies may prohibit or
restrict the types of cars you can produce. Third, patents may prevent you copying a particular form
of carbueration that you want to use, and copyrights may prevent you from using the "mustang" as a
logo. Fourth, economies of scale may exist meaning that small-scale producers may need to charge
such high prices that no one buys their automobiles.
Economies of scale helps to explain the observation first noted by Marx that there is a
tendency for firms to become larger over time. The big fish eat the little fish. Initially, most
industries are fairly competitive. Over time, some firms are able to extend their division of labor
thereby producing the same product at lower per-unit cost. Total costs may rise, but per-unit costs
decline. As per-unit costs decline, the firm reaps excess profits. At some point the firm may choose
to undercut its competitors, driving them into bankruptcy. Or the firm may choose to buy them out.
As the firm becomes an oligopolist or a monopolist, entrepreneurs who would like to enter the industry find their path blocked. They cannot produce the same product at a competitive price with
such small output. A classic example of economies of scale is Standard Oil Company founded by
John D. Rockerfeller in the 1870s.
Monopoly: The Other Ideal
Monopoly requires the following assumptions. First, a single seller of a good for which there
are no close substitutes. And second, there exist barriers to entry. In this regard a monopolist is similar
to an oligopolist. The difference is that the monopolist does not compete, even in a limited sense. The
monopolist is the industry. The implication is that there is nothing to prevent the monopolist from
62 Market Structures
restricting output to raise prices. Because of this society has chosen to regulate the monopolist to
prevent it from earning excess profits, and gouging the public.
There are in fact few pure monopolists. The assumption of a seller of a single good for
which there are no close substitutes is somewhat ambiguous. For example, Utah Power and Light
and Mountain Fuel are usually viewed as monopolists, and as such they are regulated. But could one
argue that natural gas and electricity are in fact substitutes? If so, then Utah Power and Light and
Mountain Fuel cannot be monopolists. Another clear example of monopoly is the sale of concessionaires at concerts. At Park West, for example, you cannot bring coolers or food to concerts. The
reason is not because of the trash, but because food and beverages brought from home compete
with concessionaires sold at concerts. The
monopoly over the sale of beer, for example,
enables Park West to raise its price to $2.
Monopolies restrict choice. Not only must you
pay $2 for a glass of beer, but you must drink
Coors.
Evaluating Market Structures:
What’s Best?
Economists
competitive
model
use
the
to
evaluate
perfectly
market
structures. The assumptions and implications of
the different market structures are summarized
in the table below.
Standard Oil Company
John D. Rockerfeller founded the Standard
Oil Company in June 1870. From its beginning,
the company's refinery had more capacity than its
competitors. Such capacity enabled Rockerfeller to
demand a rebate from the railroads on the oil he
shipped, or lose his business. The resulting profits
were plowed back into the firm. Rockerfeller cut
costs by reducing dividends, building his own barrels, and buying his own tank cars.
Running oil at sixty cars a day, Rockerfeller
reduced freight time from Cleveland to New York
from thirty days to ten days. Standard Oil Company became so big that Rockerfeller demanded
the railroads pay him a kickback on the oil shipped
by his competitors. Rockerfeller was able to
accomplish this by taking advantage of economies
of scale.
Rockerfeller was ruthless in his business
dealings. If a rival lowered its price below that of
Standard Oil Company, Rockerfeller did ". . . not
hesitate to consider the lower price a declaration of
war and to drop its prices and keep them down
until the rival is out of the way. The price then
goes back to the former figure or higher . . . ."
The Standard Oil Company became the
first modern monopoly, with extraordinary power
at a time of no taxes or regulation. As a result of
Rockerfeller's abuses--bribing politicians, paying
off judges, and destroying the property of his competitors--Congress
created
the
Interstate
Commerce Commission to ensure fairness in
transportation.
Assumptions
Implications
Perfect
Competition
1. many buyers
and sellers
2. perfect
information
3. free exit and
entry
4. homogenous
products
1. Maximizes
social
welfare.
2. Produces the
greatest
output at the
lowest price
Monopolistic
Competition
1. many buyers
and sellers
2. perfect
information
3. free exit and
entry
4. heterogeneo
us products
1. Price higher
2. Offers
consumers
more
choices
3. Firms
differentiate
their product
by
advertising
Oligopoly
Market Structures 63
Monopoly
1. few sellers
2. barriers to
entry
1. single seller
2. barriers to
entry
1. Price higher 1. Price higher
than under
than under
perfect
perfect
competition.
competition.
2. Size enables 2. Size enables
firm to take
firm to take
advantage of
advantage of
economies
economies
of scale.
of scale.
3. Often leads
to collusion
Recall that perfect competition maximizes the welfare of society at the competitive price, the
intersection of supply and demand. Recall too from the discussion of individual choice that the demand curve is simply the marginal utility curve. Moreover, the market demand curve is the horizontal
summation of all the individual demand curves. The market demand curve, then, can be interpreted as
a marginal benefit curve, the benefit to society of producing one more unit. The marginal benefit of
one more unit is represented on the graph by the vertical distance between the horizontal axis and the
demand curve. The total area underneath the demand curve up to the quantity produced represents the
total benefits (social welfare) of producing up to that point.
Similarly, the supply curve represents the marginal costs to society, the cost to society in
terms of land, labor, and capital to produce one more unit. The marginal cost to society is
represented by the vertical distance between the horizontal axis and the supply curve. The total area
underneath the supply curve up to the quantity that is produced represents the total costs to society
of producing up to that point.
64 Market Structures
Moving from a quan10
can demonstrate that the
9
equilibrium price maximizes
8
social welfare. For each unit
7
produced to the left of
6
Pm
5
Ppc
1
The vertical distance between
0
Qpc
400
300
200
0
Qm
1000
exceeds the costs to society.
900
2
800
ety from producing that good
700
3
600
the additional benefit to soci-
500
exceeds marginal cost, that is,
4
the horizontal axis and the
Supply
(marginal cost)
Demand
(marginal benefit)
100
equilibrium, marginal benefit
Price
tity of zero to equilibrium we
Quantity
demand curve is greater than
the vertical distance between
the horizontal axis and the
Figure 9: Comparing Perfect Competition with Monopoly
supply curve. Hence, the benefits of each unit produced prior to equilibrium exceed the costs of each
unit. And after equilibrium, costs of an additional unit exceed the benefit, indicating that social welfare
is declining. Therefore, social welfare is maximized at equilibrium.
Under perfect competition the industry produces at Qpc, charging a price at Ppc. Since
perfect competition results in equilibrium, perfect competition maximizes social welfare.
What happens to social welfare under monopoly? Monopolies, you will recall, restrict output
in an effort to increase profits. The result is that output is less, and price is greater than under
perfect competition. On the graph the monopolist charges Pm, output is at Qm. At Qm marginal
benefit exceeds marginal costs. By producing more goods, social welfare could be increased. But
because of the monopoly, social welfare is less thereby demonstrating the inefficiency of monopoly.
Or put differently, social welfare is less under monopoly because price is higher and output less than
under perfect competition.
Market Structures 65
The Static and Dynamic Concepts of Competition
Perfect competition conveys a static view of the market. Under competitive conditions price
tends towards equilibrium. A rising price signals older firms to increase output, and new firms to enter
the market. Falling prices have the opposite effect. Some economists, however, consider this view too
simplistic. Perfect competition excludes a dynamic view of the competitive process.
A dynamic view of competition is more akin to Darwin's theory of natural selection. Those
firms that survive provide products that society want, those that do not fail.
But here we may read a lesson form the young trees of the forest as they
struggle upwards through the benumbing shade of their older rivals, Many succumb
on the way, and a few only survive; those few become stronger with every year, they
get a larger share of light and air with every increase of their height, and at last in
their turn they tower above their neighbors, and seem as though they would grow on
for ever, and for every become stronger as they grow. But they do not. One tree will
last longer in full vigour and attain a greater size than another; but sooner or later age
tells on them all. Though the taller ones have a better access to light and air than
their rivals, they gradually lose vitality; and one after another they give place to
others, which, though of less material strength, have on their side the vigour of
youth.20
What factors determine which firms will grow to their full vigor? There are, of course,
various theories about this. Two perhaps of the more interesting and opposite views are presented
by Joseph Schumpeter and John Kenneth Galbraith. Schumpeter contends that it is the alertness
and actions of the entrepreneurs that ensures the firm’s survival; Galbraith contends that it is the
firm’s ability to control markets.
Schumpeter: Competition and the Process of Creative Destruction
Perfect competition assumes that firms compete based on price. If one firm sells for a price
higher than the others, sales fall to zero, for consumer could buy the same product for less.
Monopolistic competition is more sophisticated. Many buyers and sellers compete by selling
differentiated goods for which there are many substitutes. Price differentials reflect different but
similar products. Hence, firms compete on the basis of price, product differences, new products,
new technologies, and so on. But what about the monopolist? By definition isn’t he insulated from
competition? And doesn’t this insulation result in higher prices, less output, and an overall reduction
20
Marshall, Principles of Economics, p. 263.
66 Market Structures
in social welfare? Isn’t this the justification for regulating the monopolist? Or better yet, breaking
him up?
Joseph Schumpeter contends that competition characterizes free markets regardless of the
market structure. The theory of perfect competition implies that firms compete based on price. In
contrast, Schumpeter agues that firms are susceptible to competition from technological advances.
Firms compete based on innovations. No firm, not even a monopolist, is insulated from the “winds
of creative destruction.”21 A new innovation--new technologies, new techniques, new ways of doing
things--represents an alternative form of competition. That is, the entrepreneur creates new
products, develops new markets, implements new productive techniques, introduces new forms of
industrial organization, and so on. An innovation initiates a . . . “process of industrial mutation . . .
that incessantly revolutionizes the economic structure from within, incessantly destroying the old
one, incessantly creating a new one. This process of Creative Destruction is the essential fact about
capitalism. It is what capitalism consists in and what every capitalist concern has got to live in. It is
innovations that provide "the fundamental impulse that sets and keeps the capitalist engine in
motion."
The development and introduction of innovations ultimately depends on the entrepreneur's
freedom to earn profits. Economic freedom is the basis for competition, and the vehicle for dynamic
change. Schumpeter's conception of competition is dynamic. Even the monopolist, whose excess
profits represent the reward for successful innovation, is not exempt from competition. But
Schumpeter is not talking about competition in the form of price, although that is the manner in
which it manifests itself. Instead, Schumpeter refers to competition that results from innovations. In
Schumpeter’s words, “. . . the competition from the new commodity, the new technology, the new
source of supply, the new type of organization (the largest-scale unit of control for instance)-competition which commands a decisive cost or quality advantage and which strikes not at the
margins of the profits and the outputs of the existing firms but at their foundations and their very
lives. This kind of competition is as much more effective than the other as a bombardment is in
comparison with forcing a door, and so much more important that it becomes a matter of
comparative indifference whether competition in the ordinary sense functions more or less
21
J. A. Schumpeter, Capitalism, Socialism, and Democracy (New York: Harper & Row), 1942.
Market Structures 67
promptly; the powerful level that in the long run expands output and brings down prices is in any
case made of other stuff.
It is hardly necessary to point out that competition of the kind we now have
in mind acts not only when in being but also when it is merely an ever-present threat.
It disciplines before it attacks. The businessman feels himself to be in a competitive
situation even if he is alone in his field or if, though not alone, he holds a position
such that investigating government experts fail to see any effective competition
between him and any other firms in the same or a neighborhood field and in
consequence conclude that his talk, under examination, about his competitive
sorrows is all make-believe. In many cases, though not in all, which sill in the long
run enforce behavior very similar to the perfectly competitive model.
In the nineteenth century the canal owners in New England had a virtual monopoly on
transportation. Roads were filled with ruts and frequently muddy making the transportation of heavy
bundles difficult at best. The canal owners made exorbitant profits. The introduction of the railroads
effectively broke the monopoly of the canal owners. Twenty years ago AT&T had a monopoly on
communication. The demise of AT&Ts monopoly stemmed less from the antitrust suit, than from new
technologies.
For Schumpeter, monopoly profits are the reward for successful innovation. Monopoly
profits are the price society pays for successful innovations that it enjoys. Take away the profits and
you remove the incentive to develop innovations.
J.K. Galbraith: Corporation and Economic Planning
Schumpeter’s view implies that despite the existence of monopoly the market remains
competitive. The monopoly may be the only seller, but the threat of new entrants checks the
monopolist’s control over prices. In the extreme case of perfect competition, the existence of other
firms selling the same product means that if the firm that raises its price it will sell nothing. Revenues
fall to zero, and the losses incurred forces the firm to reduce its price. Or new firms will enter the
market in an effort to duplicate the success of the firm that raised its price. Again, the discipline of the
market will force prices to fall.
Galbraith, however, contends that competition is not the norm. Most industries are characterized by few sellers, not many. Information is incomplete, not perfect. Products are heterogeneous,
not homogenous. And most industries have major barriers to entry. How easy is it to begin
producing automobiles, for example.
68 Market Structures
Galbraith argues that the economy is
divided into two parts: one part fairly
competitive comprised of a few million small
firms. The other part is dominated by a few
hundred
corporations.
Moreover,
these
corporations, far from taking price as given,
seek to set their price. In effect, Galbraith
argues that the part of the economy
dominated by the corporations is a "planned"
economy.
Firms
try
to
avoid
competition.
Competition means that firms have little or no
control over price. Hence, they have little
control over profits. Moreover, competition
tends to be destabilizing by leading many firms
to produce more goods than the market can
bear, resulting in declining prices and profits.
The expensiveness of modern invest-
Advantages of Corporations
Corporations emerged in the late
nineteenth century as a new means of financing
investment. The new technologies such as the
railroad required huge sums of resources. Very few
single proprietorships or partnerships could raise
the funds necessary to undertake such
investments. Traditionally, investment had been
financed from savings, or retained earnings, or a
loan from the bank.
Corporations offered a new means of
financing investment through the issuance of
stock. As a result huge sums of investment could
be undertaken. Stocks enable millions of
individuals to pool their financial resources in
order to undertake investment.
Corporations offer another advantage:
limited liability. From a legal point of view
corporations are individuals. The corporation can
be sued, but not the owners of the corporation.
Their assets are protected. Interestingly, up until
the 1960s the fourteenth amendment, which
protects the rights of individuals from state
intrusion, had been used far more to protect
corporations than to protect individuals.
ment, the time lag between investment and return, the increase in risk, and so on all required a high degree of planning. Moreover, firms sought to control both the output market and the input markets.
Control over output is possible through the dependence effect. The dependence effect is the idea that
peoples wants depend on the corporation. The corporation is motivated by profit. Profit arises from
selling more output. This in turn requires fostering wants so people will buy the output.
Market Structures 69
Some economists have argued that corporations have too much power. Their power enables
them to influence the legislative process in
their favor.
Marketing Mistake
In effect, the size of large corporations
enables them to avoid the discipline of market
forces. Nowhere is this more evident than
with the opportunity to receive government
bailouts.
Government bailouts occur when the
government provides financial credit or cash
infusions to an ailing business. Why would
government
undertake
such
infusions?
Advertising products generally pays off
handsomely. But there are some notable
exceptions. In an effort to increase demand for its
product Pepsi-cola offered one million Philippine
pesos ($40,000). The effort worked. Pepsi sales
increased dramatically. Pepsi announced the winning number, 349. The problem, however, was
that 839,000 caps were issued with the number
349. When Pepsi refused to pay riots broke out,
law suits were submitted, and so on. Demand for
Pepsi has since declined, and Pepsi officials fear
for their life.
Because policy makers believed that the failure of large businesses would catastrophically affect the
economy. The number of businesses and workers that would be put out of work is as a result is
politically unacceptable.
In October of 1979 Chrysler sustained a quarterly loss of $460 million. Total losses up to
that time were $721 million. Chrysler attributed its losses to government regulations, gas shortages,
and the recession. Chrysler was the 11th largest corporation in America, employing 130,000 people.
Another quarter of a million work for Chryslers suppliers. The cost of allowing Chrysler to fail were
estimated at close to $3 billion in lost tax, revenues, unemployment, welfare, and so on. Chrysler’s
loss would also adversely affect the balance of payments. Wages paid to Chrysler workers and
suppliers in the state of Michigan approximated $5 billion. "The initial shock to the Michigan
economy of a Chrysler bankruptcy would throw 165,000 individuals out of work either from
Chrysler or from suppliers. ... It would cost the state more than $200 million in revenue annually."
Lee Iacoca, chairman of Chrysler at the time, said the best thing that Congress can do to mitigate
unemployment and help revive the cities is to provide Chrysler with the necessary loans.
Chrysler is not the only major corporation to receive bailouts. In 1984, Continental Illinois,
the eighth largest bank in the US, experience problems. Depositors concerned about a risky
investment strategy withdrew their deposits. Rather than let Continental Illinois fail, the government
pumped in $8 billion, with access to more money if needed. The Reagan administration defended
the action based on the size of the bank. The cost to the economy if such a large business failed far
70 Market Structures
exceeded any cost to the government by keeping it open. Congressman Stewart McKinney remarked
that "We have a new kind of bank. It is called too big too fail, and it is a wonderful bank."
Another form of government bailouts is in the form of import restrictions. In the 1970s the
steel industry had become antiquated; management did nothing to introduce new innovations. When
threatened with competition form imports the steel industry lobbied congress to restrict imports.
The costs of protecting the steel industry from 1978 to 1982 is estimated at $4.35 billion. In 1984
the Fair Trade in Steel Act was passed establishing specific quotas for the importation of steel. The
cost to the consumers: $18 billion in hire prices and welfare losses. Restraints on Japanese cars have
for many years resulted in higher auto prices, in effect, representing a bail out of American auto
manufactures.
A third form of government bailouts lies in regulatory delays. For many years America's
automobile makers put off having to meet clean air standards. Their argument: meeting the
standards would negatively affect profits, having devastating affects on the economy.
Market Structures 71
Review Questions
I.
II.
III.
IV.
V.
VI.
VII.
Define or discuss:
A.
perfect competition
B.
monopolistic competition
C.
oligopoly
D.
market structure
E.
monopoly power
F.
monopoly
G.
static view of competition versus the dynamic view
H.
creative destruction
I.
dependence effect
J.
corporation
Discuss the advantages of perfect competition relative to the other market structures.
Try to identify examples of each market structure. How well does reality fit the assumptions
of the models.
What is Schumpeter’s argument that monopolies are subject to competitive forces? Identify
examples.
Distinguish between Schumpeter’s view of market processes with that of Galbraith.
What is Galbraith's rationale in arguing that the market is controlled?
What do we mean by government bailouts? Find examples. Should the government bailout
large corporations?
Chapter Six : Economics of the Environment
“Anyone who believes exponential growth can go on forever in a finite world is
either a madman or an economist.”
Kenneth Boulding
"A man is on a boat. He is not alone, but acts as if he were. One night, he begins to
cut a hole under his seat. His neighbors shriek: 'Have you gone mad? Do you want
to sink us all?' Calmly, he answers them, 'What I'm doing is none of your business.
I paid my way. I'm only cutting a hole under my own seat.' What the man will not
accept, what you and I cannot forget, is that all of us are in the same boat."
Elie Weisel, winner of the Nobel Peace Prize in 1986
The relationship between the economy and the environment is self-evident. Nature provides us
with raw materials, and absorbs our wastes. We depend on the environment for the air we breathe, the
food we eat, and the water we drink. We cut its forests for lumber; dig its entails for coal, ore, and
minerals; and displace other species with new developments.
Over time we have become complacent, taking the things that nature provides us for
granted. We want more goods: more automobiles, bigger houses, more things. In a word, we want
growth. Growth brings jobs, revenue, and development. But more for us means less for nature, and
therein lies the tradeoff. How do we satisfy our desire for more without destroying the
environment? Is our present form of civilization fundamentally incompatible with environmental
quality?22 Is the source of this incompatibility, at least in part, traditional economic theory?
Nature as a Commodity
Until recently, we have ignored our impact upon the environment. People continued to trash
the highways until the 1960s; individuals thought nothing of dumping used motor oil on the ground;
gas station owners found it cheaper to allow their storage tanks to leak gasoline than to repair the
tanks; and rivers served as the nation's sewers. Even today, unless forced relatively few of us recycle.
Our traditional disregard for nature is reinforced by the ideology of the invisible hand.
Theoretically, in pursuing our own self-interest everyone benefits. But for the invisible hand, nature
is just another commodity. Nature in and of itself has no value. Nature only has value as lumber to
build, land to develop, or ore to mine. To transform nature into a commodity is to allow the market
to work as though the economic system is somehow independent of the environmental system.
22
See Herman E. Daly and Jr Cobb John B., For The Common Good: Redirecting the Economy Toward
Community, the Environment, and a Sustainable Future (Boston, Mass.: Beacon Press), 1989.
Economics of the Environment 73
This "independence" is expressed in the
The Tragedy of the Commons
simple model of the economy as depicted in the
The idea of limited resources underlies
what has come to be known as "the problem of
the commons." The commons refers to that
which is owned by no one; hence, everyone
owns it. We can illustrate the problem with the
following story.
Once upon a time there were a group
of sheep herders who let their sheep graze on
the common field. The grass in the field was
bountiful, so much so that the sheep flourished
without the sheepherders having to put forth
any effort. The sheepherders receive a benefit,
and because the field was so large no one felt
infringed upon by the sheep of others. But as
more sheepherders grazed their sheep upon the
field things began too change. The
sheepherders continued to receive a benefit, but
the bounty of the field declined. The additional
sheep meant that there was less for them too
eat. But so long as the shepherds received a
benefit without bearing the cost, they continued
to add additional sheep. One day, however,
there was nothing left for the sheep to eat, and
the shepherds found themselves in ruin.
The problem is perplexing. For the
commons implies that each individual takes as
much as he or she can, while avoiding the costs.
In time, the resource is depleted, and everyone
loses.
circular flow. The model is comprised of two
groups: households and firms; and two markets:
the input market and the output market.
Households consume the goods and services;
firms produce them. Households purchase the
outputs of firms in the output market. Money
flows to firms in exchange for goods that flow
to households. Firms purchase the inputs
supplied by households in the input market. The
inputs supplied by households include land (a
generic term for nature) labor, and capital. In
theory, the value of the output equals the value
of the input. The concept of production may be
depicted as follows:
Inputs  production  outputs
Implicitly, nature is an input, infinite in
quantity. If oil runs out, not to worry. As oil
supplies decline, the price of oil rises. This
provides incentive to entrepreneurs to find
additional oil, or to find alternatives. This,
however,
rests
on
a
series
of
tenuous
assumptions: the assumption that markets always work, that technology will ultimately save us from
ourselves, and the assumption that substitutes will be found (the assumption of infinite
substitutability).
Our dependence on nonrenewable resources raises questions regarding how long we can
continue the current rate of resource depletion. In the 1970s the Club of Rome, a group of
distinguished scientists, published Limits to Growth warning people about the coming disaster. The
Club of Rome predicted the depletion of many resources within 40 years. Their predictions proved
incorrect, but their central point remains: how long can the present rate of growth continue?
The idea that there are limits to growth finds its origins in the Malthusian Theory of
Population. Food increases arithmetically; population increases geometrically. At some point the
population outstrips nature’s ability to support it. But is Malthus’ theory right? What is the basis for
arguing that food increases arithmetically? England is an island. Hence, the idea that food increases
at an arithmetic rate stems from the assumption that land is limited. The assumption underlying the
Club of Rome’s predictions and those of others stems from essentially the same assumption:
resources are limited.
Conditions for a Sustainable Economy
Setting aside whether advocates of the market are right or the doom-sayers, perhaps we can get
at the environmental problem from another vantage point. What are the conditions for a sustainable
economy? How can we keep current rates of economic growth going?
As noted, nature plays two roles: both as provider of natural resources into the production
process, and as a sink to absorb wastes. This prompts two questions. First, what is the optimum use of
natural resources in order to sustain economic growth? And second, how much pollution can nature
absorb?
We can distinguish two types of natural resources: renewable resources and nonrenewable
resources. Renewable resources are resources that may be replenished, such as a forest.
Nonrenewable resources cannot be renewed. Their supply is fixed. Once gone, they are gone
forever. Such resources include coal, oil, and so on. The problem is that at present use society may
run out of both types of resources.
There are three conditions for a sustainable environment. First, the harvest of natural
resources must be less than the growth of those resources. Obviously, if the harvest rate exceeds the
growth rate the resource will soon be depleted.
Second, nonrenewable resources are by definition nonrenewable. Hence, in order to sustain
the economy we must gradually substitute renewable resources for nonrenewable resources. We
must, in the long run, find alternatives. Reserves of coal are estimated at 500 years, and reserves of
oil are estimated at less than 100 years. Ultimately, this means that to sustain the economy, we must
switch to some form of solar energy, either by tapping sunlight directly, or using plants that trap
sunlight.
Economics of the Environment 75
And third, we must not pollute more than nature's ability to absorb our pollution. Nature's
resilience is impressive. However, the products created by modern society do not easily breakdown.
Plastic milk cartons last 100 years; plutonium may last 50,000 years before breaking down. Many
steel products may never breakdown.
Externalities
The neoclassical approach to the problem of pollution is expressed in the theory of
externalities. Externalities are costs or benefits involuntarily transferred from one party or parties to
another. Externalities represent a breakdown in the market. Market transactions are voluntary.
Unanimity exists between buyer and seller regarding price and quantity.
Externalities may be positive or negative. With a positive externality the actions of one
person benefit another person without that person having to pay for the benefit. If your neighbor
keeps his yard clean, with beautiful flowers and gardens year round such that it raises the property
values in the neighborhood, you receive a benefit for which you did not pay. Or imagine that you
are walking along the beach, and a very beautiful woman (or man) barely clothed smiles at you
alluringly. This causes you great pleasure, without you having paid for it. To correct this breakdown
in the market you should proceed to offer this person a sum of money corresponding to the
happiness received. (At least, this is your defense as you are hauled away to jail.)
Negative externalities are more serious. Negative externalities impose unwanted costs on
society, resulting in declines in social welfare. The Exxon Valdiz that spilled 13 million gallons of
crude oil is a classic externality. The millions of people who were distraught over having one of the
most pristine fjords in the world covered with black slime is an externality of major proportions.
Even though they may not have been affected directly (although gasoline prices skyrocketed in the
weeks following the disaster) they nevertheless suffered a pain knowing the destruction it caused.
Those individuals, however, who lived from catching salmon suffered both from the ruined
aesthetics and loss of income.
Economics generally treats externalities as the exception. Externalities may in fact be the
rule. Many things occur in the course of our lives, both good and bad, which we did not request.
Our displeasure over apartheid in South Africa, or our pleasure over the manner in which our
neighbor dresses are both examples of externalities. Externalities, insofar as they are the rule, are a
sign of our interdependency.
Negative Externalities
To reiterate, externalities are costs or benefits involuntarily imposed on one party as a result of
the activities of others. Externalities imply a breakdown in the market. Goods and services are not
produced at their minimum costs. The graph below provides and example of a negative externality. As
noted, the demand curve represents the marginal benefit to society; the supply curve the marginal cost.
At equilibrium the benefits to society of the last unit produced just equals the cost to society of
producing that unit. If the production of that commodity, however, creates pollution, then the market
price does not reflect the costs to society. The problem lies in the supply curve. The supply curve
represents the costs to the firm in
terms of expenditures on land, labor,
12
Supply plus
Pollution costs
11
10
Demand
and capital. It does not include the
costs of pollution. In other words,
9
Supply
Price
8
given pollution the free market
7
misallocates resources: too much is
6
produced for a price that does not
5
reflect the costs to society. Hence,
4
social welfare is not maximized.
3
The
2
supply
curve
plus
900
1000
Quantity
800
700
600
500
400
300
costs to society, the costs to the firm
200
0
100
pollution costs represent the social
0
1
plus the costs of pollution. The
intersection between the demand
Figure 10: Externalities
curve and the supply curve plus
pollution costs indicate that output
should be less than the free-market quantity, at a price exceeding the free-market price.
This provides an economic rationale for government intervention in order to correct the
externality. This is the theoretical basis for emission tests, pollution control equipment, and so on.
There are several options available to government to deal with the problem of externalities:
taxes and subsidies, standards, and marketable permits. Until recently, environmental laws generally
imposed a fixed standard to which all businesses must conform. Standards have, however, received
criticism. They are arbitrary; coercive; and disregard differences in impacts and local conditions.
Economics of the Environment 77
Some economists advocate permit trading to avoid many problems with standards.
Introduced with the Clean Air Act of 1990, government issues so many permits allowing businesses
to emit so much pollution. The business has the option of buying the permit, or reducing his
pollution. Both involve a cost. Theoretically, the business will make that choice that minimizes his
cost. But the advantage of permits is that it offers to the business an incentive not to pollute. As the
price of permits rise, businesses may find it profitable to sell their permits and install pollutioncontrol equipment. Other that do not have permits may do the same than to buy the permit.
Positive Externalities
Externalities are not always bad. In the case of a positive externality the market demand curve
does not reflect the true benefits to society from the commodity. Examples include pollution-control
equipment, or to take a nonenvironmental example vaccinations against INFLUENZA. Those
individuals inoculated against the flu obviously benefit from the inoculation. But so too do those who
are not inoculated, since their chances of contracting the disease are now less. Hence, they receive a
benefit for which they did not pay.
The implication is that at equilibrium the benefit of the last inoculation exceeds the cost.
More inoculations would increase social welfare, but market forces provide a disincentive to more
inoculations. Resources are misallocated because price does not reflect the true benefit to society;
the benefit is in fact higher. To correct this externality government should subsidize the production
of flu vaccines. A similar argument rationalizes why those without children should pay for the
education of those with children. Society as a whole benefits from an educated populace.
There are numerous examples of externalities which government could help correct.
Government can through the manipulation of the tax structure adjust market signals to better reflect
the benefits of positive externalities, and the costs of negative externalities. Unfortunately, Congress
and the President have been reluctant to do so.
Conclusion
Perhaps the conditions for economic efficiency are incompatible with the viability of the
environment. Economic efficiency does not mean technological efficiency. Economic efficiency means
minimum cost, technological efficiency means minimum wastes. The United States from an economic
point of view is efficient. From a technological point of view we are very inefficient. The average
American throws out in a day what the average person in the Roman Empire threw out in a year. In
contrast, the average citizen of Nepal is technologically very efficient. Using Yak dung as fuel for
cooking is not only efficient, but burns hot for long periods of time.
Kenneth Boulding characterized the modern world as a "spaceship earth." 23 There is only
one earth, and when the earth is no longer usable, there are no substitutes. He believed that The
ideology that we can consume forever originated in the “frontier economy” of the past. It is no
longer relevant to a society that has seen the earth as a small blue sphere hanging in a black void.
23
Kenneth E. Boulding, "The Economics of the Coming Spaceship Earth," in Collected Papers: Volume Two:
Economics, ed. Fred R. Glahe (Boulder, CO.: Colorado Associated University Press), 1971, 383-94.
Review Questions
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
IX.
X.
XI.
XII.
What are the two economic functions of the environment?
Is our present form of civilization fundamentally incompatible with environmental quality?
Take a position yes or no and develop it.
What is the role of nature in the simple model of the economy as depicted in the circular
flow.
Explain the market solution to the problem of running out of resources? Upon what
assumptions does this argument depend?
What is the tragedy of the commons
A.
Explain the tragedy in terms of marginal utility and marginal costs.
B.
Identify examples of the tragedy.
C.
What solutions can you come up with?
What are the conditions for a sustainable economy?
What are some of the problems of achieving a sustainable economy?
Distinguish between economic efficiency and technological efficiency?
What does Boulding mean by his metaphor "spaceship earth?"
Define externalities. In what sense do externalities represent a breakdown in market
relations? (Hint: what is the principle underlying market relations?)
Distinguish between positive and negative externalities, giving examples of each.
Using graphs briefly explain how externalities misallocate resources. What implications do
these misallocations have for the role of government?
Chapter Seven : Distribution of Income
“Live simply so that others may simply live.”
Mahatma Ghandi
" . . . the distribution of the income of society is controlled by a natural law, and
that this law, if it worked without friction, would give to every agent of
production the amount of wealth which that agent creates."
John Bates Clark
Few issues evoke more controversy than discussions regarding the distribution of income.
For income directly affects people's access to goods and services. Income makes possible those
things necessary for a quality life: education, health care, shelter, food, and so on. And yet, such
things are beyond the incomes of many people. Why? What factors determine the income that we
receive? Why does a teacher earn $20,000 a year and a CEO of a major corporation $20,000,000? Is
this fair? Is income distribution becoming more equitable? or less?
There are two possible sources of income in our society. First, income may result from
government largess in the form of grants, welfare, and so on. While the reasons are political in
nature, such largess stem from attempts to redress some perceived inequity. And second, income
may be the result of providing productive factors: land, labor, or capital. This chapter is concerned
with the second source of income. Our objective in this chapter is to examine the neoclassical
explanation of distribution, an alternative explanation as expressed in the segmented labor force
theory, and offer some empirical findings.
Marginal Productivity Theory of Distribution
The neoclassical theory of income distribution, referred to as the marginal productivity theory
of distribution, applies the theory of perfect competition to the purchase of productive factors. Recall
there are four assumptions underlying perfect competition. As applied to the distribution of income,
these assumptions mean the following. First, there are so many buyers and sellers that no one firm or
individual can influence income received. No individual acting alone can influence the level of wages,
profits, interest, or rents. Second, factors of production are homogenous such that no distinctions exist
among different types of labor. An unemployed doctor, for example, competes with an unemployed
janitor for jobs. Third, perfect information such that firms know where to find factors, and factors of
Distribution of Income 81
production know where to find the best jobs. And fourth, free exit and entry meaning there are no
barriers to entering, say, the medical profession.
The theory assumes that the allocation of factors is already given. That is, the allocation of
labor, capital, and land is taken as given and hence fair. In the factor market firms seek to maximize
profits (hence, minimize costs) and owners of productive factors seek to maximize utility (hence,
income). Firms become the buyers, individuals the sellers.
Demand for Productive Factors
Firms purchase productive factors in order to produce goods and services. Productive
factors are the inputs necessary to produce outputs. In theory, employing an additional factor of
production--an additional unit of land, labor, or capital--increases output, assuming all other things
held constant. The increment in output from employing an additional unit of input is called the
marginal product. At the same time, in employing an additional factor the firm incurs a cost. In
maximizing profits, the firm employs productive factors up to the point that the additional value
created by employing an additional factor equals the additional cost of the factor. More formally, the
equilibrium condition for the purchase of productive factors is this: the firm purchase additional
factors up to the point that the value of their marginal product (price of the output times the
marginal product) just equals the price of the factor. Each factor purchase prior to this point yields
more value than it costs. And each factor purchased after yields less. No firm will hire a worker
whose wages exceed the value that the worker creates.
Table 5: Marginal Productivity of Distribution
Labor
Output
Marginal
Product
Output Price
0
1
2
3
4
5
0
5
9
12
14
15
5
4
3
2
1
$10
$10
$10
$10
$10
$10
Value of the
Marginal
Product
$0
$50
$40
$30
$20
$10
Factor Price
$20
$20
$20
$20
$20
$20
82 Distribution of Income
The table above illustrates the theory.
Note as we add additional units of labor,
output increases but at a decreasing rate. The
first unit of labor added increases output to
five units, hence the marginal product is five.
The value of the marginal product is $50, the
costs to the firm is $20. The firm proceeds to
hire a second worker. Output increases to
nine units; the marginal product of the
second worker is four; the value of the
marginal product is $40; the costs to the firm
is $20. The firm will hire four workers. The
firm will not hire the fifth worker, because
the costs to the firm exceed the value that the
fifth worker generates.
Supply of Productive Factors
Individuals supply factors because
the return from the supply of the factor
exceeds the cost. Labor, however, becomes a
particularly interesting case. Theoretically,
individuals have two choices: they may
Are Americans Overworked?
Juliet Schor in a book entitled The Overworked
American argues that the amount of time that
Americans work has risen steadily over the past
twenty years. Technology was to give us more time,
more leisure, making our lives easier. What has
happened?
Schor points out that since 1948 productivity,
defined as output per how, has more than doubled.
We could have the same level of output as that in
1948 by working only half as much. “Or, every
worker in the United States could now be taking
every other year off from work—with pay.”
Why haven’t Americans enjoyed my leisure
time? Schor contends that it is because American
have such an abundance of goods available to them.
Corporations spend millions of dollars trying to get
Americans to buy their products, from the latest
computer to the latest fashion. “Americans have been
found to spend more time shopping than anyone else.
They also spend a higher fraction of the money they
earn. And with the explosion of consumer debt, many
are now spending what they haven’t earned.”
Second, corporations don’t give Americans
much opportunity to take leisure time. “The
overwork that plagues many Americans, especially
married women, springs form a combination of fulltime male jobs, the expansion of housework to fill the
available hours, and the growth of employment
among married women.”
choose to spend their time working, or their time in leisure. The choice between leisure and work is
assumed rational. Individuals find work irksome, leisure pleasurable.
Individuals work for income. Hence, they continue to supply labor so long as the disutility of
work is less than the utility derived from their income. As their income rises, the marginal utility of
income (the additional satisfaction from earning one more dollar) declines. At the same time, as they
work longer, the marginal disutility of labor (the additional dissatisfaction of working one more
hour) rises. Hence, a decline in wage rates would mean a decline labor supplied. At the same time, a
rise in the wage rate means an increase in labor supplied. At some point, however, as the wage rate
Distribution of Income 83
increases individuals choose to purchase more leisure. Hence, increasing the wage rate may at some
point lead to a decline in labor supplied.
Human Capital
Human-capital theory attributes differences in the distribution of income to differences in
productivity. Enhanced productivity is the result of human capital. That is, productivity results from
training, education, and so on.
Human-capital theory draws an analogy between investment in capital and investment in
human beings. Capital yields a return on investment, and the same is true for people. People invest
in themselves through job training or by obtaining an education. Presumably, individuals do so
because they believe that the enhanced future earnings exceed the expense of obtaining an
education. The investment pays off in the form of higher-paying jobs. In brief, human-capital theory
suggests that income is proportional to education.
The empirical data is clear on this issue. There is a relationship between education and
income. But do the higher paying jobs associated with higher education result from individual choice
as suggested by neoclassical theory? Or are their cultural factors that lead certain groups to obtain an
education?
Segmented-Labor Force Theory
The segmented labor-force theory rejects the marginal product theory of distribution. Income
distribution is a matter of culture, not productivity. It is a matter of who you know, not what you
know.
The theory argues that the labor force is not homogenous but segmented. College graduates
do not compete against high school dropouts. They are in separate groups. There is a core group
who receives good paying jobs, benefits, and educational opportunities. And there is a peripheral
group who has low-paying jobs, few benefits, and few educational opportunities. Moreover,
opportunities to move from the periphery to the core are relatively few. Hence, most workers are
stuck in doing relatively unskilled jobs for which they are paid very little.
The theory does not reject the idea of human capital. Rather, those who invest in human
capital already have an advantage. Their parents, ethnic group, and so on value education to begin
with. They already have relatively high incomes, and steady jobs. The associated institutions channel
the children of these people into the core. The same is true for those in the periphery: their parents,
84 Distribution of Income
ethnic group, and so no place a low value on education. Hence, they face greater obstacles in
moving into the core group.
Table 6: Income Distribution Among Families
Empirical Findings
on the Distribution of
Income
Table 6 indicates
changes in the distri-bution
of income in the United
1968
5.7
12.4
17.7
23.7
40.6
Lowest fifth
Second fifth
Third Fifth
Fourth fifth
Highest fifth
Top 5%
1980
5.10
11.60
17.50
24.30
41.60
1989
4.60
10.60
16.50
23.70
44.60
1995
4.1
9.9
15.7
23.3
47
20.3
States since 1968. For example, the table indicates that in 1968 the lowest fifth of families received
5.7% of the income. By 1989 their income had fallen to 4.6%. The lowest forty percent of the
population received only 18.1% of the income in 1968, by 1989 that had fallen to 15.2%. Over the
same time period, the highest fifth of families received 40.6% of the income in 1968. By 1989 their
incomes had risen to 44.6%.
The same information is presented in the graph below. The straight line indicates an equal
distribution of income. The further from the straight line, the more inequitable the distribution.
Percent of families is read on the horizontal axis, percent of income on the vertical axis. The indicates
the percent of income that different percentages of the population receive. For example, sixty percent
of the population receives approximately 35% of the income.
Figure 11: Percent of Income Distributed to Familes
100%
Percent of Income
90%
80%
70%
60%
1989
50%
1980
40%
30%
20%
10%
0%
0%
20%
40%
60%
Percent of Families
Figure 12
80%
100%
Distribution of Income 85
Figure 13: Income Distribution for 1995
50
45
40
Percent of Income
35
30
25
20
15
10
5
0
Lowest
Second
Third
Fourth
Highest
Top
Using data for 1995 summarized in Table 6 we find that the distribution of income among
families has become even less equitable. The lowest fifth of the population receives only 4.1 % of the
income. While the highest fifth earns 47% of the income. The Highest fifth earns just under what
80% of the rest of the population earns. The top 5% of families earns 20.3 % of the income, more
than what the bottom 40% earn. The median income for a family in the United States is
approximately $38,000.
Concluding Remarks
According to the marginal productivity theory, each individual receives the value of his or her
contribution to production. Income, therefore, reflects the value of one's contribution. If you receive
no income, your either contributed nothing or your contribution was not valued by society. From this
point of view, the drug lord who earns $10,000,000 per year contributed far more value than the firstgrade teacher who earns $20,000 per year.
86 Distribution of Income
There are two possible explanations for the differences in income between men and women.
First, women earn less than their male counterparts because women are less productive. The lower
income that women receive reflects their smaller contribution.24 Second, women earn less than their
male counterparts because of discrimination. This discrimination may take several forms. Women
may be prevented from making a fuller contribution. Or their contribution may not be as valued
because of their sex. Or custom and tradition may channel women in jobs that are not as valued.
The notion that individuals receive an income corresponding to their contribution is an
interpretation, a reflection of the underlying ideology that many of us share. We view our incomes as
a measure of how society values our contribution. In this regard, income affects one's self-worth.
Hence, differences in income, insofar as they reflect differences in the value contributed, represent a
moral evaluation. Those with high incomes contributed more in terms of value, hence, those
individuals are more valuable. This is reflected in differences in which wealthy individuals and those
of more moderate means are treated at restaurants, before our criminal justice system, and so on.
24
Some researchers reject this view, pointing out that women in fact do 70% of the work in the world.
Distribution of Income 87
Review Questions
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
IX.
X.
XI.
What are the two economic functions of the environment?
Is our present form of civilization fundamentally incompatible with environmental quality?
Take a position yes or no and develop it.
What is the role of nature in the simple model of the economy as depicted in the circular
flow.
Explain the market solution to the problem of running out of resources? Upon what
assumptions does this argument depend?
What are the conditions for a sustainable economy?
What are some of the problems of achieving a sustainable economy?
Distinguish between economic efficiency and technological efficiency?
What does Boulding mean by his metaphor "spaceship earth?"
Define externalities. In what sense do externalities represent a breakdown in market
relations? (Hint: what is the principle underlying market relations?)
Distinguish between positive and negative externalities, giving examples of each.
Using graphs briefly explain how externalities misallocate resources. What implications do
these misallocations have for the role of government?
88 Measuring Output, Employment, and the Price Level
Chapter Eight : Introduction to Macroeconomics: The Big Picture
“The fatal metaphor of progress, which means leaving things behind us, has
utterly obscured the real idea of growth, which means leaving things inside us.”
G. K. Chesterton
“Economic growth may one day turn out to be a curse rather than a good, and
under no conditions can it either lead into freedom or constitute a proof for its
existence.”
Hannah Arendt
“You take my life
When you do take the means whereby I live.”
William Shakespeare
Capitalism is first and foremost a vehicle for economic growth. At the end of WWII only half
the households in this country had automobiles; virtually no one had a television set; and the interstate
system had yet to be built. Today, most households own two cars; 97% of them have television sets;
and the interstate, once touted as the solution to our transportation problems, seems woefully
inadequate. As Americans we like growth; we like the benefits it brings; and we are very desirous that it
continue.
As a society how do we maintain economic growth? How do we ensure that businesses earn
sufficient profits to produce the goods and services that people buy? How do we provide jobs to
ensure that people have the income to buy those goods and services? How do keep the prices of
those goods and services from rising or falling? These questions are the subject of macroeconomics.
More formally, macroeconomics is the study of the determinants of income, employment, and the
price level. All macroeconomic theories are concerned with increasing income, providing
employment, and stabilizing prices. They differ, however, in how best to achieve these goals.
Conversely, macroeconomics is also concerned with understanding the absence of economic
growth, and the ensuing poverty that its absence can bring: breadlines, bankruptcies, unemployment,
bank closings, and so on. In turn, such poverty on a mass scale results in social unrest, crime,
suicides, and potentially revolution. The depression of the 1930s saw both Hitler and Mussolini rise
to power. People are more receptive to a political ideas when politicians put bread in their mouths,
even ideas that today we find loathsome.
Measuring Output, Employment, and the Price Level 89
As a discipline separate from microeconomics, macroeconomics stems from the Great
Depression of the 1930s. Specifically, we find its origins to the efforts of economists, particularly John
Maynard Keynes, to understand the causes of the Depression, and suggest policies to resolve it.
Today, however, we face a very different set of problems from that experienced by those
living in the depression. How, for example, should we deal with a rising government deficit? Should
we pass a balanced budget amendment? Or would such an amendment make it more difficult to
resolve another depression should one occur? Prices are stable now. But is there a possibility of
worse inflation as the Fed anticipates? Or is the threat instead one of deflation? All of us want prices
to fall, unless of course one of those prices happens to be your income. And while we presently are
enjoying an economic boom, why have the incomes of most American not increased? Why is the
median income today not much more than it was in 1974?
The structure of our economy is also very different from that which existed during the Great
Depression. First, we are becoming increasingly global. The shoes we wear are made in Tawaiin, the
computer we use in Japan, the car we drive from Mexico. What we do affects them; and what they
do affects us to a far greater extent than ever before. Second, our jobs have changed. Only 3% of us
farm anymore versus 20% in the 1930s. Fewer of us work in steel mills, coal mines, or automobile
plants. Manufacturing has found cheaper labor overseas, forcing more of us find jobs in service
industries: working at McDonalds, selling shoes, or advising clients on the best investments. What
does the transition to a service economy mean for sustaining economic growth? Third, the role of
government has changed profoundly since the great depression. Government is a major force in the
economy, spending at all levels 1/3 of the economy’s output. The employment act of 1946 formally
established the government’s responsibility to maintain economic growth. Moreover, institutions
now exist to short circuit an economic collapse: deposit insurance, unemployment insurance, welfare
programs, social security, and so on, not to mention the sheer magnitude of government spending.
All these points suggest that a depression could not happen again. Still, others thought the same in
the past, and have been surprised.
Measuring Output, Employment, and the Price Level
There are various measures of economic output, employment, and the price level. The purpose
of these measures is to provide information to policy makers, businesses, and individuals regarding the
90 Measuring Output, Employment, and the Price Level
economic well being of the nation. It offers us an indication of the economy's past and present
performance. And it helps us project, however difficult, where the economy is heading.
Output
The most famous measure of economic output is gross domestic product (GDP). Prior to
1992 the most important measure of economic welfare was gross national product (GNP). GDP is
defined as the value of all final goods and services produced within an economy in one year. GDP is a
measure of currently produced goods and services. It excludes financial transactions, transactions of
goods produced in previous years, and transfer payments.
The difference between GDP and GNP is slight. GDP measures the output of the domestic
economy. GDP adds to GNP the income of foreigners earned domestically, and subtracts out the
income of domestic citizens earned abroad.
A second measure of economic output is net domestic product (NDP). NDP is equal to GDP
minus depreciation, that is, minus investment expenditures used to replace worn out capital goods.25
GDP can be measured two ways. The first approach is called the expenditure or product
approach. The approach is self-explanatory: GDP is determined by measuring the expenditures of
various groups in the economy: consumers, entrepreneurs, government, and exporters and importers.
That is, we measure consumer expenditures (C), investment expenditures (I), government expenditures
(G), and net exports, exports minus imports (X-M). GDP = C + I + G + (X-M).
25
For other measures of national output see the U.S. Statistical Abstract or the Economic Report of the President.
Measuring Output, Employment, and the Price Level 91
110%
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1930
Net Exports
Government
Investment
Consumption
35
40
45
50
55
60
65
70
75
80
85
90
95
Figure 14: Components of GDP--The Expenditure Approach
Consumer expenditures are broken down into expenditures for nondurable goods such as food
and clothing, durable goods such as automobiles, and services. Investment expenditures are broken
down into expenditures for capital goods, inventories, and new construction. Government
expenditures include all government spending excluding transfer payments such as social security and
the like. Exports are goods that other nations buy from us; imports are goods we buy from other
nations. Net exports (X - M) is referred to as the trade balance.
The graph above breaks down GDP into the various forms of products. The largest
component of GDP is consumption, which hovers on average around 67% of GDP. Notice that
during the depression years of the 1930s, consumption as a percentage of GDP was relatively high,
indicating that as incomes fell, individuals sought to maintain former spending levels. During WWII
consumption fell dramatically. There was little to buy, goods were rationed, and individuals were
encouraged to buy war bonds.
Investment spending is the most volatile part of GDP. Note that during the Great-Depression
years of 1932-34, investment spending was almost nonexistent. Investment was also slight during
WWII, explained largely by the dramatic increase in government spending that crowded out both
investment and consumer spending. While investment spending has been strong since WWII, the
trend indicates that as a percentage of GDP investment is declining.
92 Measuring Output, Employment, and the Price Level
In contrast, government expenditures on goods and services26 has remained relatively constant
since WWII at approximately 22%. And finally, net exports (exports - imports) was positive until 1982,
meaning that up to 1982 the United States had a balance of trade surplus. Since then, however, we
have run a balance of trade deficit.
1
0.95
Interest
Corporate Profits
0.9
0.85
Rents
0.8
Propretor Income
0.75
0.7
Farm Income
0.65
0.6
Emplyee Compensation
0.55
0.5
30
35
40
45
50
55
60
65
70
75
80
85
90
Years
The second approach to measure GDP is called the earnings or income approach. It sums the
Figure 15: The Income Approach
costs incurred in producing goods and services. In this case GDP is the sum of wages (employee
compensation), profits, rents, interest, and indirect business taxes.
The graph below examines the income components of GDP expressed as a percentage of
national income. In contrast to GDP, national income excludes indirect business taxes and transfers to
foreigners. As a percentage employee compensation is the greatest, comprising approximately 70% of
national income (Note that the graph begins at 50%, in order to better see the trends in the other types
of income). Farm income over the years has been declining. Non-farm proprietor income, income of
small businesses owned as proprietorships or partnerships, has been steadily declining. Corporate
profits has been following this trend. Rents over the years have also declined. But net interest, that is,
interest on debt, has over the years been increasing.
26
Government expenditures on welfare is not included as government spending, but as spending on consumption
goods.
95
Measuring Output, Employment, and the Price Level 93
Both the decline in corporate profits and proprietor profits and the rise in net interest as a
percentage of national income warrant concern. Declining profits may portend declines in investment,
which in turn means slower growth, fewer additional jobs, and smaller increases in income.
Problems with GDP
The importance of GDP lies in its use as a measure of economic welfare, a measure of how
well the economy is doing. But there are some problems with using GDP in this sense. First, GDP
does not consider the distribution of income. A distribution of income that is less equitable than
another intuitively has a lower degree of social welfare, but this is not indicated in GDP. Second, GDP
does not account for changes in goods and services that people consume. Fifty years ago microwaves,
televisions, computers, and so on did not exist. Third, GDP does not consider increases in population.
If the population is rising faster than GDP, then economic welfare could be considered declining.
Fourth, GDP measures the economic value of the output of currently produced goods, nothing more.
GDP is inherently biased against non-economic values: the value of leisure, the value of wilderness
areas, the disseminates of urban living, and so on. And fifth, GDP does not include the economic costs
associated with pollution. The Exxon Valdiz oil spill, for example, actually caused an increase in GDP.
The habitat that was destroyed is not included in GDP. But Exxon's hiring of thousands of individuals
to wipe oil off rocks is included. Despite such problems, GDP is viewed as the single most important
measure of the economy's performance.
94 Measuring Output, Employment, and the Price Level
Real and Nominal GDP
$6,000
Billions of dollars
$5,000
$4,000
$3,000
$2,000
$1,000
$1930
35
40
45
50
55
60
GDP Current $
65
70
75
80
85
90
GDP Constant $
Figure 17
The graph above indicates GDP expressed in current dollars, and GDP expressed in constant
dollars since 1930. Current dollars are dollars unadjusted for inflation, constant dollars are adjusted for
inflation. While increasing, GDP in terms of real dollars indicates that GDP has been slowing down,
with nonexistent growth in 1974, 1982, and 1991.
Employment
Individuals in the work force are defined as those who have a job, who are not institutionalized
(such as a mental ward, prison, or college), and who are over 16 and under 65. The unemployed are
those individuals who are looking for a job but cannot find one. In other words, the unemployed are
involuntarily out of work.
Measuring Output, Employment, and the Price Level 95
25%
Unemployment rate
20%
Post-war
Inflation
30
15%
20
5%
65
1960
70
75
80
1990
60
1980
55
1970
50
1950
45
1940
40
1930
35
1920
30
10
-5%
1910
15
0%
1900
Inflation
Rate
25
10%
85
90
-10% 5
-20%
1890
-15% 0
Great
Depression
WWII
Korean War Inflation
Years
Years
Vietanm
Inflation
Oil
Embargo
Fed Induced
Disinflation
Figure 18: Unemployment over Time
Figure 18 shows the unemployment rate over time. During the Great Depression
unemployment increased to about twenty-five percent of the work force. By the early forties that rate
had fallen to around two percent. Since the unemployment rate has followed the business cycle, cycles
of economic booms and busts. But the long-term trend appears foreboding. The trend line indicates
rising unemployment. Moreover, the unemployment rate itself is somewhat deceptive. It only indicates
the percent of the labor force who do not have jobs. It does not indicate the kind of jobs that people
have. Structural changes in the American economy have led to a shift from industrial jobs to service
jobs, which typically pay less.
Price Level
The price level is defined as the average level of prices. A rising price level is called inflation; a
falling price level is called deflation. Both can be troublesome.
Inflation, particularly if it is unanticipated, hurts creditors, those on fixed incomes, and those
whose assets or incomes that rise less than the inflation rate. Creditors are hurt because debtors repay
95
96 Measuring Output, Employment, and the Price Level
their debts with dollars worth less than those they originally borrowed. Many people who purchased
homes in the 1960s benefited from inflation, Ronald Reagan among them. Those on fixed incomes are
hurt because inflation erodes their purchasing power. Although they receive the same number of
dollars as before (nominal income), they can buy fewer goods and services (real income) with those
dollars. Those whose assets or income increase in value at less than the rate of inflation are hurt for
similar reasons. Deflations have the opposite impact. Creditors benefit at the expense of debtors, those
on fixed incomes benefit, and those who hold dollars or dollar denominated assets.
During this century inflation has been the primary culprit. But during the nineteenth century
and during the Great Depression deflation was the problem. Figure 19 traces changes in the price level
since 1930. Note that 1987 is selected as the base year, since it is set equal to 100. This means that an
increase in the price level to 120 means an increase in inflation of 20%. On the other hand, a price level
of 20 indicates that things in 1987 cost five times as much as things, say, in WWII, and more that six
times as much during the depression years. During the depression years of the 1930s the price level
actually declined. The price level increased dramatically, after WWII. Inflation was moderate
throughout the 1950s and mid 1960s. By the late 1960s inflation began accelerating.
The data from the 1950s led one economist to hypothesize a tradeoff between unemployment
and inflation, a tradeoff that has come to be known as the Phillips curve. To reduce unemployment
policy makers must increase inflation. By the same token, reducing inflation means accepting hire levels
of unemployment.
By the late 1970s this tradeoff appeared not to the case. For both unemployment and inflation
increased, a situation called stagflation. By the 1980s, however, both inflation and unemployment had
moderated. By 1996 and 1997, unemployment and inflation achieved levels not seen since the early
1960s. Low inflation, low unemployment, and sustained economic growth has in fact led some
economists to argue that the business cycle is dead.
Measuring Output, Employment, and the Price Level 97
20%
15%
5%
1986
1976
1966
1956
1946
1936
1926
1916
1906
1896
-5%
1886
0%
1876
Percent Change in GDP
10%
-10%
-15%
-20%
-25%
Years
Figure 20: Business Cycle
Business Cycles: What goes up must come down
For at least two-hundred years the capitalist system has been plagued by business cycles, the
cycles of economic boom and depression. During much of that same time span, economists concerned
with macro issues have concerned themselves with explaining the causes of the business cycles, and
recommending policies to resolve them.
Figure 20 traces the annual changes in the business cycle since the 1880s. The business cycle
measures changes in GDP over time. The business cycle is comprised of four parts: the boom, peak,
recession, and trough referring to the rise, the top, the fall, and the bottom of the business cycle.
Economists have sought to predict the business cycle by examining certain "indicators." Leading
indicators indicate a future change in the business cycle, coincident indicators occur simultaneously,
and lagging indicators follow the changes in the business cycle.
Since WWII the American economy has sustained eight recessions, defined as two quarter of
negative growth. The ability of policy makers to counteract changes in the business cycle has not
98 Measuring Output, Employment, and the Price Level
proven very good. There are several reasons for this. First, there lacks a consensus regarding the proper
policy? Should government use fiscal policy (government's power to tax and spend) and monetary
policy (government's powers over the money supply). Or should government leave things alone?
Second, there lacks a consensus regarding what are the major economic problems. Should government
reduce unemployment? Fight inflation? Or reduce the federal deficit? Third, there is a lack of good
data. And fourth, the economy is a multivariate system. Like weather systems, there are many variables
interacting together. At present, out theories fail to take into account the complexity of the economic
system. In brief, they miss things that may in fact alter the outcome.
Much of Macroeconomic theory has, in one form or another, concerned itself with smoothing
out the business cycle. The ideal goal is to achieve full employment with no inflation, and rising real
incomes. The chapters that follow take up how best to achieve this goal in the following areas: classical,
Keynesian, monetarist, and supply-side.
Aggregate Demand and Aggregate Supply
Aggregate demand and aggregate supply curves are important for understanding the theoretical discussions in the chapters that follow. Aggregate demand expresses an inverse relation between the price level and the amount of economic output (or national income) that individuals plan
100
Aggregate Demand (AD)
90
80
70
60
50
40
Price30Level
20
10
0
0
10
20
30
40
50
60
70
80
90
100
GDP
Figure 21: Aggregate Demand
to purchase. The idea is that the higher the price level, the lower the amount of expenditures. Why?
There are several reasons. First, as the price level rises creditors raise interest rates to compensate
them for inflation. This, however, reduces borrowing, which in turn reeuce expendituers on part
Measuring Output, Employment, and the Price Level 99
consumers and firms. Second, as the price level rises wealth expressed in dollars declines. If people
are less wealthy, they buy fewer goods. And third, an increase in the price level makes foreign goods
a better buy. People buy more foreign goods and fewer domestic goods.
Aggregate supply expresses a positive relationship between the price level and planned
output. As such, aggregate demand and aggregate supply are analogous to the concepts of supply
and demand covered in Chapter 2.
Price Level
AS
100
90
80
70
60
50
40
30
20
10
0
0
10
20
30
40
GDP
50
60
70
80
90
Full
Employment
100
Figure 22: Classical Aggregate Supply Curve
There are three different types of aggregate supply curves, each depending upon the underlying assumptions. First, the classical economists assume that aggregate supply is vertical at full-employment income. The underlying assumption is that there is a tendency for GDP to be at full employment. Moreoever, wages and prices are flexible. Hence, increases in aggregate demand increase
prices, not output.
100 Measuring Output, Employment, and the Price Level
Price Level
100
90
80
70
60
50
40
30
20
10
0
AS
0
10
20
30
40
50
GDP
60
70
80
90
100
Figure 23: Keynesian Aggregate Supply Curve
Second, Keynesians assume that aggregate supply is horizontal up to full employment income, and then vertical at full employment. The horizontal aggregate supply curve reflects the
assumption that wages and prices are rigid. That is to say, wages and prices do not easily fall. In this
scenario, increases in aggregate demand prior to full employment have no impact on prices; but they
do serve to increase GDP.
Price Level
AS
100
90
80
70
60
50
40
30
20
10
0
0
10
20
30
40 50
60
70 80
90 100
110
GDP
Figure 24: Neo-Keynesian Aggregate Supply Curve
Measuring Output, Employment, and the Price Level 101
And third, the neo-Keynesians assume that the aggregate supply curve slopes upward prior
to full-employment output, and vertical at full employment. That portion of the supply curve that is
horizontal implies excess capacity in the economy; that portion that is upward sloping implies that
there are bottlenecks. That is, while certain key sectors of the economy may be at full employment,
the overall economy is not. Increases in demand in those sectors that are at full employment are reflected in price increases. That portion of the supply curve that is vertical means that increases in aggregate demand cause increases in prices not output.
102 Measuring Output, Employment, and the Price Level
Review Questions
I.
I.
II.
III.
IV.
V.
VI.
Define or discuss the following:
A.
inflation
I.
real income
B.
deflation
J.
cyclical unemployment
C.
unemployment rated
K.
frictional unemployment
D.
stagflation
L.
structural unemployment
E.
nominal income
M.
business cycle
F.
GDP
N.
Phillips curve
G.
NNP
O.
unemployment
H.
aggregate demand and
aggregate suppy
Discuss the who benefits and who loses in inflation
Discuss the two different ways of measuring GDP
Discuss the various problems with GDP as a measure of economic well being.
Define the aggregate supply and aggregate demand curves, explaining the underlying
rationale for their different shapes.
Distinguish between the two types of inflation, identifying their underlying causes.
What has been the long-run trend of inflation and unemployment?
Chapter Nine : Classical Economics as The Economics of Laissez Faire
“It is not from the brewer, the baker, or the butcher that we expect our dinner,
but from regard to their self love. We address ourselves, not to their
benevolence, but to their self-love, and never talk to them of our own necessities
but of their advantages.”
Adam Smith
The economic teachings of the classical economists—Adam Smith, David Ricardo, and John
Stuart Mill--taught that the market economy is natural. So long as individuals are allowed to pursue
their self-interest, everyone benefits. The capitalist receives his profit, the worker his wages, and the
consumer his goods. Business cycles are an aberration from the norm. Depressions are temporary
phenomena. There is no need for government intervention. If goods are unsold or workers
unemployed, prices will adjust until the surpluses are eliminated. Markets work.
How then do the classical economists explain persistent unemployment? Unemployment
results from barriers that keep wages from falling. The policy implication is that government should
remove such barriers: eliminate minimum wage laws, labor unions, and the like.
Historical Backdrop: Market Capitalism
The Industrial Revolution occurring in the 1790s and the early decades of the nineteenth
century in Britain ushered in the era of laissez-faire or market capitalism. The mercantilist system of
regulations impeded the dramatic increase in output and the increased need for inputs resulting from
the introduction of machines. Entrepreneurs needed to be freed from burdensome regulations. The
machine age needed a new policy: laissez faire.
Classical economics emerged as a complement to the new economic system. It offered an
explanation regarding how market capitalism works, and served to legitimize the policy of laissez faire.
Adam Smith's work, An Inquiry Into the Nature and Causes of the Wealth of Nations, raised the following
question: why are some nations wealthy and others not? Smith's answer: the wealthiest nations are
those whose citizens have the greatest measure of individual freedom, what Smith called "natural
liberty". Unimpeded in pursuing their self-interest, capitalists invest extending the division of labor,
increasing productivity, and augmenting economic growth. Economic growth provides income to
individuals and revenue to governments. If problems arise, they are more than likely the result of
104 Classical Economics
government intervention which slows economic growth. On the whole, the theory expresses an
unbounded optimism in the future.
Assumptions
The assumptions underlying the classical school are as follows. First, the classical economists
assume Say's law, the principle that supply creates its own demand. In the process of producing goods
income is created with which to buy those goods. And since wants are infinite, whatever is produced
will be purchased. Hence, an economic glut persisting beyond a few months is not possible. Second,
wages and prices are flexible. As noted, if there are unsold goods, or unemployed workers, prices will
fall until the unsold goods are sold. Any efforts to restrict price adjustments, such as unions or
minimum-wage laws, should be banned. Third, there is no involuntary unemployment. If
unemployment exists, it must be voluntary or frictional (unemployment associated with job changing).
This amounts to arguing that the aggregate supply curve is vertical at full-employment income. Fourth,
the individual and the social interest are naturally harmonious (the invisible-hand doctrine).
The Classical View of Depressions
The classical economists' view of depressions is expressed in the assumption of Say's law.
Depressions are temporary phenomena. Given time, prices will adjust and the glut of goods and
resources will be eliminated. Continued unemployment is either voluntary, in which case it is
inconsequential, or the result of institutional barriers to price adjustments.
The classical view can be presented as follows. Assume for the moment that aggregate demand
depends on the quantity of money (AD = (Ms)), aggregate demand is a function of the supply of
money. As the money supply increases aggregate demand increases, and as the money supply declines
aggregate demand declines. We further assume that since the classical economists assumed no unemployment, at least in the long run, then the aggregate supply curve is vertical at full employment.
The classical view of depressions may be illustrated as follows. Assume for the moment that
the nation is running a balance of trade deficit, that is, we are importing more than we are exporting.
To pay for this deficit gold flows from the United States to other nations. This results in a contraction
in the money supply meaning that aggregate demand falls.
Initially, business and individuals are unaware that the money supply has contracted. They
continue to charge the same prices as before. Billy Bob's self-flagellation kits, for example, earned
Classical Economics 105
$1000 in revenue last month; his expenses including a small profit of $100 was also a $1000. Then Billy
notices that his receipts for the current month fall to $800. He asks his employees to take a pay cut; he
does the same with his suppliers. Naturally, they tell him to stick it forcing Billy Bob to close his doors.
100
AS
90
AD
AD'
80
Price Level
70
60
50
40
e1
d
30
20
e2
10
0
0
10
20
30
40
GDP
50
Y1
60
70
Yf
80
90
Figure 25: Classical View of Depressions
The graph above indicates what happens. Initially the economy is in equilibrium at point a.
Income is at full employment (Yf), income corresponding to a low price level. The contraction in the
money supply causes aggregate demand to shift downward. Resistance on part of suppliers and
workers to accept lower prices and wages means that the economy moves from equilibrium point e1 to
point d, a point of disequilibrium. National income falls from Yf to Y1, indicating an increase in
unemployment. Soon, however, with unemployment rising and businesses hurting, everyone begins
accepting lower prices. Workers prefer to work for lower wages than no wages, and suppliers
begrudgingly accept orders at lower prices than none. As prices fall, expenses to firms fall as well, and
new firms enter the market, including the return of Billy Bob. Soon, everyone is employed again, and
income has returned to full employment income (Yf) at point e2. What has changed is prices. Prices, or
more precisely the price level, have fallen. So long as markets are allowed to work, that is, so long as
prices are allowed to adjust, there is no need for government intervention.
100
106 Classical Economics
Review Questions
I.
II.
III.
IV.
V.
What was the historical backdrop of the classical economics?
Discuss the assumptions underlying classical economics.
What are the policy implications underlying classical economics?
Explain the classical view of depressions. Use graphs.
How is equilibrium restored in the classical model? Explain.
Chapter Ten : Keynesian Economics and the Welfare State
“I think that Capitalism, wisely managed, can probably be made more efficient
for attaining economic ends than any alternative system yet in sight, but that in
itself it is in many ways extremely objectionable. Our problem is to work out a
social organization which shall be as efficient as possible without offending our
notions of a satisfactory way of life.”
John Maynard Keynes
No other economist of this century has had a greater impact on economic thinking than
John Maynard Keynes. Keynes’ purpose was to save capitalism itself. But to save it capitalism must
change. Laissez faire must be abandoned. The capitalist ship cannot continue without someone
steering.
Prior to revolutionizing economic thinking Keynes had already left his mark on the world
scene. Keynes had served as an advisor to the treaty of Versae ending WWI. He became so incensed
with the terms of the treaty that he wrote a book entitled The Economic Consequences of the Peace.
Keynes argued that Europe was economically united, yet politically divided. To demand that
Germany pay for the costs of the war would sew the seeds of a future war.
Keynes’ most famous work, however, is entitled The General Theory of Employment, Interest, and
Money. The book was published in 1936. Its purpose was to understand the causes of the depression,
and recommend policies to resolve the depression. Keynes realized that classical economics was
inadequate to explain severe depression. But before he could develop a new theory, Keynes first had
to shed classical economic theory upon which he had been raised. “The difficulty lies, not in the new
ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have, into
every corner of our minds.”27 Keynes’ theory has to be understood in light of the problems that he
addressed: mass unemployment, declining prices, and falling GDP.
Historical Backdrop: The Great Depression
The burning political question of the 1920s was whether individuals had the constitutional
right to get inebriated. The 1920s were a carefree decade, a decade in which Americans either
27
J.M. Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace, and World,
1964), p. viii.
108 Keynesian Economics
enjoyed the good life, or worked hard to obtain it. The laissez faire views of the classical economists
carried the day. Warren Harding, elected President in 1920, ran on the view of “less government in
business and more business in government.” And Calvin Coolidge, who succeeded Harding in 1924,
proclaimed that “the chief business of the American people is business.” Hoover, who presided as
President during the early years of the Depression, predicted soon after taking office that poverty in
America would soon be abolished.
The 1920s were good to America. Industrial production increased by fifty percent.
Prosperity was heralded by the development of the automobile industry and construction. It was
commonly believed that everyone could become rich if they invested in the stock market.
Economists too were swept up in the euphoria of the day. One month before the stock-market
crash of 1929 a leading economist of the time, Irving Fisher, prophesied that America had achieved
a “permanent plateau of prosperity.” In the same year Herbert Hoover in his inaugural address
looked forward to the day when poverty in America would soon be abolished.
The permanent plateau was short lived. On October 29, 1929 the stock market fell twenty
percent; within a year industrial output fell twenty five percent. Within three years GDP fell forty-six
percent in current prices, thirty-one percent in real prices; industrial output fell by one half;
consumer prices fell by one fourth; employment declined by twenty percent; and the unemployment
rate soared to twenty-five percent. Durable goods declined by eighty percent. From the outset of the
depression in 1929 to its depth in 1932 80% of the banks folded, 9 million people lost their savings,
stocks plummeted by 80%. Foreclosures rose along with suicides and crime. In the countryside
farmers burnt their fields, slaughtered their pigs, and dumped their milk for want of buyers, while
unemployed workers stood in bread lines for want of food; factories lay idle for lack of orders;
banks closed their doors for lack of money. People lost their jobs, their homes, and perhaps most
importantly, their confidence in the future. The advice of the classical economists: do nothing, the
economy will correct itself.
In the meantime, the United States government took numerous actions that actually
exacerbated the situation. Taxes were raised and government spending cut to balance the budget,
interest rates were increased in an effort to stem the flow of gold to Britain, and tariffs were
increased in an effort to induce Americans to “buy American.”
Keynesian Economics 109
With his vision of a better world shattered, a frustrated and depressed Herbert Hoover went
fishing. John Steinbeck wrote the Grapes of Wrath. Using the plight of the migrant workers as his
backdrop Steinbeck warned of the impending revolution:
At the time many intellectuals believed that the great depression represented the fulfillment
of the prophecy offered by Marx some seventy years earlier. Marx claimed that the capitalist system
is unstable. Depressions are inherent in a system based not on the satisfaction of human needs, but
on the pursuit of profit. Pursuit of profit on the one hand, and the displacement of labor by laborsaving technology on the other would cause depressions to become increasingly severe, and
unemployment to grow until workers revolt. Following the revolution workers would establish a
communist society, a society that Marx envisioned would allow the full and free development of
each individual.
Keynes, however, rejected Marx’s prophecy. He considered Marx’s Das Kapital muddled,
although Keynes had not read it. And Keynes himself disliked the revolutionary solution that Marx
advocated.
The depression shook America’s confidence in itself, altered forever the role of government
in the economy, and spawned new ideas about how the economy works. Economists at the time
offered little advice other than wait a few months and the economy will turn around. Keynes,
however, was not content to wait. “In the long run we are all dead. Economists set themselves too
easy, too useless a task, if in tempestuous seasons they can only tell us that when the storm is long
past the ocean is flat again.”28
Assumptions Underlying Keynes’ Theory
Keynes rejects classical economics because its assumptions are unrealistic. Classical
economics assumes an economy at full employment. It does not address the conditions of an
economy in depression.
Keynes makes the following assumptions. First, aggregate demand determines the
equilibrium level of national income. This assumption amounts to a rejection of Say’s law. For
Keynes, aggregate demand equals the sum of expenditures for consumption, investment,
government, and exports minus imports, or net exports. Hence, AD = C + I + G + (X - M).
28
Keynes quoted in Roy Harrod, The Life of John Maynard Keynes (New York: W.W. Norton, 1951), p. 341.
110 Keynesian Economics
Second, those who save and invest are different economic agents, with different objectives.
Consumers save, particularly the rentier (the functionless investor). Their objective may be to save
for a rainy day, to earn interest, or to speculate. In Keynes’ time those who saved the most were the
idle rich, those who earn their income from accumulating wealth. Today, those who save the most
are the institutional investors: pension funds, insurance companies, and so on.
In contrast to savers, entrepreneurs invest. They take risks, organize businesses, open new
markets, introduce new techniques, and so on. Their purpose is to make profits.
Third, Keynes assumes that prices are rigid downward. Entrepreneurs and workers resist
lower prices and wages. If declining prices work, it works only at the cost of considerable pain and
suffering. In fact, during times of depression falling prices may actually aggravate the situation by
changing expectations. People may put off spending today in anticipation of lower prices tomorrow.
Fourth, involuntary unemployment may exist. In contrast to the classical economists,
Keynes believes that the system is responsible for unemployment, not workers. If the system is
responsible for causing unemployment, then the system is also responsible for resolving the
problem.
Fifth, Keynes rejects the invisible-hand doctrine. There is no reason to think that there exists
an identity between the individual and social interests. Put differently, that which is most profitable
is not necessarily socially beneficial.
Sixth, Keynes assumes the following class structure: consumers, entrepreneurs, and the
rentier. Consumers include everyone. As consumers, their economic function is to consume.
Entrepreneurs’ economic function is to invest, that is, to spend the savings of the community to
purchase capital goods and inventories. Entrepreneurs insofar as they control the means of
production decide how much goods and services to produce. According to Keynes, the rentier serve
no economic function. They are those individuals who live off their accumulated wealth. Insofar as
they are the primary savers, the rentier may actually harm the economy if their savings is not
invested.
Consumption and Saving
Recall that AD = C + I + G + (X-M). Consumption, of course, represents spending on
consumer goods such as clothes, food, refrigerators, prophylactics (just to see if your still reading)
and so on. Consumption depends on such items such as expectations, income, wealth, interest rates,
Keynesian Economics 111
taxes, and so on. Approximately seventy percent of aggregate demand represents consumer
spending. Keynes assumes that consumer spending is based on a psychological law, a law that claims
that as income rises consumption rises but not by as much as income. This implies that as income
rises saving also rises.
For Keynes saving is income not consumed (S = Y - C). As income rises saving rises.
Keynes believed that this tendency for saving to increase as income rises posed a problem for the
economy. Saving is a type of surplus, income not spent on goods and services. In contrast to the
classical economists, a decision to save is not a decision to investment. It simply means that goods
and services go unsold. If the savings of consumers is not spent, the unsold goods cause the
economy to stagnate creating unemployment. Keynes did not believe that a laissez faire economy
would ensure that the savings of the community would be spent. Hence, economies characterized by
a policy of laissez faire are prone to stagnate.
Investment
Investment is determined by entrepreneurs. Investment spending represents spending on
capital goods and inventories. Capital goods are goods used to produce other goods. They include
factories, tractors, machines, and so on. Inventories are the goods that the entrepreneurs have in
stock in order to meet future and current demand. Changes in business inventories are a key factor
in shaping business expectations.
Investment is affected by many variables: expectations, interest rates, costs, taxes, and so on.
Interest rates affect investment spending by raising the costs of financing investments. As interest
rates rise, the financial costs may become so great that entrepreneurs may choose not to invest. In
fact, they may find it more profitable to loan money to other entrepreneurs, or to the government.
As Francis Turgot noted long ago:
112 Keynesian Economics
The price of interest may be looked upon as a kind of level beneath which all
labour, all agriculture, all industry, all commerce come to an end. It is like a sea
spread over a vast area: the summits of the mountains rise above the waters, and
form fertile and cultivated islands. If this sea happens to roll back, in proportion as it
descends, first the slopes of the hills, then the plains and the valleys appear, and are
covered with every kind or produce. It is enough that the water should rise or fall a
foot to inundate immense tract, or throw them open to agriculture. It is the
abundance of capital which animates all undertakings; and the low interest of money
is at once the effect and the indication of the abundance of capitals.29
Expectations are another major factor affecting investment spending. Theoretically,
investment decisions are based on a rational choice; on weighing the costs and benefits of a prospective investment. The problem, however, is that the future is uncertain. Entrepreneurs do not know
for sure the outcome of their investment decisions. Investment decisions are something of a
crapshoot. They are, for the most part, based on entrepreneur's guesses about the future.
Most, probably, of our decisions to do something positive, the full consequences of which will
be drawn out over many days to come, can only be taken as a result of animal spirits—of a
spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of
quantitative benefits multiplied by quantitative probabilities.30
The importance of expectations, that is, of how entrepreneurs perceive the future, implies
first that investment is suspect to events that influence the state of confidence. Changes in the stock
market, war, new innovations, and so on all may affect expectations and in turn investment spending. Second, the importance of expectations implies that investment spending is a highly volatile
component of aggregate demand. This volatility is a major factor in explaining the business cycle.
Aggregate Demand
One of Keynes’ central insights is the role of aggregate demand in determining the level of
national income. The classical economists had looked at the supply side. Keynes was arguing that in
fact the key was not the supply of goods, but the demand.
29
Anne Robert Jacque Turgot, Reflections on the Formation and the Distribution of Riches (London: MacMillan
Co., 1898), p. 86.
30
Keynes, The General Theory, p. 161.
Figure 26: Keynesian View of AD and AS
Keynesian Economics 113
100
AD=C+I+G+(X-M)
AS
90
80
70
60
50
Price 40
Level
30
20
10
0
0
10
20
30
40
50
GDP
60
70
80
90
Full Employment
At the equilibrium level of national income aggregated demand equals aggregate supply. The
level of spending is sufficient to purchase the amount of goods and services produced. Since
entrepreneurs’ expectations about the level of demand are realized, there is no tendency for income
to change. In the figure above equilibrium occurs where AD equals AS, in this case at full
employment.
Disequilibrium may take two forms. First if aggregate demand is less than aggregate supply,
demand is insufficient to purchase the amount of goods and services produced in the current year.
Insufficient demand leads to an accumulation of inventories causing a decline in profits. Entrepreneurs react by contracting production and firing workers which causes national income to decline.
Second, if aggregate demand exceeds aggregate supply, demand is more than sufficient to
purchase the amount of goods and services produced in the current year. Inventories decline,
causing a rise in profits. Entrepreneurs react by expanding production and hiring workers, which
causes national income to increase.
The key to avoiding depression and maintaining demand, then, is to ensure a sufficient level
of aggregate demand. To do so requires government intervention.
Paradox of Thrift
The paradox of thrift stems from the observation that the decision to save more means a
decision to spend less. If everyone were to double their level of saving, the simultaneous decline in
100
114 Keynesian Economics
consumption would precipitate a depression. The reason is that an increase in saving means a
decline in consumption, resulting in a decline in aggregate demand. Assuming that investment and
government spending did not increase to offset the decline in saving, then goods would go unsold.
Inventories would pile up, profits would fall, and business would react by cutting production, laying
off workers, and cutting orders.
This does not mean that saving is bad for the economy. On the contrary, Keynes’ point is
that saving that is not spent—either on investment, government, or exports—drags the economy
down. Saving must be spent if the economy is not to stagnate. Saving then is not the culprit, but
saving that is unspent.
In Keynes’ theory not everyone saves the same amount. Keynes assumed that the rentier
save the most, since they have the greatest incomes. In a sense, then, it is the saving of the rentier
that pose the major threat to the economy. In contrast to classical economics, Keynes’ theory
implies that inequality is no longer necessary to maintain full employment. The saving of the
wealthy, rather than promoting economic growth, actually retards growth if the economy is at less
than full employment.
Cause of the Depressions: Keynes’ View
The depression, Keynes argued, was caused by a failure of aggregate demand. But the decline in demand was in turn caused by several other factors. The stock-market crash altered expectations, such that entrepreneurs reduced investment spending. Second, the distribution of income was
highly inequitable. Much of the income was in the hands of the wealthy. In general, the more
income a person has, the smaller the proportion of the income is spent on consumption. You or I
spend a much greater percentage of our income on living than would, say, the Imelda Marcos (Bad
example, she spends most of her income on shoes).
In the 1920s much of the wealth and income was in the hands of the rentier. As their
incomes increased, less was spent and more was saved, meaning that aggregate demand actually
declined. Third, interest rates were increased, which as noted above tended to stifle investment
spending. Fourth, during the depression the various countries of the world erected trade barriers in
an effort to shift the burden of the depression off on other countries. The effect was to further
causes a decline in aggregate demand.
Keynesian Economics 115
100
AD
90
AS
AD'
80
Price Level
70
60
50
40
30
b
a
20
10
0
0
10
20
30
40
50
GDP
60
Y1
70
80
90
100
Yf
Figure 27: Keynesian View of Depression
The graph above illustrates what happened. The initial equilibrium at point a corresponds to
full employment (Yf). Aggregate demand falls from AD to AD’. The result is that the economy
moves from a to b. The new equilibrium, however, is at less than full employment (Y1). Moreover,
given that prices are rigid downward (indicated by a horizontal aggregate-supply curve up to full
employment), there is no automatic mechanism to restore the economy to full employment. Unlike
in the classical model, prices cannot fall. And even if prices could fall, it may not be enough to
restore optimism in the future. Without an optimistic outlook, entrepreneurs will not invest. And
depression may continue.
Rationale for the Mixed Economy
Keynes believed that both World War I and the Great Depression represented the failure of
market capitalism. During the nineteenth century governments following a policy of laissez faire had
no means whereby they could influence the domestic economy. Government cannot influence
consumption since there are no income taxes; government cannot influence investment spending in
part because there are no tax incentives, in part because the economy is on a gold standard, meaning
that government has no control over the interest rates. Government has no control over
government spending, since conventional wisdom dictates that budgets must balance. The only way
to influence the economy is through the government’s power to influence imports and exports. An
116 Keynesian Economics
increase in exports you will recall increases aggregate demand, an increase in imports lowers
aggregate demand. Hence, a country that is trying to improve its domestic economy will try to
restrict imports through tariffs, and increase exports by obtaining colonies. Keynes comments that
World War I was the result of nations attempting to prop up their domestic economies by obtaining
colonies; that is, by imperialism, the economic domination of other nations. Colonies served as a
source of raw materials, as well as a market for excess goods. The scramble for colonies in the late
nineteenth, early twentieth centuries ultimately led to war.
Keynes’ purpose in The General Theory was to save capitalism by changing it. Keynes believed
that “the outstanding faults of the economy in which we live are its failure to provide for full
employment and the arbitrary and unequal distribution of wealth and incomes.”31 Keynes’ solution
to both depression and war lay in government intervention. Use the government’s power to tax and
spend (fiscal policy) in order to stimulate aggregate demand, and the government’s power over the
money supply (monetary policy) to keep interest rates low.
Keynes’ theory implies the following. First, inequality can no longer be justified using the
argument that the wealth of the rich is necessary to sustain the economy. In fact, redistributing
income from rich to poor through tax and spending policies increases demand. Why? Because the
poor are more likely to spend their incomes than are the rich. Second, Keynes believed that the
investment process must be socialized. This does not mean socialize the means of production.
Rather, socialize the level of investment through fiscal and monetary policies, thereby ensuring that
social saving is invested.
Keynes’ ideas have had a considerable impact on economic policy. They provide a rationale
for the progressive-tax system, social programs, and tax policies to encourage investment. Keynes’
ideas have changed the way many economists and social thinkers think about how the capitalist
system works, so much so that many social scientists consider The General Theory the most influential
book of this century. But Keynes’ ideas have also served purposes different from those intended by
Keynes. Keynes, for example, advocated running deficits in times of recession. He never advocated
running perpetual deficits.
31
Keynes, The General Theory, p. 372.
Keynesian Economics 117
Review Questions
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
IX.
X.
XI.
XII.
What was the economic situation that Keynes’ theory was reacting to.
What are the assumptions underlying Keynes’ theory? How do they differ from the classical
view?
What was Keynes objection to classical economics?
What is the psychological law underlying Keynes’ consumption function? As income
increases what happens to saving?
Define savings, define consumption.
Explain the paradox of thrift. How is this related to Keynes’ assumption that aggregate
demand determines the level of income?
Define investment. Discuss some of the variables that affect investment.
How do expectations affect investment?
What according to Keynes caused the Great Depression? Would the classical economists
agree? Explain.
What are the policy implications of Keynes’ theory?
How does Keynes’ theory explain WWI?
What does Keynes’ theory imply regarding the relation between income distribution and
economic growth?
Chapter Eleven : Money Makes the World Go Round
“It is no accident that banks resemble temples, preferably Greek, and that the
supplicants who come to perform the rites of deposit and withdrawal
instinctively lower their voices into the registers of awe. Even the most junior
tellers acquire within weeks of their employment the officiousness of hierophants
tending an eternal flame. I don’t know how they become so quickly inducted into
the presiding mysteries, or who instructs them in the finely articulated
inflections of contempt for the laity, but somehow they learn to think of
themselves as suppliers of the monetarized DNA that is the breath of life.”
Lewis H. Lapham
Money is that mysterious elixir, so difficult to come by, yet so easy to lose. More powerful
than armies, more influential than Popes, money is capable of enticing people to make their deals
with the devil to do things they would not otherwise do. Playwrights and social critics have long
observed the mysteries of money. As George Bernard Shaw once said, it is not money that is the
root of all evil, but the lack of money.
What is money? Where lies the source of its power? How is money central to market
economies? What is the relation between money and other assets such as bonds? How is money
created? What role does money play in influencing the level of output?
Money
Money, of course, is central to a market economy. By its nature money facilitates trade, it is
the oil that greases the wheel. Without money individuals would have to barter for the things they
want. Jim has a pig but wants a horse. Jack has an ass but wants a pig. And Jill has a horse but wants
an ass. Jack can trade his ass for Jim’s pig. Jack would be satisfied, but Jim would have an ass that he
does not want. He needs to find someone who wants his newly acquired ass, but has a horse to sell.
Money simplifies the problem. Rather than having the ass price of pig, with the pig price of
horses all prices are expressed in terms of money. Money, therefore, reduces the costs of making
transactions, thereby facilitating trade.
But what is money? Money is a claim on resources, a universal equivalent in which other
things may be substituted in exchange. Marx sought to understand the implications of money on
human relationships. Marx viewed money as a social relation having the power to invert reality.
Money Makes the World Go Round 119
I am ugly, but I can buy the most beautiful woman. Which means to say that I am
not ugly, for the effect of ugliness, its repelling power, is destroyed by money. As an
individual, I am lame, but money procures for me twenty-four legs. Consequently, I
am not lame. I am a wicked, dishonest, unscrupulous and stupid individual, but
money is respected, and so also is its owner. Money is the highest good, and
consequently its owner is also good. Moreover, money spares me the trouble of
being dishonest, and I am therefore presumed to be honest. I am mindless, but if
money is the true mind of all things, how can its owner be mindless? What is more,
he can buy clever people cleverer than the,? Through money I can have anything the
human heart desires. Do I not therefore possess all human abilities? Does not money
therefore transform my incapacities into their opposite?32
Originally, money was a commodity having value. The commodity that was selected was one
that could easily serve as money such as tobacco, whiskey, wampum, paper, cattle, and so on. The
most popular commodity to serve as money, at least in the West, has been the precious metals—
gold and silver. Later, paper money backed by gold served as money. Our present society uses fiat
money, money based on faith. As our currency says, “In God we trust.”
Definitions of Money
There is a problem that is inherent in all theories regarding how money influences economic
activity. The problem is what is money? How do we define it? The problem is more fundamental
than one might think. For while the question may seem obvious, defining money is not as simple as
it appears.
Normally, we think of money as currency and coins. But checks serve the same functions, so
checks are also included as money. But so too are savings accounts, and stocks, bonds, and anything
else that another person is willing to accept in trade.
Economists have sought to circumvent this problem by distinguishing different types of
money based on their liquidity, that is, how easily money is spent. There are as many as fifteen
different definitions of money. The two most important are M-1 and M-2.
M-1 is defined as currency plus demand deposits, that is, currency plus checking accounts.
The rationale is that these are the most liquid assets.
M-2 is defined as M-1 plus time deposits less than $100,000. Time deposits include checking
accounts, certificates of deposits and so on. Again, M-2 is somewhat less liquid than M-1, and M-3 is
32
Karl Marx, Early Writings, (New York: Vintage Books), 1975, p. 377.
120 Money Makes the World Go Round
somewhat less liquid than M-2, and so on. For years the FED followed M-1 in their assessment of
the money supply. More recently have they also looked at M-2.
Functions of Money
Money has five functions, each associated with the development of a new institution. First,
money serves as a median of exchange. That is, it facilitates trade. Trade in the absence of money is
referred to as barter. Barter means one good exchanges for another. If I have a pig and I want a
horse, I must find someone who wants my pig and at the same time wants to sell a horse.
Difficulties arise if he wants a cow instead. Barter results in literally millions of different prices for
the same commodity, depending on what it is to be traded for. Moreover, in the absence of money
the transactions costs become enormous. Money simplifies everything. By lowering the costs of
making transactions, money facilitates the exchange process.
Second, money serves as a store of value. The problem with using chickens or grain as
money is that they perish. Money, particularly in its metallic form, solves this problem by storing the
value permanently.
Third, money serves as a means of deferred payment, that is, it serves as a means of paying
debts. Fourth, money serves as a means of measuring value. And fifth, money serves as a means of
influencing economic activity.
The first four functions are associated with the emergence of two important institutions.
First, money as a store of value, and a means of deferred payment is associated with the
development of banks. The early banks were originally goldsmiths, who began to hold the gold of
others for a fee. The goldsmiths soon recognized that they could earn more money by loaning out
gold, and hence banks were born. Mints are associated with money as a store of value, and a
measure of value. Central banks are a relatively recent innovation, associated with money used to
influence economic activity.
Money Supply
How is money created? And in turn, how does the Fed influence the money supply? To
understand money creation one must first understand banks. Banks originated in medieval Europe.
People would deposit their gold with gold smiths for safekeeping. The gold smiths quickly realized
that the gold could be put to better use by lending it out. Hence, the gold smiths began loaning out
the gold at interest. So long as the original depositor did not come for his gold all was well. Even if
Money Makes the World Go Round 121
he did come for his gold, others would not, so the system worked fine. The only problem was that if
the gold smith loaned out all the gold, and a depositor wanted to make a withdraw, problems might
arise. Hence, the gold smith only needs to keep a portion, a fraction, or the deposits on hand during
normal times, thereby satisfying the demand of depositors.
Money Creation
Modern banking works much as it did in medieval Europe. In the table below Jane deposits
$1000 in Billy’s Bank. Billy, mindful of the Fed’s regulation that he must keep a portion of his
reserves on hand, loans out $900. This $900 is then loaned, spent, and received by Tom who
proceeds to deposit the $900 in his account at Mountain Point. Now the bank holds $90 in reserve,
and loans out $810. Hence, the original deposit of $1000 now also supports itself, plus a deposit of
$900, and $810, and so on. This is how a deposit may in fact increase the money supply. After the
process has gone through many banks, we find that from the original deposit of $1000, reserves
have increased $1000, loans increased $4000; and deposits increased $5000.
Bank
Billy’s Bank
Mountain Point
Sugarhouse
Total
Assets
Reserves
$ 100
$ 90
$ 81
.
.
.
$1000
Loans
$ 900
$ 810
$ 729
.
.
.
$4000
Table 7: Money Creation
Liabilities
Deposits
$ 1,000
$ 900
$ 810
.
.
.
$5000
But there is another way
in which banks make money,
referred
to
as
liability
management. So long as the
interest that banks charge differs
form the interest that at which
banks can borrow banks can
increase their profitability by
engaging
in
liability
management. Liability management means that banks go, say to the Eurodollar market and borrow
$1,000,000 at 6% interest. They turn around and loan the money to customers at 16% interest. As a
result, the banks earn a profit of 10% interest without having to wait for depositors to deposit
money. But what are the implications? So what? After all, banks have always made money by
incurring debts. True. But the new method of making money differs. For under asset management
approach the banks incurred a debt (your deposit) but also had an asset (reserves) from which they
made the loans. Now under liability management they first incur a debt (borrow from a money
market) and subsequently incur an asset (loans). The difference is that the Fed could more easily
regulate asset management. Liability management in which banks borrow from secondary markets
122 Money Makes the World Go Round
do not leave the Fed with as much control. One might consider this a good thing, for who needs
government intervention in banking. But the trend is alarming, for if some reason people are unable
to repay the banks how then will banks repay their loans? The Fed was established in part to ensure
business access to credit to enable them to make their obligations.
The endogenous money-supply approach may be summarized as follows: loans create
demand deposits, demand deposits create reserves, and the demand for money creates its own
supply. The approach views banks as profit maximizers. Hence, banks will always makes loans
assuming they believe that they will be repaid, and assuming that banks can borrow at a lower
interest than the loans issued to generate reserves. Hence, through liability management banks are
able to circumvent the Fed’s controls.
The Federal Reserve
The Federal Reserve, commonly known as the FED, is the central bank of the United States.
The Federal Reserves was established in 1913 in response to the panic of 1906. Its original purpose
was to provide liquidity to business when needed. That is, the Fed serves as lender of last resort. But
the Fed has other functions as well: supply the economy with currency, facilitate check clearing,
serve as the bank for the United States government, regulate commercial banks that are members of
the federal reserves system, and most importantly, influence economic activity.
At present, the importance and prestige of the Fed is unparalleled. Business leaders,
politicians, and so on are particularly concerned with Fed policy. The ability to influence the money
supply, and in turn, interest rates, gives the Fed enormous power.
Despite the Fed’s reputation, there is disagreement regarding the Fed’s ability to control the
money supply. The monetarists, for example, contend that the Fed exerts considerable control over
the money supply. Others contend that the Fed can influence the money supply; but the Fed cannot
control the money supply.
Tools of the Fed
The Federal Reserve has several tools with which it can influence the supply of money, and
in turn economic activity. First, the FED can engage in open market operations (OMO). Open
market operations are the purchase and sale of government bonds.
Understanding open market operations depends on understanding the relation between
bond prices and interest rates. Bonds have two different prices: the face value of the bond and the
Money Makes the World Go Round 123
market value. The face value of the bond is the value of the bond at maturity. The market value of
the bond (Pb) is the value of the bond today. These two values will differ except at the time the
bond is paid off. The interest payment of the bond (D) is the payment made to the holder of the
bond per year. The interest payment is usually constant. The rate of interest (i) is inversely related to
the price of the bond (Pb = D/i). Or conversely, the interest rate is equal to the interest payment
divided by the market price of the bond (i = D/Pb).
How does this relate to open market
operations? The FED influences the interest rate
through selling or buying bonds. If the FED wants to
contract the supply of money, it sells bonds. The sale
of bonds lowers the prices of bonds, which given a
Market Price of Bonds Interest Rate
$2000
5%
$1000
10%
$ 500
20%
Table 8: Bond Price and
Interest Rates
fixed interest payment increases the rate of interest.
The table below indicates what happens. Assuming an interest payment of $100, and the market
value of the bond at $1000, then the rate of interest is 10 percent. Now assume that the FED sells
bonds, depressing the price to $500. What happens to the interest rate? It jumps to 20 percent. The
higher rate of interest indicates a greater return relative to the investment costs. Before it cost $1000
to receive $100 per year. Now, the same $100 return costs only $500.
Those who bought the bond at $1000 now have a bond worth only $500. They have
sustained a capital loss. Conversely, if the government buys bonds such that the price rises back to
$1000, then those who bought bonds at $500 now have a bond worth $1000, they have sustained a
capital gain.
124 Money Makes the World Go Round
The government sells bonds at
lower and lower prices in order to induce
people to buy bonds rather than other
assets (real estate, gold, stocks, and so on).
People buy bonds with cash or check,
which is then redeemable by the FED for
cash. In this manner, the FED is able to
soak up the supply of money. People hold
bonds, but they have less money to buy
stocks, goods, services, and so on. If the
sale of bonds is sufficiently aggressive, the
FED can actually lower prices.
Conversely, if the FED chooses to
expand the money supply, it buys bonds.
It induces people to sell bonds by offering
ever higher prices for their bonds. The
result is a decline in interest rates, since to
receive the same $100 interest payment
people must pay ever higher prices.
Hence, interest rates fall. But at the same
time the FED is giving people cash for
their bonds, resulting in an increase in the
supply of money. In turn, these people use
their money to make investments, loan
Savings and Loan Fiasco
The Glass-Steagall Act of 1933 segregated
financial institutions into three categories:
commercial banks and S&Ls, insurance companies,
and investment and finance companies (deposit
intermediaries, contractual intermediaries, and
investment intermediaries). Commercial banks and
S&Ls were further subdivided such that banks were
allowed to finance certain types of commercial loans,
S&Ls were to finance long-term mortgages. This
worked fine so long as interest rates remained
relatively low.
In the late 1970s, however, the FED
engaging in contractionary monetary policy to curb
inflation raised interest rates. Since the interest that
S&Ls could pay was capped, depositors fled S&Ls
for more lucrative interest rates offered elsewhere.
Congress responded in 1980 with the Depository
Institutions Derogation and Monetary Control Act
(DIDMCA). This act eliminated the cap on the
interest that the S&Ls were allowed to pay, and
increased deposit insurance from $40,000 to
$100,000. The Act helped, but did not solve the
problem.
Congress again responded in 1982 with the
Garn-St. Germain Act, which deregulated the S&Ls
allowing them to invest in other areas. By this time
hundreds of S&Ls were insolvent, but allowed to
operate in the hope that they would grow out of
their problems. Many owners and managers chose to
make risky investments in the hope of a large payoff
with little or no risk. The policies were a prescription
for disaster: deregulating the S&Ls while
guaranteeing their losses. Estimates place the cost to
taxpayers at over 500 billion dollars
money, buy goods and services, and so on.
A second method through which the FED may influence the supply of money is by
manipulating the reserve requirement. The reserve requirement is that percentage of deposits that
the bank must have on hand either in its vault or at deposit with the FED. Reserves are required to
ensure that a bank has sufficient cash to meet the demands of its customers. Too few reserves may
mean that the bank cannot meet the withdrawals of its customers, possibly leading to a run on the
bank. While it is in society’s interest to ensure that there is sufficient cash on hand, it is in the bank’s
Money Makes the World Go Round 125
interest to minimize its reserves. Why? Because reserves earn no interest. If the FED increases the
reserve requirement, banks have less opportunity to make money by making loans. The reduction in
loans means less money in the economy.
A third tool that the FED can use to influence the money supply is the discount rate. The
discount rate is the interest rate that the FED charges member banks. The discount rate is usually
less than the prime rate. Its purpose is to provide banks with a supply of money for exigencies.
Banks are discouraged from resorting to it as a primary of cash.
The fourth tool of the FED is moral suasion, the Fed’s ability to cajole member banks
through intimidation, credit policy, and so on. The tools of the FED enable the FED to influence
the money supply, through which it can influence the interest rates and in turn economic activity.
The ability to influence interest rates gives the FED enormous power within our economic system.
Quantity Theory of Money
At present in the US both inflation and unemployment are relatively low. This, however, has
not always the case. In the late 1970s the US economy was racked with both high inflation and high
unemployment. Consumers saw their paycheck buy less and less. In Germany in the 1920s things
were even worse. In an effort to pay war reparations Germany sustained hyperinflation. Prices rose
so quickly that patrons found restaurant prices higher after their meal than before. Brazil in the
1980s sustain inflation rates of over a thousand percent.
The relatively high inflation of the 1970s gave rise to the monetarist challenge to the
Keynesian orthodoxy. In brief, monetarists find the cause of inflation in increases in the money
supply. In an effort to stimulate the economy central banks print money. This money competes with
those held by the public, driving up prices. In some cases governments find it easier to finance their
expenditures by printing money than through taxation. In such cases the result is frequently hyperinflation.33
The monetarists viewpoint rests on the quantity theory of money. The quantity theory of
money is based on the following equation: MV = PQ. M is the supply of money. V is the velocity of
33
Keynesians agree that hyper inflation is the result of increases in the money supply. But not moderate inflation.
Keynesians assert that moderate amounts of inflation are the result of increases in costs, notably, wage costs. For
example, in the 1970s inflation hovered at around 10%. This was in part due to the oil embargo. But it was also due
to what economists call a wage price spiral. Are corporations with monopoly power increase prices. Powerful unions
respond by demanding higher wages. Corporations in turn claim that to pay higher wages they must again raise
prices, and so on
126 Money Makes the World Go Round
money. The idea underlying the velocity of money is that the same dollar can be used in a number of
transactions in the course of a year. Velocity is the number of times a dollar changes hands during a
year. P represents the price level. And Q represents the quantity of goods and service. Hence, PQ
represents gross domestic product (GDP).
The quantity theory of money makes the following assumptions. First, V is assumed stable.
This means that V is not constant, but almost constant. Second, we assume that Q tends to full
employment.
The implications of the quantity theory should be clear. Assuming that V is stable, if M
doubles then GDP will increase as well. It may more than double, or the increase may be less than
double. In either case, the quantity of money determines the level of economic activity. Inflation is
caused by too much money, deflation by too little. Since the monetarists believe that the Fed
controls the money supply, then the Fed is responsible for inflation.
The Great Depression: The Monetarist View
The quantity theory of money implies that the Great Depression was not caused by a lack of
aggregate demand. Rather, the depression was caused by a major contraction in the supply of
money. It was not caused by a failure of the market system, or the absence of government
intervention as Keynes’ theory suggests. Rather, it was caused by government intervention.
Milton Friedman, one of the foremost monetarists of today, argues that the Federal Reserve
transformed a minor banking panic into a major depression. In 1931 Britain went off the gold
standard, causing the price of gold to rise in Britain. Many people saw an opportunity to make a
profit by converting dollars into gold, taking the gold to England to redeem for pounds, and turn
the pounds into dollars again. In an effort to stem the flow of gold to England, the Federal Reserve
raised interest rates, which contracted the money supply, causing a rash of business failures.34
Role of Government: The Monetarist View
From the monetarist point of view, the Fed’s discretion over the supply of money is too
powerful a tool. Inevitably, governments will abuse such power. Monetarists reason that the
difficulty of raising taxes leads the government to print money. Printing money, however, causes
inflation. The printed money competes with money held privately, bidding up prices. The increase in
34
Milton Friedman, Capitalism and Freedom (Chicago: University of Chicago Press), 1962, pp. 48-50.
Money Makes the World Go Round 127
prices is a manifestation of a forced reallocation of resources from the private individuals to the
government.
Even if government did not create inflation to confiscate resources, discretionary monetary
policy should not used. The rationale is that control over the money supply is too powerful, and the
government does not have sufficient knowledge to use the policy effectively. There is a lag between
the time in which the money supply is increased and it impacts the economy. The Fed cannot
predict this lag for certain. Moreover, by the time the increase in the money supply impacts the
economy the problem may be resolved.
To check the government’s power over the supply of money the monetarists advocate a
monetary rule. Such a rule would check the government’s ability to alter the money supply. In effect,
the gold standard represents one kind of monetary rule. In a gold standard the government pegs the
price of gold. It does so by buying or selling gold at a fixed price. In this manner, the Fed has no
control over the supply of money.
Instead of a gold standard, Friedman advocates a rule where the money supply grows at a
constant rate. He believes that a constant increase in the money supply approximating the increase
in GDP would effectively eliminate inflation, and smooth out the business cycle.
Rational Expectations
Monetarism gave rise to an even more conservative theory of the macroeconomy in the
1980s, a theory called rational expectation. In many ways rational expectations resembles classical
economics. The model makes two assumptions. First, market work. So long as prices are flexible,
surpluses or shortages result in prices changes that allows the market to clear. Second, individuals
are rational. Not only are they rational, but having been burned before individuals are
knowledgeable of economic theory and can take measures to protect their wealth and incomes. For
example, if the Fed announces an expansionary monetary policy individuals will come to expect
higher inflation. Hence in their wage negotiations they will demand higher prices to compensate
them. The higher wages, assuming that inflation does indeed occur, leaves workers with the same
real wage and business with the same real costs as before. Since real costs remains the same, and
hence profits remain the same, businesses choose not to higher more workers. The result:
unemployment remains the same.
This in turn led the rational expectations to argue that there exists a natural rate of
unemployment. The natural rate of unemployment is assumed to be approximately 6%. The rationale is
128 Money Makes the World Go Round
that at any one time 6% of the labor force is changing jobs (frictional unemployment). Any efforts
by the political authorities to reduce unemployment simply results in inflation. Hence, monetary
policy and fiscal policy are ineffective in reducing unemployment. Moreover, monetary policy may
be inflationary. So the policy recommended by the rational expectations is laissez faire.
The assumption that there is a natural rate of unemployment has been reflected in Fed
policies. The Fed observed that unemployment during 1995 fell below 6%, its allegedly natural rate.
Expecting inflation the Fed responded by increasing interest rates. Many economists and theorists,
however, challenge the Fed’s action. They argue that there are no inflationary pressures.
Globalization of the world economy has kept increased competition, keeping prices and wages
increases in check. Hence, raising interest rates is unnecessary.
Money Makes the World Go Round 129
Review Questions
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
Define or discuss the following:
A.
functions of money
B.
barter
G.
tools of the FED
C.
advantages of money
H.
relation between bond prices
D.
M-2
and interest rates
E.
Liquidity
I.
quantity theory of money
F.
Federal Reserve
J.
Natural rate of unemployment
Explain how the FED can expand or contract the money supply using open market
operations.
Explain the quantity theory of money.
What is the monetarist explanation of the Great Depression?
How do the monetarists explain inflation?
From the monetarist perspective what is the proper role of government?
Explain the theory of rational expectations.
Explain the recent decisions of the Fed to increase interest rates are based on the concept of
the natural rate of unemployment?
Chapter Twelve : Budget Deficits and Balanced Budgets
“Great nations are never impoverished by private, though they sometimes are
by public prodigality and misconduct.”
Adam Smith
“Experience since the mid-1960s shows that massive government deficits . . .
increase the robustness of the financial system. That is, in the modern economy
the job that was done by deep depressions can be accomplished without the
economy going through the trauma of debt deflation and deep depression.”
Hyman Minsky
The role of government has changed profoundly in a hundred years. These changes reflect a
change in social values. Since the Great Depression government leaders have become more willing
to intervene in the economy. Until the depression, fiscal policy--the government’s power to tax and
spend--was used to finance wars, not to reduce unemployment. Politicians were committed to
balanced budgets except in times of war. Aside from war pensions, expenditures for social programs
did not exist. The primary source of revenue in the nineteenth century was from land sales and
tariffs. The income tax was not enacted until 1913 with the passage of the sixteenth amendment.
Following the prescriptions of the classical economists, government’s role was that of an umpire.
Make sure the rules are followed, but do not interfere in the game.
During the nineteenth and early twentieth centuries depressions were a common part of the
American landscape. Depressions were viewed as something unpleasant but necessary. Bankrupt
businesses became fodder for new businesses. The prevailing wisdom, reflected in the prescriptions
of classical economics, was that the economy would take care of itself. The Great Depression
proved otherwise.
Since the 1930s depressions have become politically unacceptable. People want security.
Business and consumers alike embrace laissez faire when incomes are rising; when incomes fall they
want bailouts. The market giveth, but don’t let the market taketh away.
Achieving economic security, however, means abandoning laissez faire. With the
employment act of 1946 government assumed responsibility for managing the economy. The search
for theories to manage the economy gave rise to macroeconomics. The primary policy tools of
macroeconomics are fiscal and monetary policies. For the most part fiscal policy has been guided by
Budget Deficits and Balanced Budgets 131
Keynesian-economic theory (demand oriented). During the Reagan-Bush administrations, however,
the theoretical basis of fiscal policy was supply-side economics (supply oriented).
Historical Background
As noted, the Great Depression meant the abandonment of laissez faire policies with regard
to fiscal matters. Herbert Hoover sought to help businesses in order to help the poor. Roosevelt
resorted to employing the poor directly. The Work Progress Administration (WPA) established in
1935 represented the government's effort to put Americans to work.
5%
0%
40
45
50
55
60
65
70
75
80
85
90
-5%
-10%
-15%
-20%
-25%
-30%
Despite efforts to bringFigure
the economy
out of
Roosevelt
28: Deficits
asdepression,
a Percentage
of GDPremained committed to
balanced budgets. In 1936 the government inadvertently ran a deficit. The Roosevelt administration
reacted by cutting spending, sending the economy into a downturn. When World War II erupted,
any reservations about deficits fell by the wayside. Government spending increased dramatically,
effectively ending the depression. Deficits soared to twenty eight percent of GDP, compared with
2% today. Government consumed 50% of the nation's output, compared with 33% today.
Following the war many economists expected the military cutbacks to reinitiate the
depression. Consumers, however, quickly picked up the slack. With little to buy during the war,
people saved. After the war people used their savings to go on a buying binge purchasing homes,
cars, and baby things. The economy, along with the population, boomed.
95
132 Budget Deficits and Balanced Budgets
The twenty years following WWII has been referred to as the golden age of American
Capitalism. Corporate profits were high, interest rates were low, unemployment was low, and
inflation was low. There was little competition from foreign countries, for their economies had been
destroyed. Given that the economy was doing so well, there was no attempt during Truman’s (19451952) or during Eisenhower’s (1952-1960) terms in office to implement Keynesian ideas.
The first implementation of Keynesian theory came with the Kennedy-tax cut of 1964. The
underlying rationale was that a tax cut would stimulate consumer spending, thereby raising national
income. The increase in national income would in turn increase tax revenues, leaving the deficit
unchanged. Taxes were cut, the economy grew, and the deficit increased slightly just as the theory
predicted.
During Johnson’s administration (1963-1968) the economy began to “over heat”. Johnson
sought to fight two wars: the war on poverty and the war in Vietnam. Both wars relied in part on
deficit spending financed by printing money. The result was an increase in inflationary pressures.
Inflation continued to increase during Nixon’s term in office (1968-1974), aggravated by a four-fold
increase in the price of oil in 1974. By the late 1970s the nation was experiencing a new kind of
phenomenon: stagflation. Stagflation is the worst of both worlds characterized by rising inflation
and rising unemployment.
Stagflation presented a dilemma to policy makers. To reduce inflation using Keynesian
theory meant reducing aggregate demand either through raising taxes or cutting government
spending. But this in turn meant higher unemployment. Conversely, reducing unemployment meant
increasing aggregate demand through cutting taxes or increasing government spending. But this in
turn meant higher inflation. By the time Ronald Reagan took office in 1981, interest rates were at a
historical high: 21 percent, inflation was 13 percent, unemployment was around 8 percent, and
productivity was declining.
Supply-Side Economics
Supply-side economics was Ronald Reagan’s answer to the apparent inability of Keynesian
theory to deal with stagflation. Reagan’s purpose was to create a revolution in government the likes
of which had not occurred since Roosevelt. Government is not the solution to the economy’s
problems; rather, government is the problem. Reagan sought to resurrect the American economy by
cutting taxes, eliminating unnecessary regulations, decreasing social spending, and increasing defense
Budget Deficits and Balanced Budgets 133
spending. Reagan promised that his policies would do what Keynesian economics could not: lower
inflation, lower unemployment, increase productivity, and balance the budget by 1984. Rather than
focusing on manipulating aggregate demand, supply-side economics sought to manipulate aggregate
supply.
Reaganomics echoes classical economic theory. The way to help the poor is by making
business more profitable. And this means cutting their taxes, primarily the taxes of those in the
upper income brackets.
Assumptions
The assumptions underlying Reagan’s economic program differ markedly from that of
Keynesian economics. Supply-side economics assumes the following. First, it assumes tax rates are
too high. Tax rates are stifling incentives to save and invest. Lower tax rates means more savings,
which in turn means more investment. Moreover, the declines in tax rates give individuals an
incentive to work longer since they retain a greater share of their income. The cut in taxes would
unleash an amount of stored up energy unprecedented in the American economy. The resulting
increase in national income would be such that tax revenues would increase, thereby allowing
Reagan to pay for the military buildup and balance the budget.
120
AD
AS
AS'
Price Level
100
80
60
a
40
b
20
0
0
20
40
60
80
100
GDP
Figure 29: Supply-side Economics
Second, supply-side economics rests on Say’s law, the doctrine that supply creates its own
demand. The corollary is that savings equals investment, hence if saving increases so too does
120
134 Budget Deficits and Balanced Budgets
investment spending. Since the rich save more as a percentage of their income than do the poor, tax
cuts are directed primarily at the wealthy.
The
logic
underlying
Reagan’s
economic program is this. By cutting tax rates,
savings increases, which in turn increases
investment. The increase in investment causes
the aggregate supply curve to shift to the right;
that is, it increases the quantity of goods and
services sold on the market. Hence, both
employment and GDP rise which in turn leads
to an increase in tax revenues. The graph
shows the impact on GDP and the price level.
By shifting the aggregate-supply curve to the
right, the economy moves from point a to
point b. GDP increases and the price level falls,
hence the name supply-side economics.
Implications
In a manner of speaking supply-side economics worked, but not in ways intended.
The economy sustained a period of economic
growth for seven years from 1982 to 1989,
although growth averaged an anemic 2-3%.
Inflation declined, but not as a result of fiscal
policy but monetary policy. The Fed-induced
An Alternative to the Income Tax:
A Consumption Tax
Supply-side economics rested on directing
its tax cuts to those save. Pat Buchanan, columnist
and former presidential candidate, wants to take
supply-side economics one step further. Buchanan
proposes abolishing the income tax. In its place he
advocates imposing a 16% national sales tax.
The idea underlying this proposal is
straightforward: tax consumption and encourage
saving. With a 16% tax increase many consumers
would think twice before purchasing the product.
Hence, consumer spending would probably
decline.
What are the advantages of such a
proposal? First, saving resources by abolishing the
IRS. The tax could be collected using the current
apparatus for collecting sales tax. Second, many
individuals avoid paying income taxes because
their incomes derive from illegal activities. A 16%
sales tax would force them to pay taxes on their
boats, cars, planes, and so on.
What are the disadvantages? The most
obvious is that those who spend the greatest
percentage on their income on consumption will
bear the greatest burden of the tax, namely the
poor. Hence, as a super sales tax the consumption
tax is regressive. In fairness to Buchanan, however,
he advocates some measures to mitigate the
impact on the poor. The tax burden on the rich
would decline substantially.
recession of 1982 successfully brought inflation to a screeching halt. Unemployment has come down
since the early 1980s, but it remains high compared to the 1950s and 1960s.
Despite the problems, what happened? Was supply-side economics successful? Supply-side
economics was supposed to eliminate deficits. In fact, it took the deficits to new heights. From a
Keynesian perspective, supply-side economics worked by stimulating aggregate demand by running
the large deficits.
Budget Deficits and Balanced Budgets 135
Debt and the Deficit
The tendency towards deficit spending has been reinforced by two factors: war and the
demand for economic security. In some sense changes in society's values are reflected in changes in
the government budget. The graph below indicates these changes. During WWII spending on
military comprised 80% of the budget. The United States continued to spend more than 50% of the
budget on military until the 1970s. At the same time, expenditures on Social Security, income
security, and Medicare have increased dramatically.
Government Expenditures as a Portion of the Budget
100%
Other
80%
Social Security
60%
Income Security
International
Affiars
Medicare
Health
40%
Defense
20%
Net Interest
Millions of Dollars
Figure 30: Changes in Government
Expenditures over Time
1995
1990
1985
1980
1975
1970
1965
1960
1955
1950
1945
1940
0%
136 Budget Deficits and Balanced Budgets
In general, efforts to provide economic security have been financed through deficits. The
deficit is government expenditures in excess of tax revenues. What does government spend its
money on? At present, government spends most of its money on social services: about 47% of the
federal budget. This includes social security, welfare, and so on. About 20% of the budget is spent
on defense. 22% of the budget goes to pay interest on the government debt. If social spending and
defense expenditures are considered necessary there is really not much left over. Cutting the budget
becomes extremely difficult, because there are many things that people want: national parks, national
forests, meat inspections, education, transportation, and so on. Moreover, cutting the budget is a
politically wrenching process. Remember that one person’s expenditures are another person’s
income. Whose income does the government cut?
Social
Spending
48%
Defense
20%
Other
5%
Education
2%
Transp.
3%
Interest on
debt
22%
Figure 31: Government Expenditures
What about taxes? Most of the tax revenue comes from individual income tax, followed by
social security taxes. Corporate income taxes account for only 11% of the tax revenue.
When tax revenue is insufficient to cover expense government must borrow. The difference
between tax revenue and expenditures is the deficit. The last time the government ran a surplus was
1969.
Budget Deficits and Balanced Budgets 137
The debt is the accumulated deficits and surpluses since George Washington’s
administration. In the past 12 years, the debt has quadrupled; as a percentage of national income the
debt has doubled. The deficit is 5 times larger for 1992 than in 1979. Presently, the deficit represents
22% of federal spending, 40% of income tax revenues, and 6% of national income.
Is the debt inherently bad? Will it eventually spell the demise of the American economy?
What can be done?
There are three different perspectives on the current debt situation. First, conservatives
contend that increases in debt hurt the economy. They argue that rising debt burdens future
generations who will have to pay for it. Paying for our excesses means less future investment and
less for future consumption.
Second, others contend that focusing on the debt alone is misleading. You must also look at
the assets, things of value that theoretically could serve to payoff the debt. Our public lands, our
military hardware, publicly-owned resources, and so on could be used theoretically to payoff the
debt.
And third, others argue that what is how the debt is used. Incurring debt to finance a luxury
cruise is not the same as incurring debt to finance education. Money used to finance a cruise is gone
forever; but money used to finance investment repays itself many times over. How the debt is used
is critical for evaluating its impact. The problem during the 1980s is that none of the debt was used
to invest in America. It was used to pay interest on previous debt, to finance the Reagan military
buildup, and to bail out the Savings and Loans.
Solving the Debt Problem
The problem is not so much the size of the debt, but the interest payment on the debt. As a
130%
percentage of GDP interest on the debt is rising, twice as large today as in 1946. Moreover, the
110%
interest
on the debt tends to redistribute income from those who pay taxes but own none of the
debt to those who own the debt.
90%
As noted, government expenditures, in some sense, represent the values of our society; more
70% they represent the values of those who influence the political process. To reduce the
specifically,
deficit and restore our economy requires realigning the political interests, and rearranging our
50%
priorities. It’s too early to tell if this will occur.
30%
10%
-10% 40
Government
GDP 85
45 Figure
50 32:55
60 Debt
65 as a70Percentage
75 of80
90
95
138 Budget Deficits and Balanced Budgets
Bill Clinton’s strategy in reducing the deficit was twofold. First, Clinton proposed to raise
taxes on those in the upper income brackets. Second, Clinton attempted to reign in some of the
costs partly by slowing the growth of Medicaid and Medicare, and with the cooperation of the FED
by lowering interest rates. Lower interest rates reduce the costs of financing the current debt. Hence,
lower interest rates reduce the interest payment on the debt Approximately 45% of the increase in
the debt between 1980 and 1991 represented borrowing to pay interest on the debt.
At present, the deficit is approximately 150 billion dollars. The reduction in the deficit has
been dramatic. Clinton has benefited greatly from a booming economy, which increases the tax
revenue, while reducing the government's need to support the unemployed.
Prospects for the Future
No one can predict the future. At best, we can only look at current trends, and extrapolate
them into the future. But things can and do change quite suddenly, proving the best of predictions
false.35
There are, however, some positive trends that bode well for the economy. First, since WWII
unemployment had been steadily rising until a few years ago. At present, unemployment is around
5%, a figure that most economists consider full employment. The unemployment rate, however,
does not reflect the discouraged workers who have dropped out. Nor does it reflect increases in
inequality that have occurred, nor the shift to lower-paying service sector jobs. Second, the
productivity (output per hour) of the American workers had been declining. But for the past several
years productivity is once again rising. Increases in productivity are critical, for it means that workers
income may rise without having to raise prices. The median income for workers in the United States
was the same in 1990 as it was in 1974, leading one economist to refer to this time period as a “silent
depression”.36 But median incomes are once again on the rise. Third, personal saving for Americans
has been declining along with investment. And if this continues, growth in the future will continue
to be sluggish. Moreover, manufacturing jobs continue to decline, and service-sector jobs continue
to rise. Historically, however, manufacturing pays better than service jobs. These, of course, are side
from the problems of over-population, pollution, and crime.
35
Ben Franklin is credited with saying that the only things one could rely on with some certainty are death and taxes.
36
Wallace C. Peterson, "The silent depression," Challenge 34, no. 4 (1991): 29-34.
Budget Deficits and Balanced Budgets 139
There are other promising trends. The cold war has ended, and with it has ended the
prospect of global suicide. Moreover, the ensuing peace dividend gives us the potential to reallocate
resources to address some of the pressing problems mentioned above. But many members of
congress continue to refuse cutting the military, for fear that bases in their district might be cut.
Managing the macroeconomy is at best difficult, perhaps impossible. Our leaders cannot
control unemployment, output, and the price level. But they can influence them, albeit sometimes in
ways unintended. The value of macroeconomic theory, however, lies in understanding the ideas
upon which our leaders base their policies, and understanding how those policies affect us. Such
policies are too important merely to leave to the politicians or to the economists. For as Keynes one
said,
the ideas of economists and political philosophers, both when they are right and
when they are wrong, are more powerful than is commonly understood. Indeed the
world is ruled by little else. Practical men, who believe themselves to be quite exempt
from any intellectual influences, are usually the slaves of some defunct economist.
Madmen in authority, who hear voices in the air, are distilling their frenzy from some
academic scribbler of a few years back. I am sure that the power of vested interest is
vastly exaggerated compared with the gradual encroachment of ideas.37
37
Keynes, The General Theory of Employment, Interest, and Money, p. 383.
140 Budget Deficits and Balanced Budgets
Review Questions
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
IX.
X.
XI.
Why did the era of laissez-faire capitalism fail?
Discuss the various ways in which Keynesian economics has been implemented?
Identify the assumptions underlying supply-side economics.
What is the historical backdrop to supply-side economics?
Explain the rationale underlying supply-side economics. Use graphs.
How is Buchanan’s proposal of a consumption tax consistent with supply-side economics?
How might Keynes respond?
What impact did supply-side economics on:
A.
income distribution
B.
debt and the deficit
What is the difference between the deficit and the debt?
Discuss some of the arguments regarding the positive and negative aspects of the federal
debt.
What is Clinton’s plan to reduce the deficit?
What is meant by “silent depression?”
Chapter Thirteen : International Trade and Development
“By preferring the support of domestic industry to that of foreign industry, he
intends only his own security; and by directing that industry in such a manner
as its produce may be of the greatest value, he intends only his own gain, and he
is in this, as in many other cases, led by an invisible hand to promote an end
which was no part of this intention."
Adam Smith
Since its inception in the 16th century capitalism has been a world economic system, a system
characterized by a unified economy with differing political units.38 The contradiction posed by a
unified economy with different governments has often manifested itself in war. At present, with the
demise of the Soviet Empire the threat of war has diminished. Political stability, the emergence of new
technologies that have lowered the costs of transportation and communication, and the rise of the
industrial powers in Asia have laid the basis for a new era for capitalist system, the emergence of global
capitalism.
An indicator that we have entered a new era is that the level of international trade among
peoples of different nations is without precedent in world history. Half of the vegetables we
consume come from Mexico. Much of the oil that we depend upon comes from the Middle East,
Venezuela, or Mexico; many of our textiles are made in Taiwan; computer parts are made in Japan,
Korea, or Singapore. Many automobiles and their parts are made elsewhere. Even pollution is not
immune. We export car batteries and scrap metal to Taiwan; And Britain, which has no autoemission standards, exports its pollution via the Westerly winds to Central Europe only to fall as
acid rain.
The slogan, "buy American," is almost impossible to follow. America has become a service
economy. Manufacturing is declining, as industry moves overseas in search of cheap labor.
Meanwhile, domestic labor--which historically has found well-paying jobs in steel, automobile, and
other industries--must look elsewhere. Many Americans face prolonged unemployment, low-paying
jobs, and fewer benefits.
What is the best policy with respect to our trading partners? In light of a declining industrial
base, the export of American jobs, and a mounting trade deficit, is free trade the best policy? Or
should we do more to protect jobs at home? What is the argument if favor of free trade?
38
In contrast, an empire is characterized by a unified economy with a one political unit.
142 International Trade and Development
Free Trade: The Theory of Comparative Advantage
The argument in favor of free trade is found in Adam Smith's invisible-hand doctrine, the
doctrine that each individual freely pursuing his or her own self-interest involuntarily promotes the
interest of all. David Ricardo provided a formal proof of the invisible-hand doctrine in his theory of
comparative advantage.39 Trade Ricardo argued is based on comparative advantage, not absolute
advantage.
England
Portugal
Wine
Cloth
80 hrs (1 case of wine costs 80 hours) 60 hrs (1bolt of cloth costs 60 hours)
20 hrs (1 case of wine costs 20 hours) 40 hrs (1 bolt of cloth costs 40 hours)
Table 9: Absolute Costs
Absolute advantage is defined as a situation in which one party produces a good with fewer
resources than another. For example, in the table below it takes Portugal fewer hours to produce a case
of wine than England.
Comparative advantage is defined as a situation in which the opportunity cost of producing
a commodity is less for one party than another. Comparative advantage focuses on the tradeoffs
involved in production. For example, in the table below to produce a bolt of cloth means that both
countries must forgo producing some wine. The country that gives up less wine than the other has a
comparative advantage. England producing a bolt of cloth gives up less wine than Portugal.
Producing one item means foregoing producing another. Countries and individuals trade
those things that it costs them less to produce. Hence, it becomes advantageous to trade, even if the
other party can produce the item as fast. The table below illustrates our points.
Table 10: Comparative Costs
Even though Portugal has an absolute advantage in producing both commodities, Portugal
has a comparative advantage in only one commodity: wine. In turn, England has an absolute
disadvantage in producing both commodities, yet England has a comparative in producing cloth.
Hence, both countries will find it in their self-interest to specialize in that commodity in which they
have a comparative advantage, and engage in trade.
39
David Ricardo, Principles of Political Economy and Taxation (New York: Everyman's Library), 1911.
International Trade and Development 143
England, specializing in cloth, will reallocate the 80 hours formerly used in wine production to
Cost of one case of Wine
Cost of one bolt of Cloth
in terms of cloth
in terms of Wine
England 80/60 = 1.33 (1 Case of wine costs 1.33 bolt
60/80 = 0.75 (1 Bolt of cloth costs .75
of cloth)
units wine)
Portugal 20/40 = .5 (1 case of wine costs 0.5 bolt of
40/20 = 2.0 (Bolts of cloth costs 2
cloth)
cases wine)
cloth production. Since 140 hrs are now allocated to producing cloth, and it requires 60 hours to
produce 1 bolt of cloth, cloth production will increase to 140/60=2.33.
Portugal, specializing in wine, will reallocate the 40 hours formerly used in cloth production
to wine production. Since 60 hrs are now allocated to producing wine, and it requires 20 hours to
produce 1 case of wine, wine production will increase to 60/20=3.
Both countries specializing in producing that commodity in which they have a comparative
advantage causes total world production to increase, benefiting both countries. Their self-interest to
specialize in that commodity in which they have a comparative advantage leads to an increase in
output, thereby benefiting both countries.
What happens if one country has an absolute advantage in producing all commodities? Even
if a country can produce all things with fewer resources, trade remains advantageous. The manager
may be able to type faster and better than her secretary. But does this mean the manager should
type? No. She should focus on other matters that yield a higher return, and allow the secretary to
type.
The theory of comparative advantage is the corner stone of the free-trade argument.
Individuals and countries always have the option of producing the goods themselves. No one forces
them to engage in trade. They do so presumably because it costs them less to trade than to produce
the item themselves.
Fair Trade
Since the end of World War II the United States has generally embraced the doctrine of free
trade. There are of course exceptions. Protection was extended to the garment industry, and recently to
the automotive industry. But for most items free trade has been the guiding principle.
It is not coincidental that our commitment to free trade served our interests. At the end of
World War II the only industrial power with its economy intact was the United States. And while the
United States provided much aid to the rest of the world, much of this aid flowed back into the
144 International Trade and Development
United States in the form of purchases of goods and services. As the only player with goods to sell,
free trade benefited our economy.
The world, however, has changed. Japan and Germany have emerged as major economic
powers. To develop their economies Japan and Germany protected their domestic markets, actively
financed the development of their industries, and aggressively marketed their products in the United
States. In the early 1980s, the United States trade surplus became a trade deficit. The value of goods
and services we purchased abroad exceeded that which foreign countries purchased from us. Our
imports are their exports. Importing goods made abroad helped fuel the booming economies of
Japan and Germany. The policy of free trade has made our markets accessible to other nations,
while their policy of protection has made their markets largely inaccessible.
In a world in which trade is protected is free trade the best policy? Is not free trade always
the best policy? What are the arguments in favor of protection?
There are a number of arguments in favor of protection. First, we must produce some
commodities domestically for purposes of national security. Imported F-16 fighters and M-1 tanks
would give the enemy the ability to undermine our ability to protect ourselves. Hence, such an
industry or work force must be protected.
Second, infant industries must be protected. Such industries are too small to compete
internationally, and need some protection. Protection is extended until such industries become
sufficiently large so as to take advantage of economies of scale, that is, until they can reduce their
per-unit costs to compete. Today, those who make this argument have altered the tune. American
industry has fallen behind. To compete effectively they need protection so that they might introduce
innovations that would allow them to compete effectively.
Third, protection is needed to reduce unemployment, in effect inducing domestic citizens to
"buy American" rather than foreign products. Imports decline and the demand for domestic
products increases. Domestic unemployment falls, but unemployment may rise in foreign countries.
In effect, protection enables the domestic country to shift its unemployment to another country.
Efforts to reduce unemployment in the 1930s led to the Smoot-Hawley tariff bill. The bill
raised tariffs over 140%. The policy would have worked, except that our trading partners retaliated
by raising their tariffs as well. The result was that would trade declined, with all nations losing.
Fourth, and perhaps the most persuasive argument in favor of protection is the fair trade
argument. The fair-trade argument asserts that free trade is preferred. But if one nation is trading
International Trade and Development 145
freely and the other is not, the latter has an unfair advantage. Hence, the fair trade arguments is one
that favors establishing protectionist measures as a means of inducing foreign countries to open up
their markets. To engage in free trade in a world where other countries are not playing by the same
rules is to play the role of a patsy.
The balance of trade, also known as the trade balance, refers to the difference between
exports and imports. That is, the trade balance refers to the difference between the value of the
goods and services that we sell to other countries, less the value of the goods and services that we
buy from other countries. If exports exceed imports, the trade balance is in surplus, and if exports
are less than imports, the trade balance is in deficit.
In theory, while a country may for a time run a balance of trade surplus or deficit, this
cannot continue indefinitely. In the nineteenth century surpluses or deficits were settled using gold.
Gold served as the universal money, the money that all other currencies could be converted into.
Hence, if the United States has a balance of trade deficit, foreigners receive dollars for the goods
sold here. These dollars would then be redeemed for gold, which would be taken back to the home
country. Hence, a balance of trade deficit results in a flow of gold from the United States to the
foreign country. The contraction of the domestic money supply in turn results in a decline in prices,
making US goods more attractive. Theoretically, imports would fall and exports would rise resulting
in a trade balance.
A gold standard represents a fixed exchange rate. Following WWII we continued to have a
fixed exchange rate established by the Bretton Woods agreement, but trade imbalances of the late
1960s and early 1970s led President Nixon to allow the dollar to float. This means that the value of
the dollar expressed in other currencies fluctuates, depending on supply and demand for dollars.
14%
12%
10%
8%
6%
4%
2%
0%
1930
35
40
45
50
55
60
65
70
Years
Imports
Exports
75
80
85
90
95
146 International Trade and Development
Supply and demand for dollars, however, is affected by a number of variables that may for a time
not allow exchange rates to adjust. These variables may include interest rates, tastes and preferences,
income, and so on.
The trade balance for the United States is presently in deficit, meaning that we are importing
more than we are exporting. In part, this is the result of high interest rates in the US in the early
1980s. High interest rates increased the value of the dollar relative to other currencies. The reason:
high interest rates attract speculators to invest in US government assets because they yield a higher
rate of return. Hence, speculators bid up the value of the dollar. As the dollar appreciates, foreign
goods became cheaper in terms of dollars, and domestic goods become more expensive in terms of
foreign currencies. This resulted in a decline in exports and an increase in imports. The resulting
trade deficit is the first since before W.W.I. How long can this continue? Is there a point at which
foreigners will refuse to lend us money? Or will they continue to loan us money in exchange for
"owning America?"
Development:
Following WWII many of the so-called third world nations chose to follow the Western
road to development. This meant large, capital-intensive industries. But third-world nations neither
had cultural heritage of the West, nor the financial resources. Third world nations are characterized
by a dual economy: a market economy and a traditional economy in which many people did not
depend on the market for their needs. They produced the goods themselves: they made their own
clothes, produced their own food, and so on. The dual nature of many third-world economies meant
that these peoples could be paid far less than their counterparts in the West, who depend on the
market to fulfill virtually all their needs.
Second, introducing capital-intensive industries meant employing few people. In fact, such
industries displaced many. The result was that industrialization in the 1950s and 1960s did little to
alleviate the problem of unemployment or underemployment.
Third, in many cases the introduction of Western-style developments have in fact created
what Vandana Shiva characterizes as maledevelopment. In a country as densely populated as India
the development of dams or the construction of power plants means displacing people. Hence,
villages are removed or farms flooded to make way for the new development. In effect,
development requires destruction of the forest, the land, or the rivers. This amounts to separating
International Trade and Development 147
the means of production form the people. In order to live, the people must now sell their labor in
the open market. Hence, the people become worse off than before. Development at one end means
maledevelopment at the other.
In the West we associate poverty with a lack of material goods. The Indians are poor by
Western standards. But they belong to a rich network of social relations. The have the support of
their family, extended family, and the village. Western style development, insofar as it requires
removing the means of production, means breaking up the social bonds. Hence, the people become
actually worse off than before.
The world, however, has chosen the Western path to social development. But is this
possible? Is it possible that all the peoples of the world can live at the same standards as that set by
the West? At present the US comprises 3% of the world population, yet consumes 30% of the
world’s income. Are there sufficient resources for the entire world to live at our standard?
148 International Trade and Development
Review Questions
I.
II.
III.
IV.
In brief, what are the arguments for and against free trade?
Define exports, imports, and the trade balance. What has happened to the trade balance in
recent years? Why?
Define comparative and absolute advantage.
Given the following:
Absolute costs of producing of producing 1 case of
wine and one bolt of cloth in terms of labor hours
Wine
Cloth
A.
Which country has an absolute advantage in England
50 hrs
50 hrs
the production of cloth? In the production of wine?
30 hrs
Portugal 20 hrs
B.
Which country has a comparative advantage Table 11: Absolute Costs
in the production of cloth? In the production of
wine?
C.
Is there a basis for trade?
D.
What is world production before trade? After trade?